This is a thought experiment, so bear with me.
I have written repeatedly how I felt that the U.S. Government’s plans to save the banking system were not adequate in the face of a severe capital shortfall in banking.
On one level, I cannot understand the seemingly blinkered view now being taken in Washington by the Obama Administration. However, I do have immense respect for the intelligence and experience of the Obama economic team, which includes Tim Geithner, Christina Romer, and, critically, Larry Summers.
Summers is nominally the Director of the White House’s National Economic Council for President Barack Obama. But, I imagine he has much more influence given his experience in government and finance. Therefore, I have decided to take a different tack and write a post as if I were Larry Summers thinking out loud and laying out a plausible and logical framework which underpins the banking plans of the Obama Administration.
What follows is me channeling my inner Larry Summers. I hope to conclude with some closing thoughts after I step ‘out of character’ and review what my inner Summers has written.
Last year, we witnessed a breakdown in the fabric of the global financial system of a severity that few have anticipated. To be sure, there are those who had prognosticated a calamity of this type. Yet, the large majority of us in economics, finance and government simply did not imagine anything as severe as we have witnessed.
The question I asked myself before taking on my present role is this: Can I help the President restore full confidence in our banking system with a minimum of cost and a minimum of government intervention, cognizant of enormous political constraints. I believe I can. In order to do so, I have to lay out a mental map of what my key assumptions about the global financial system and deflationary environments are and what the key political and legal constraints are as well.
- The economy is self-equilibrating. That means I reject Hyman Minsky. It also means that market forces will naturally bring the (U.S. and maybe the global) economy into line over time. In the interim, some pretty terrible human suffering can take place, but the pain of recession/depression is temporary. Equilibrium will return.
- The natural course of the economy is up. Humans will continue to progress over time. We will use our intelligence to collectively become more productive, grow richer, and increase wealth. As a result, in most instances, time is our friend. We can grow our way out of economic difficulty.
- Government is necessary. The essence of government is to do for its citizens what they cannot do for themselves. In my view, one of those things is to ease (though not eliminate) the suffering associated with economic downturns. This means that it is necessary for government to intervene in periods of severe economic dislocation, not to right self-equilibrating markets, but to hasten the return to equilibrium.
- Government should be limited. By that I mean we must respect a healthy tension between the necessity of government and the limits of government. Government intervention, while often necessary, distorts market forces, and must, therefore, be limited. This certainly means that competitive, deregulated markets are preferable to over-regulation and anti-competitiveness. In finance, we probably got the regulatory mix wrong during the 1990s and that fostered an industry climate which contributed to excesses. This will change, but not in a way that will lead to over-regulation.
- Government stimulus is effective in a deflationary environment. It stops a potentially devastating deflationary spiral, eliminating worst case outcomes that result from dead-weight economic loss. Yes, this stimulus can pull demand forward or crowd out the private sector, both of which are bad. But, ultimately, the priority of government must be to end a deflationary spiral because of the attendant dead-weight loss it creates. (dead-weight loss being economic destruction that should not and would not take place in a non-deflationary environment).
- The U.S. banking system is fundamentally solvent and is suffering from liquidity problems. The last 25 years did see excess where the financial industry in the U.S. grew to outsized proportions. Asset prices rose too high. But, things have overshot. The U.S. is more productive and wealthier than at any time in the past. Our banking system should reflect this. However, liquidity constraints and asset price falls driven now by fear are making our system look weaker than it actually is.
- The checks and balances of democracy necessarily lead to a sluggish response in crisis. So be it. That is democracy in action. If I had the power to dictate, I might be able to fashion a financial crisis plan which would work. However, the legislative and judicial branches are going to slow what could be an optimal response by effecting the system’s necessary checks. It is incumbent upon the President to respond to crisis in a manner both respectful and cognizant of these constraints but using all available resources available to him.
- The government cannot fund itself with deficit spending ad infinitum. Contrary to what Dick Cheney claimed, deficits do matter. Debt is a claim on future income and an increase in these claims erodes future growth at the expense of current consumption. To the degree that government finances current expenses with debt — and not tax and income — we should expect an erosion of future growth. This fact sets up a tension between the need for government to spend in crisis and the erosion of future growth this spending might create. When push comes to shove, I choose deficit spending in crisis.
