In my training as an economist, I must admit, studying the Great Depression was barely on my radar. I have for some time wanted to read more about economic history. I found Chistina Romer’s speech to the Brookings Institute delivered today to be very educational in that vein, the essay for which can be read here. Maybe I’m just to much of an economics dork, but I also found the footnotes to be very helpful as well, as they contain many primary sources of scholarship and data I was unaware of. I cannot speak to the degree of bias or lack thereof in the speech, I would assume– given her status in the Obama Administration as one of his economic ad visors– she would hold back views she privately held that are in contrast to those of the Administration in general.
March 9, 2009
March 1, 2009
Ryan, recently wrote about the Broken Window Fallacy, and was wondering whether the Administration’s policy of continuing to inject capital into illiquid or potentially insolvent banks is analogous. Although his skepticism is warranted, the current bailouts are different in several respects, but also shares some commonality.
Let’s take the Broken Window example. The winners are the glazier and those transactions downstream of the glazier (multiplier off the glazier new found income). The losers are the storekeeper (he is less well endowed by the cost of a window) and those who would have supplied goods or services to the shopkeeper had he not had to spend it on the window instead (and multiplier effect of therein). Assuming the multiplier effect is the same in both cases, society’s total welfare is reduced by the cost of the broken window. The broken window parable demonstrates that society is always made worse by a coercive or violent act (in other words an asymmetric transaction). By definition such a transaction can not be pareto improving.
So let’s take apart the banking transactions. The banking transactions are more subtle and nuanced. To start, there is significant information asymmetry. The banks have a much better understanding of their capital needs than the government and certainly better than the U.S. citizen. This is one of the reasons for the so called “stress tests”. The government has been injecting capital into the banks by giving cash in exchange for preferred stock. In many ways the preferred stock is equivalent to a high yield coupon bond. The terms of the preferred stock for most of the transactions were 5% dividend payments for the first 5 year followed by 9% thereafter. The preferred stock can be retired by the financial institution after 3 years if it is repaid after raising an equal or greater amount through equity stock offering made in the private sector. The CBO calculated the “subsidy” to the banks that these funds represent. The overall weighted average subsidy was 26%. My understanding of the calculation is that it was a probability of ruin calculation (cost if the bank eventually defaults times the prob. of default) and a present value calculation of the below standard terms of the dividend payments calculated using a discount rate equivalent to that used in commonly traded preferred stock for that company or industry. If you want to read more about these transaction the CBO released an analysis of the TARP here. I consider it to be fairly unbiased and thorough, although somewhat out of date at this point (End of Dec.)
So that’s a lot of background on the nitty gritty, but how can we relate this to the Broken Window. Who would be the victim of the Broken Window in this case. What Ryan had a hard time putting his finger on, and for good reason, is the victim is not a single person, but rather the entirety of American taxpayers. As the analysis of the TARP indicates there is a subsidy rate of approximately 26% of the $350B spent through December, which is $91B. That being said, more TARP funds have been dispersed since December and more will likely be dispersed in the future. One of the key learning from the Broken Window is you must think about the counter-factual or said differently the opportunity cost, consider both costs and benefits.
There are several options as I see them.
- Do Nothing
- Keep propping up banks by buying preferred shares
- Bankruptcy proceedings through receivorship
Doing nothing is potentially cataclysmic as financial intermediation would come to a grinding standstill. In that case the Quantity theory of money (which really should be referred to as a law, as it is a tautology) would predict a severe contraction in the economy.
Buying preferred shares is unequivocally a subsidy to poorly managed banks. The subsidy is at taxpayer expense. This is the prototypical broken window, except the window is already broken, now we are stuck deciding whether or not to fix the broken window. As with the shopkeeper there is good reason to fix the window. The shopkeeper can’t keep running his business with the window broken and if it isn’t fixed it invites looting. Similarly, we can’t have a functioning banking industry without the banks capitalized sufficiently and without the bank intermediation the economy crumbles.
