DeLong, "Policies that Might Work II-Banking" (May 12, 2009) by James DeLong

Policies that Might Work II: Banking Policy J. Bradford DeLong University of California at Berkeley and NBER brad.delong@gmail.com http://delong.typepad.com/ +1 925 708 0467 May 12, 2009

How Not to Analyze Banking-Side Policy Robert Lucas: I don't -- I don't know. I don't think you have to be fancy about the nature of economic growth in the real economy, which is what was Schumpeter's main interest, and I think Keynes was one of those who thought that when the interest rate was down to zero monetary policy was over and I think that's wrong. I think that's one of the things that Friedman and Schwartz showed. So I think it's a monetary stimulus of the sort that leaves doubt. I think Bernanke agrees with this. He's also very much concerned with somehow fixing up the banking system, which may be -- it's his job, but I -- I'm just talking about the -- getting the reserves out there as a stimulus to spending. I think we know enough to do that. Hope we do….

I avoided this bank bailout issue in my 15 minutes and there's a reason for it. I don't really get it. Some of the problems you're talking about about deciding who gets paid and who doesn't, that's the whole function of bankruptcy law is to deal with that in an effective way. Now, it may be that the kind of neighborhood effects of the bankrupt banks are sufficiently different from the neighborhood effects of a bankrupt auto company -- that they need some kind of special treatment. But then it seems like the right public policy is something that -- maybe some kind of accelerated bankruptcy proceedings. Just to say make them well on all the money they've lost over this thing, I just -- I do not get it and I know of -- I don't know whether we're headed that way or not. I hope not. Now, what was the first part of that? (Off mike exchange.) Oh, the differences with -- I did want to say something. I think Friedman and Schwartz have got a lot to tell us about the current situation. There's certainly plenty of differences between the '29 to '33 period and the present period besides magnitude, the whole role of who provides liquidity which was then more or less completely confined to cash and commercial bank deposits as, you know, partly because of the '70s inflation spilled out into the shadow banking system, which is, you know, unregulated and which the Fed has no special responsibility for. And so there's been a lot of improvising in that dimension. I said I was going to not deal with moral hazard. This is not the right time to worry about too big to fail, you know? What I'd say now is the failure of

the bank is going to cause spill over effects that deepen this recession and so on, it's now -- keep them alive. We're going to come out of this with a new regulatory structure, a new set of incentives and we're going to have to kind of start from scratch anyway. So in terms of you bailing out a bank and setting up incentives for the next 30 years for bank behavior, that's not what's going on right now I don't think…

How to Analyze Banking-Side Policy Jeff Sachs thinks that Obama banking policy is really lousy: Geithner and Summers have now announced their plan to raid the Federal Deposit Insurance Corporation (FDIC) and Federal Reserve (Fed) to subsidize investors to buy toxic assets from the banks at inflated prices… a massive transfer of wealth -- of perhaps hundreds of billions of dollars - to bank shareholders from the taxpayers (who will absorb losses at the FDIC and Fed). Soaring bank share prices on the morning of the announcement, and in the week of leaks and hints that preceded it, are an indication of the mass bailout at work. There are much fairer and more effective ways to accomplish the goal of cleaning the bank balance sheets…. [G]iant investment funds will be created to buy up toxic assets from the commercial banks…. For every $1 of toxic assets that they buy from the banks, the FDIC will lend up to 85.7 cents (sixsevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity…. The Federal Deposit Insurance Corporation (FDIC)

loans will be non-recourse….. The FDIC is giving a "heads you win, tails the taxpayer loses" offer to the private investors… lending money at a low interest rate and on a non-recourse basis…. With a little arithmetic, we can calculate the size of that transfer. In this scenario, the private investors (who manage the investment fund) will actually be willing to bid $636 billion for the $360 billion of real market value of the toxic assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders!… If the toxic assets actually pay out the full $1 trillion, there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion. Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion… both the TARP and the private investors break even…. The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the toxic assets in fact pay only $200 billion…. The investment fund then defaults on its debt to the FDIC…. From March 9 to March 20, the KBW bank index rose by 33 percent, while the overall Dow Industrials rose by only 11 percent, indicating how the rumors were especially good for the banks. This morning, bank shares across the board soared in value. Citibank has tripled in value since its low in early March. The value of the bailout dwarfs the

AIG and Merrill bonuses, but since the bailout is much less obvious than the bonuses, the public's reactions have been muted, at least at the start. The plan should not go forward on such unfair terms…. There are countless preferable and more transparent courses of action. The toxic assets could be sold at market prices, not inflated prices, making the bank shareholders bear the costs of the losses of the toxic assets. If the banks then need more capital, the government could invest directly into bank shares…. The process would be much fairer, less costly, and more transparent to the taxpayer. Take insolvent banks into receivership instead: a bailout needs a workout plan…. [T]he allocation of bank shares between the taxpayers and the current bank shareholders could be make contingent on the eventual value of the toxic assets, ensuring fairness between the shareholders and the taxpayers. What is the right discount for risk? The discount for duration has been driven to zero as central banks worldwide have flattened the intertemporal price system. There remain discounts for risk, for default, and for information. Sachs assumes that there are no discounts for risk and for information—that Wall Street is risk neutral. Hence the only reason why asset prices are below par values is default. Hence any policy to raise asset prices via intervention in the banking sector transfers money straight from the Treasury to the owners of bank assets. But if Wall Street is risk neutral, what possible justification could there be for something like the PPIP? If Wall Street is risk neutral,

then bond and stock prices are currently low because likelihoods of default and dividend cuts are extremely high—in which case we shouldn’t be hoping that asset prices will recover so that businesses can borrow: businesses simply shouldn’t be borrowing. We should be using fiscal policy to get us to full employment, but nothing else because asset prices are telling us something important. And if Wall Street is risk neutral, we might be able to understand Bernanke-Gertler “impaction” if nobody were willing to entrust their money to the banks, but that is not what is going on—the banks have enormous fortunes all tucked up into excess reserves. So what is the case for the PPIP? • • • •

The funds will operate on large enough scale to avoid the adverse selection problem… The funds will take risky assets off of the private sector’s books and onto the government’s, with its extremely low cost of capital. In the long run risk tolerance will recover to its normal levels—and the government will make a fortune. In the short run taking risky assets off the private sector’s books will diminish their supply and so raise their price.