So given those assumptions and constraints, the question is how do we deal with this crisis. The first priority must be to forestall a deflationary spiral because that induces a dead-weight loss and extracts a cost of incalculable consequences. The best way for government to end the spiral is to temporarily increase spending or temporarily induce more private sector spending. Is this re-flating the bubble? No, because deflationary forces will continue to extract a price even with these measures in place. The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.
But, spending alone won’t get it done. Ultimately, we will need to increase credit availability. Just because people are spending more, does not mean the economy will grow. Growth depends critically on increasing credit in line with the growth of the economy.
I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing. The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government. What we need to do is put a number of government-assisted programs into play — cognizant of that healthy tension between limited government and necessary government — and get credit flowing this way.
Let me enumerate some mechanisms:
- First we should try bank re-capitalization. Our first priority must be to have an adequately-capitalized banking system. Absent that, increases in lending are impossible and the system will continue to be doubted. So that’s number one. We can do this through preferred equity so that the government is senior to common equity and receives some compensation for taxpayer money. What’s more is it limits government interference. Remember – most of these institutions are having temporary problems. With enough capital, they can weather the storm. There is no need for heavy-handed government interference.
- If re-capitalization proves inadequate because of depreciated legacy assets, we will need to remove those assets from banks’ balance sheets in a way that promotes price discovery, increases asset liquidity and respects the tension between government involvement and government’s limitations. The PPIP and TALF can help achieve this.
- Moreover, by allowing financial institutions to borrow with a government guarantee, we can ease the funding liquidity constraints as well.
Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.
Obviously, if these plans do not work out because the economy declines more than expected, we can always fall back to the more coercive, interventionist mode of nationalization. However, that is Plan B only – measures to be taken only if necessary.
I am confident these plans will work. We are already seeing some faint signs of recovery. Mind you, unemployment will continue to rise at a devastating clip. But, by the second half of 2009, we should see some many more signs of recovery and with all of these plans in place, the liquidity crisis will be recede into the past.
Stepping out of character
Whew. Now I can step out of Larry Summers mode and move back to Edward Harrison mode – I was starting to believe this stuff.
The truth is that I sympathize with the logic above. There is much to believe in the preceding paragraphs. In a best-case scenario, Summers would be right if this is the line he is taking.
But what about worst-case scenarios? Where I differ is the one line ” in most instances, time is our friend. We can grow our way out of economic difficulty.” The whole edifice depends critically upon that one statement. If this statement turns out to be false, the whole logical construct collapses. I prefer to go — as the Germans would say — “auf Nummer sicher (with the sure thing)” and not have my plan hinge critically on one potentially false assumption.
Time is NOT our friend. Time is our enemy.
- The economy will worsen considerably more. The stress tests indicate a worst-case scenario which is unrealistically optimistic. The necessary corollary of this statement is that the legacy assets which are already impaired will become more impaired. In a worst-case scenario, many institutions will be insolvent.
- Balance sheets will worsen because of commercial real estate loans, credit card loans and other real economy effects as well. This double whammy of deteriorating legacy assets and new asset impairments in a worst-case scenario will overwhelm the programs now in place.
- Political capital will be consumed over time. Americans will tire of this crisis. And, therefore, the natural checks and balances in the system will stymie further efforts. The legislative branch will re-asset itself in the government budget process and in the financial sector oversight process. The judicial branch will be called on to take issue with the turn of events. Obama is not going to get more stimulus. He is not going to get additional funds to re-capitalize banks. And he will not get a free hand in administering these programs already in place. Moreover, the Fed’s quasi-fiscal role will cause a backlash from Congress and risk its independence.
I have other objections but this post is getting much too long in the tooth. So I will leave it to you to make others.
What worries me is that behind Summers’ (and Geithner’s) calculus is a belief that the system is fundamentally sound and that we should not upset the cart. In my view, the last 25 years of U.S. growth have rested mostly on the creation of debt in complete disproportion to the economic growth the debt has engendered. This has meant we have consumed more in the last generation than we could possibly afford without cutting back our standard of living for at least the next generation.
Add in the belief that this is about asset prices overshooting to the downside and a banking system which is fundamentally sound and you have mental constraints which could prove catastrophically limiting.
I will have more to say about this in upcoming posts, but I do hope you enjoyed seeing the other side of the debate.