So the question comes down to how to recapitalize the banks. If we continue buying preferred shares, it comes at taxpayer expense. If on the other hand, if the government asserts its right of receivorship and takes control of the banks while Chapter 11 proceedings take place, then it does not come at tax payer expense at all. The losers in this scenario would be the shareholders who would be wiped out. The real advantage of this approach is that banks that currently have to pay interests to creditors would be absolved of these interest payments. This would make it less costly for the banks to raise new capital through equity or debt financing as the banks would now be less leveraged. Not forcing banks through Chapter 11 runs the significant risk of having a lost decade similar to the Japanese economy. On the other hand, we can take the approach that Sweden used to end their banking crisis which “took a pound of flesh” out of stock holders of the banks before injecting new capital. One other argument for the necessity of whipping out the shareholders it to demonstrate to investors that taxpayers will not tolerate the moral hazard induced by allowing shareholders to avoid the downside risk of excess leverage.
See the following NYT article about the Swedish banking crisis. See the following article by Paul Krugman (written 10 yrs previously) about why Japanese banks were so unwilling to receive capital injections (hint, it is not in the interests of shareholders or managers because they only get the potential gains and none of the losses).
February 22, 2009
I’m making a new category for my posts because of this. The category will be call “Lies, Damn Lies, and Statistics”. This goes under the sub-category of lying through failure to recognize the denominator. Speaker Pelosi’s either failed grade-school math, or more likely, is purposeful distorting job market data. The following graph I believe is accurate in the facts it displays:
What is conveniently left out was that during the time between these recessions the size of the labor force increased as well. Primarily this occurred through growth in the population of working age individuals. If this chart had gone back further to the recessions of Jul ’74, Mar ’80, and Jul ’81 it would be even further distorted by the change in the percentage of working age individual participating in the labor force (primarily driven by the increase in women’s participating in the work force). Here are two graphs that illustrates the demographic changes.
Clearly the labor market is hurting badly, but we have seen two post WWII recession that have seen worse unemployment. If you also consider the runaway inflation of the 1970’s recessions you could make an argument that recession was far worse seeing as current inflation is almost zero. The 1982 recession saw peak unemployment of 10.8 percent.
For a source of official recession dates you can go to the National Bureau of Economic Research (NBER) Business Cycles website
It occurred to me while listening to a local college radio station program about a boycott of the Washington Post for publishing a racially offensive comic; many Americans can do something about the financial crisis even if government seems spineless to do what is necessary. You can vote with your patronage of where you keep you banking deposits and other financial assets. Banks largely make their money on a percentage of assets under management. You can help banks that avoided complex and exotic financial instruments and were adequately capitalized by rewarding them with you deposits. Similarly, if you currently have your deposits with a bank that received TARP funds, you can close your accounts and transfer the funds to a bank that behaved more appropriately. I am in the process of doing just this. I used to bank with National City, largely for convenience (they have an ATM machine at my office building). However, they went bust and were swallowed up by PNC Financial who received TARP funds on the condition of the merger taking place (a condition I strongly oppose). If the idea of bailing out banks and industries is they are “too big to fail”, why does it make sense to make them larger through merger and acquisition. Furthermore, by withdrawing your funds from these banks you will further force the government’s hand on wiping out the shareholders of these “Zombie banks”. As you take your assets out of these TARP banks, the gap between assets and liabilities will grow. The solvent banks that you deposit your funds into will become more able to fund new loans. The government will be forced to put the zombies into conservatorship and eventually bankruptcy. But since it is a zero sum game (Ryan is learning about these in his game theory class), it rewards the management and shareholders of prudent banks and wipes out the investment of the imprudent shareholders and poor management.
I strongly encourage you to look over the list of banks receiving TARP funds. If your bank is on the list please take your deposits and business to a bank not on the list. Vote with your money!
If you are looking for a suggestion, I have moved my funds to Charles Schwab. I find the banking experience superior to every bank I have used previously. They have all the standard bill pay, online banking, FDIC insured, blah, blah, blah. Separating themselves from the rest though: 1) ATM fees are reimbursed at any ATM. 2)You are given postage paid pre-addressed envelopes to deposit checks. Therefore you don’t have to go to a bank to make deposits or withdrawals. 3) It seem like the phone call centers are staffed by competent people even late at night (11:30 pm on a Thursday). All of these features respect my time as a customer which is the sign of a mature institution. When I am working 60 hrs/wk and studying 20+ hrs/wk, wasting my time on the trivial task of managing banking is a pain to be sure.
Disclosure: I work in the Financial Services industry at an insurance company. The company has no banking interests and I have no interests in any of the banks mentioned. I did work for one summer as an intern for one of the banks that received TARP funds, but have no current link to any bank other than were I have my deposits.
