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).