Stiglitz (and Krugman) on Bailouts

A few weeks ago, Joseph Stiglitz wrote an article (“A Bank Bailout That Works”) for The Nation.

He was highly critical of the policy decisions taken to date by both administrations. Even though he didn’t at the time have the details of Geithner’s latest plan, its core principles are anything but new and his analysis suggests he’d be most unlikely to view it favourably:

Still worse are proposals to try to enlist the private sector to buy the trash. Right now, the prices the private sector is willing to pay are so low that the banks aren’t interested–it would make apparent the size of the hole in banks’ balance sheets. But if the government insures private-sector investors–and even makes loans at favorable terms–they’ll be willing to pay a higher price. With enough insurance and favorable enough loan terms, presto! We can make our banks solvent.

But there is a sleight-of-hand here: go back to the zero-sum principle. The private sector is not going to provide money for nothing. It expects a return for providing capital and bearing risk. But its cost of capital is far higher than that of government. The losses are real, and the private sector won’t bear them without full compensation. This means that the amount the government is likely to have to pay in the end is all the greater.

This proposal, like so many others emanating from the banking community, is based partially on the hope that if banks make things sufficiently complex and nontransparent, no one will notice the gift to the banking sector until it is too late. It appears as if they are at last getting the high market prices that they hoped they would get all along. But it would be a misnomer to call these market prices, since the government has taken away the downside risk.

The markets don’t seem to agree. They put on an uninhibited celebration after Geithner’s announcement last night, with the S&P 500 soaring over 7%. Even normally grouchy commentators like Alan Kohler give it a qualified tick of approval. Perhaps they’ve got it right; then again, perhaps the markets are just sick of being depressed and feel the need to kick up their heels for awhile; they’ve certainly been acting that way for the last few weeks. Not even “great depressions” (assuming that’s what we’ve got on our hands) travel all the way to their destinations in a straight line.

We’ll find out soon enough. Meantime, Stiglitz’s preferred solutions to the banking crisis are fairly traditional:

Firms often get into trouble–accumulating more debt than they can repay. There is a time-honored way of resolving the problem, called “financial reorganization,” or bankruptcy. Bankruptcy scares many people, but it shouldn’t. All that happens is that the financial claims on the firm get restructured. When the firm is in very bad trouble, the shareholders get wiped out, and the bondholders become the new shareholders. When things are less serious, some of the debt is converted into equity.

Banks aren’t airlines, of course, and dealing with their demise is a bit trickier but Stiglitz sees no reason why similar principles can’t be successfully applied. He looks at a few alternatives, including the “good bank” proposal put forward by, amongst others, Willem Buiter at the London School of Economics.

Underlying it all is a conviction that the banks are profoundly crippled as a result of the multiple excesses of recent years. The primary problem is insolvency, not illiquidity, and the underlying economic fundamentals are likely to get a whole lot worse before they get better. Propping banks up by taking toxic assets off their hands at above market prices, all on the taxpayer’s tab, is in his view an exceptionally roundabout, opaque and expensive way to try to deal with the problem.

He’s not alone. In a column on the weekend, Krugman was not happy:

If the reports are correct, Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy – specifically, the “cash for trash” plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.

This is more than disappointing. In fact, it fills me with a sense of despair.

[ . . . . . ]

But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus – for that is what the Geithner plan amounts to – will change that fact.

I enjoy Krugman even when I disagree with him; he just writes so well. In this case, though, it seems to me he’s also spot-on. This is duck and weave stuff, papering over cracks, leaving the utterly discredited status quo in place. Not only is it unlikely to be effective in the long run, it risks (as Krugman and others have pointed out) so depleting Obama’s political capital that his ability to take effective action becomes severely curtailed.

Still, if the market’s in a mood to party then the celebratory fashion in which this plan has been received may carry on for a while; maybe even quite a while. Truth is, nobody knows how this tragedy-cum-farce will play out.

Perhaps the curtain’s only just been rung down on the first act.

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pedro
pedro
12 years ago

Here is an alternative proposal that is different from nationalisation:

http://www.voxeu.org/index.php?q=node/3320

Tel_
Tel_
12 years ago

Banks arent airlines, of course, and dealing with their demise is a bit trickier but Stiglitz sees no reason why similar principles cant be successfully applied. He looks at a few alternatives, including the good bank proposal put forward by, amongst others, Willem Buiter at the London School of Economics.