February 4, 2009
For some time now I have thought the public should have a better understanding of the relative merits of the economic policies including the costs and benefits, the winners and losers, and tradeoffs, as well as the economic rationale behind policies that politicians and economists advocate. I decided to start documenting what I think about certain economic policies that I myself advocate, or am still debating myself. I decided the best forum and method of documenting my thoughts would be an ongoing editable document. I also wanted something that other users could contribute to. It seemed the perfect format for this would be a Wiki. So I’ve set up a Wiki at the following website:
I am still getting to know the administrative aspects of implementing this Wiki, however, I intend to make it a document that should be able to be edited by others rather than just myself. I am still not sure if I will allow anyone to edit the document freely like wikipedia does, without editorial oversight . I am worried that some policies would take on more of a prescriptive economic policy perspective related to normative values of economics rather than positive economic thought. I guess it will be an interesting experiment assuming anyone actually decides to add content other than just myself. Even if it ends up only being myself I still think it will be valuable in terms of being able to organize my own thoughts on economics.
Another ancillary reason for creating this Wiki is to document the various opinions from economists on what the government response should be to the recent economic downturn. If you subscribe to my shared RSS feed of blog posts I find interesting you will have noted that there is an incredible amount of diversity of opinion on what the response of government should be to the current economic downturn. I may create a separate Wiki to document the various policy prescriptions that economists have had for the downturn, as this seems to be a separate topic then what economic policies should be under more normal times.
October 30, 2008
Undercapitalized firms do not pay dividends, they suspend the payment of dividends. Lawmakers foolishly did not require by law that banks receiving capital from the government to suspend share buybacks and dividend payments until lending is resumed at normal levels. It is not hyperbolic to say that at a least part of the current implementation of the “rescue package” is a direct transfer payment to the shareholders of these companies. These firms would rebut, if they suspend their dividends then it would signal weakness to investors. Well, these are the same firms which were verging on bankruptcy only weeks ago, so signaling weakness would not be informing the markets couldn’t figure out on their own. On the other hand distributing dividends will certainly lower their capital bases and most importantly reduce their ability to lend. If you’re not mad, you should be.
October 28, 2008
The worst is not over yet. There last shoe has yet to drop. Hedge funds are supposed to be the for only the rich, key words “supposed to be”. However, as with everything about our economy, they too are highly intertwined in the markets. If they fail the ramifications will be indiscernible for the failure of any other financial institution. Their demise will have similar contagion effects to retail banks. Worse, hedge funds are often leveraged at very high levels. If underlying asset values increase, then the value of the fund goes up by a multiple of that value. However, like all things in life, you can’t get something for nothing, what goes up twice as fast falls twice as fast as well. Therefore, given that the stock market has fallen approximately 40% recently, any fund that was leveraged by more than 2.5 times would be insolvent. If this were the case why haven’t we heard about more failing funds? Well, many of these such funds have withdrawal timing constraints. For many of these funds, the timing of this withdrawl window will be quarter end (yeah Christmas gift). And when investors in these funds start pulling funds out it will be a self fulfilling, the more investors who want their money, the faster the funds will have to liquidate positions at large losses. So what’s the big deal? The only people that are going to be wiped out will be rich kids with trust funds right? Wrong!
Pension funds are supposed to have the fiduciary duty to conservatively manage assets to better ensure the likelihood of fully vesting assets for their pensioners come retirement time. In spite of this duty, many pension funds have invested large sums of money in hedge funds. This is not news either, see this 2005 NYT article, which discusses this idiotic investment risk. Furthermore, all of the selling from these hedge funds to meet the flood of people pulling their assets out of these funds will leave stocks at even lower levels.
So that’s the bad news. Is there any good news? Perhaps. If sensible regulation can be inacted, then some good may come of this. I don’t advocate regulating except in the case when industry’s actions impose externalities. One of my greatests concerns with the financial system has been that financial institutions have learned, because government has taught them, that the federal government and fundamentally tax payers will always backstop their excessive risk taking. In financial terms, the public is writing the financial system a put option, but charging no premium for the risk we bear. I don’t know about you, but when I want to recieve auto insurance I have to pay a premium. Similarly I think it is reasonable to charge financial institutions who leverage themselves at excessively high levels to pay the tax payer for the additional risk they add to the health of the financial system.