Evidence that this is so? The strongest evidence that this is so comes from the stock market. Let’s look at the Graham Ratio again:

And at ten-year real stock returns as a function of the Graham Ratio:

Raise the Graham Ratio by 10%, and you lower the ten-year rateof-return by 0.6%. That is perilously close to full mean reversion within a single decade. This is, of course, driven by symmetry and extreme observations—that what went up came down and came down within a decade. Perhaps things don’t work out so neatly on the downside. Nevertheless, the regressions do tell us that stocks are likely to beat ten-year Treasury bonds by an average of 7.5% per year over the next decade—and beat short-term Treasuries by 9% per year or more. With a standard deviation of stock index returns of 15% at an annual frequency—well, at a ten year horizon that is a two standard deviation edge. I am the wrong person, however, to be defending Tim Geithner and company here. For I agree in the end with Keynes and Simon Johnson: Financial sophistication… • • • • •

Financial sophistication allows for rich fools to be separated from their money, which is then plunged into enterprise after the IBs take a 20% cut… Financial sophistication allows for a great deal of additional risk spreading—a great deal of mobilization of the collective risk-bearing capacity of the globe… Financial sophistication allows for the more easy assembly of positions for corporate control transactions (pluses and minuses here)… Financial sophistication allows for the pooling of savings to support large-scale enterprise… Financial sophistication enables the transformation of investments that are fundamentally long-term, fixed, and risky into investments that are short-term, liquid, and safe—almost al the time.

The other side: Keynes chapter 12 <http://www.marxists.org/reference/subject/economics/keynes/gen eral-theory/ch12.htm>: If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase…. Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market…. [W]hen he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation…. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism…. These tendencies are a scarcely avoidable outcome of our having successfully organised “liquid” investment markets…. The introduction of a substantial Government transfer

tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States. The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage… might be a useful remedy… this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma… the fact that each individual investor flatters himself that his commitment is “liquid”… calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment… The other side: Simon Johnson, “The Quiet Coup” <http://www.theatlantic.com/doc/print/200905/imf-advice>: The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emergingmarket crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time….

[T]he IMF specializes in telling its clients what they don’t want to hear…. [T]o IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions… the economic solution is seldom very hard to work out. No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis. Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their privatesector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy…. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs. Squeezing the oligarchs, though, is seldom the strategy of choice…. So the IMF staff looks into the eyes of the minister of finance and decides whether the government is serious yet…. In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging

markets…. In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling…. This is precisely what drove Lehman Brothers into bankruptcy on September 15…. But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive…. The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful.… Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent…. The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man)….

In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts…. [T]he American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country…. A whole generation of policy makers has been mesmerized by Wall Street…. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible…. The oligarchy and the government policies that aided it did not alone cause the financial crisis that exploded last year. Many other factors contributed, including excessive borrowing by households and

lax lending standards out on the fringes of the financial world. But major commercial and investment banks—and the hedge funds that ran alongside them—were the big beneficiaries of the twin housing and equity-market bubbles of this decade…. Stanley O’Neal, the CEO of Merrill Lynch, pushed his firm heavily into the mortgage-backed-securities market at its peak in 2005 and 2006; in October 2007, he acknowledged, “The bottom line is, we—I—got it wrong by being overexposed to subprime, and we suffered as a result of impaired liquidity in that market. No one is more disappointed than I am in that result.” O’Neal took home a $14 million bonus in 2006; in 2007, he walked away from Merrill with a severance package worth $162 million, although it is presumably worth much less today…. In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy…. Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own

terms, at a time when that behavior must change…. Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support…. To break this cycle, the government must force the banks to acknowledge the scale of their problems… the most direct way to do this is nationalization…. Nationalization would not imply permanent state ownership. The IMF’s advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process…. This may seem like strong medicine. But in fact, while necessary, it is insufficient. The second problem the U.S. faces—the power of the oligarchy—is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy. …. To paraphrase Joseph Schumpeter, the early-20thcentury economist, everyone has elites; the important thing is to change them from time to time. If the U.S. were just another country, coming to the IMF with hat in hand, I might be fairly optimistic about its future…. In my view, the U.S. faces two plausible scenarios. The first involves complicated bank-by-bank deals

and a continual drumbeat of (repeated) bailouts, like the ones we saw in February with Citigroup and AIG. The administration will try to muddle through, and confusion will reign…. Our future could be one in which continued tumult feeds the looting of the financial system, and we talk more and more about exactly how our oligarchs became bandits and how the economy just can’t seem to get into gear. The second scenario begins more bleakly, and might end that way too. But it does provide at least some hope that we’ll be shaken out of our torpor. It goes like this: the global economy continues to deteriorate, the banking system in east-central Europe collapses, and—because eastern Europe’s banks are mostly owned by western European banks—justifiable fears of government insolvency spread throughout the Continent. Creditors take further hits and confidence falls further. The Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off. A dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration’s current budget are increasingly seen as unrealistic, and the rosy “stress scenario” that the U.S. Treasury is currently using to evaluate banks’ balance sheets becomes a source of great embarrassment. Under this kind of pressure, and faced with the prospect of a national and global collapse, minds may become more concentrated…