Keeping the failed banks limping forward in a walking frame with money dripping into their arm tends to keep the same mortgages in the same hands and they keep clobbering the home owners by applying the same failed logic that the home has some market value as depicted on the books.

Bankruptcy and big shareholder losses result in the mortgages being bought cheaply on the open market and the new mortgage owner being much more amenable to making a deal with the home owner for delayed repayments or whatever because the loss has been done with.

Hence it is to be remarked that, in seizing a state, the usurper ought to examine closely into all those injuries which it is necessary for him to inflict, and to do them all at one stroke so as not to have to repeat them daily; and thus by not unsettling men he will be able to reassure them, and win them to himself by benefits. He who does otherwise, either from timidity or evil advice, is always compelled to keep the knife in his hand; neither can he rely on his subjects, nor can they attach themselves to him, owing to their continued and repeated wrongs. For injuries ought to be done all at one time, so that, being tasted less, they offend less; benefits ought to be given little by little, so that the flavour of them may last longer.

http://italian.about.com/library/anthology/machiavelli/blprince08.htm

Dallas Beaufort
Dallas Beaufort
12 years ago

The missing Zoned Zones returns to reality

Paul Frijters
12 years ago

Hi Ingolf,

interesting. Its not just about maintaining the status quo though. Right now they are artificially creating inflation, which implicitly is a means of fleecing the foreign and domestic holders of treasury bonds. I dont think the Chinese and others realise yet that they are paying for the US recovery plan. Stiglitz has made similar comments in the past.

Tel_
Tel_
12 years ago

http://davos.wsj.com/quote/07czfxW5iB0X7?q=Wen+Jiabao

Of course, we are concerned about the safety of our assets.

We have loaned a huge amount of money to the United States.

Special consideration should be given to giving the SDR a greater role.

Yes the Chinese realise, and they have a contingency plan (the SDR), and they are speaking extra polite so you know they are cranky :-) Get ready for a long staring contest with a light touch of brinkmanship. Will the SDR actually work? Hmmm, I think it needs some backing of the metallic kind but we have China, India, Russia, South Korea, South Africa and Brazil tossing around ideas so no doubt they are running through a short list of viable options right about now.

Paul Frijters
12 years ago

Tel_, Ingolf,

I think this is really the big issue so let’s pursue it a bit, even though there is a large chrystal ball element to speculating about the Chinese authorities might or might not know and do.
The Chinese have made all kinds of noises in the past, but they are not known for making quick decisions on this type of thing. These are strategic decisions for them, made at the highest level, which takes time and are not easily reversed. Stiglitz has been telling them for years they are artficially supporting the US without any change in policy. The reason they kept buying treasury bonds in the past even though the returns were very law was because they had a huge trade surplus and re-investing was thus a way to keep their exchange rate down, implicitly protecting their export industry at the cost of other domestic industries. All this was based on the belief in the great multipliers of manufacturing exports, and of course the concentrated political clout of these sectors. To suddenly wind back these positions would be very uncharacteristic and, within the Chinese political system, would surely need the backing of the very highest political leaders. After all, a decision to sell all their bonds would have big political repercussions and would mean a great increase in their own relative exchange rate which would hurt their exporters. Of course some Chinese realise they are being fleeced, but does their political system as a whole realise this? I dont think they as a group realise all this and I dont think they are capable of the quick decision making they would need to force the US to do something else. My guess is also that the US treasury has thought through all this and is simply imposing an inflation tax on groups they believe wont react fast enough to avoid it.

I will make you one clear prediction though: as soon as the market believes the Chinese will start dumping US assets, the dollar will begin a long slide down and would probably be overtaken by the Euro as the main international currency.