The banking crisis could have been avoided if the banks carried enough equity capital to absorb their loses. The banks did have enough total capital to absorb the loses. When equity capital runs out, the bank is insolvent, and in normal circumstances would go through bankruptcy precedings. This would mean the debtholders become stockholders and the original stockholders are wiped out. This is why investors require a higher rate of return from stock than corporate debt. Since you don’t have time to go through bankruptcy preceedings during a banking crisis the logical regulation is to require banks to hold enough equity capital to absorb a very large loss of capital. But even with a large amount of equity there is still a small possibility of catastrophic loss and furthermore capital isn’t free. So somehow you would like banks to be capitalized with a high amount of equity capital for the people writing the put option to be compensated for its expected value. The first part is justified by the “Capital Structure Irrelavance Principle”, which despite an onslaught of attacks by economists since it was originally postulated in 1958 by Modigliani and Miller has proven very robust. The theorem in a nutshell states that the rate of return from a firm is not affected by the form of financing (debt or equity). Since equity makes sense for the public good in the case of banks, lets not suggest it, lets require it. That is the first line of defense, but even if we follow this prescription there would still be residual risk. I suggest using VaR modeling, we determine an appropriate value for the implicit put option for financial firms. Some might call that a tax, I don’t care, I call it an insurance premium.
October 13, 2008
There has been a lot of criticism of the “rescue plan” retitled from the “bailout plan”. Although I was reluctantly in favor of swift action to avoid systemic risks to the real economy, I was still ill at ease over the adverse fallout to the incentives that drive rational and socially beneficial economic behavior. If we recapitalized banks through the purchase of distressed assets, then the banks who wisely avoided these assets are punished for their conservatism and maybe worse, teaches the finacial markets that overleveraging will not be punished. I read an article by Luigi Zingales, which I think skillfully solves the issues with recapitalizing banks and stabilize housing prices and at the same time pareto improving for all parties with the exclusion of the shareholders of banks that made poor risk management decisions.
September 29, 2008
I have seen this misconception portrayed in almost every media article that I have read concerning the proposed government intervention in the capital markets. The overriding error in logic is that the proposed 700 Billion dollars is simply flushed down the toilet. Wrong! The federal government would be buyings assets that currently are not liquid, but do have some value. Much of these assets are collateralized debt obligations, or sometimes referred to as securitized loans. A substantial portion of these loans are “non-performing”, meaning that that there are payments in arrears or perhaps the foreclosure proceeding have already begun. This does NOT mean these instruments are worth nothing! For instance, even if they government had to foreclose on every loan, the government would still be able to sell the collateral (the house) for some amount of money. Furthermore, since the borrowing costs to the federal government are extremely low (treasury yields are almost at 0.0% percent right now), this means the government can take a long time to unwind these securities. Many reputable economists and financiers believe the government will be able to purchase the distressed asset for less than cost (including carrying costs). This is commonly referred to as a profit. For instance, Warren Buffet believes that the few securities that are trading in this highly illiquid market are seeing potential rates of returns in the 15-20% range. Meaning, the federal government may ultimately be able to turn a profit on investment of around 140 Billion dollars. Failure to act on the other hand could lead to a collapse of the finance markets.
I should state that there are highly intelligent people who disagree with me. For instance Robert E. Lucas Jr and James Heckman both Nobel Laureate economists along with ~200 economists signed a petition with objection to the original State Department proposal. I have excerpted the objections from the position below:
As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:
1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.
2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.
3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.
For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.
I hope my two cents have helped you be more informed as to the trials and tribulation of the current economic mess. If you would like to know how we got into this mess in the first place you might want to check out this funny cartoon.
September 22, 2008
Related to the economy:
Why Steve Paulson is Wrong is a short essay by a well respect U. Chicago professor Luigi Zingales about the bailout plan for the financial industry.
Greenspan interviewed by George Stephanopoulos watch the video
Freakonomics blog post which discusses the current upheaval.
The President of South Africa Thabo Mbeki has been removed from power which I see as a very positive development withstanding the possibiliity that he could be replaced by someone worse. It is a positive development in my mind because Mbeki furvently denies that HIV causes AIDS, which is made worse because South Africa already has one of the highest HIV infection rates in the world at 20%. Link