Paul Frijters
12 years ago

Hi Ingolf,

like yourself, I have a daytime job and cant stay on top of the avelanche of new developments in the economy. I dont think anybody can, even those whose job it is to look at these things. You just make do with a stylised understanding and strategic bits of information.
Much of the growth in China is financed locally and without much of a financial system at all (their market capitalisation is peanuts compared to ours. Last time I looked, no more than 20% of GDP compared to our 80%). Hence they are relatively insulated from international capital flows and their behaviour is more likely to depend on trade surplusses than capital inflows.
The trade surplus will decline because of US demand contraction, but this in turn just reduces Chinese output and thus also reduces the appetite for US luxury goods, which dampens the reduction in the trade gap. What I think should happen is a large appreciation in the Chinese Yuan which would boost the demand for US and Australian goods and would reduce these trade gaps. One way for that to happen is for the Chinese to start selling some of their US assets and swap them for long-term assets in other places (like long-term mineral rights), but you are right to question whether they will do this at a sufficient scale to make any difference. The markets’ expectations appears to be that China will simply fund the US recovery via allowing its assets to be partially inflation taxed.

Tel_
Tel_
12 years ago

There’s a subtle but important difference between “exposure” (as Ingolf calls it, which is kind of exhilarating in the small chance that you might pull it off and ride home a hero) and the cold dead feeling of the shaft going in when you start to recognise that the money really is gone, forever.

Sure Stiglitz has been warning them that they were in danger, but that’s risk, not loss. Risk is fun and macho. Every few weeks now they see another 100 megadollars roll off the electronic printing press and that looks very much like loss. Not fun. I feel there’s a kind of turning point, and reports of US job losses aren’t very reassuring either. If you lent your life savings to some guy and then he lost his job, what is the emotional response to that?

I have a lot of trouble understanding how China feels about bailout plans. On the one hand, bailouts are Socialist, so the Party officials might nod in sympathy with Obama from that point of view. On the other hand, China-style Socialism has always involved billing the family for the bullet (these days they just float undesirables on the open market… err… the organ market that is). From this point of view, bailouts look pretty soft and whimpy when viewed through Chinese eyes (and just for the record, they look pretty ’bout same through my eyes too). Let’s go evens on bailouts.

To suddenly wind back these positions would be very uncharacteristic and, within the Chinese political system, would surely need the backing of the very highest political leaders.

I dont think they as a group realise all this and I dont think they are capable of the quick decision making…

Agreed on both points, but they must have been thinking this over for some time. I mean it’s been a year of bad news since the first hints of subprime disaster started hitting the news (and we are still feeling around for some bottom under our toes). That’s why I point out, that there’s an emotional turning point where uneasy feeling converts into action. My guess is that we just recently crossed that threshold, and it’s now only a process of figuring out that the action will be.

One thing I am sure of is that export slowdown means idle hands, which means social unrest and questioning of government policy (even silent questions are intolerable). Central power don’t like that, make idle hands work. They are Socialists so they will predictably decide that Infrastructure projects are the go (the only other choice is war which they don’t want). Idle hands are commanded to work on internal infrastructure projects.

I predict: military expenditure (R&D, better gear, plenty of keep-busy exercises); technology infrastructure (anything that looks impressive, maybe a few things that actually work); at least a few of the things that other people are doing, but bigger!

What I think should happen is a large appreciation in the Chinese Yuan which would boost the demand for US and Australian goods and would reduce these trade gaps.

Now, let’s just suppose that internal infrastructure projects become a higher Party priority than exports (go out on a limb) and let’s also suppose that they ease out of their position on US dollars, stop buying dumbarse US treasury bonds and let the Yuan float up like a balloon. Well ho, now they can hire unemployed foreign engineers at basement prices with a strong Yuan to help them along with their most excellently conceived infrastructure projects. How joyous lucky harmonious! If the strong Yuan doesn’t convince these foreign employees, stuff their fists with US paper. Instant successful infrastructure project.

What can I say? It pays to be the big guy…

JC
JC
12 years ago

Hi Ingolf:

I’m actually not sure if the markets going up are necessarily a signal that what is good for the markets is good for the economy over the longer term.

Perhaps the market is reacting to the possibility that we’re going to have inflation in the not too distant future and the early part of an inflationary push is usually pretty good for stocks.

If the parcel of toxic assets get passed over from the banks to the government the effect should be that the price of bank stocks ought to go higher I’d say.

Here’s the thing though… as much as a hate the plan, it could work as inflation over the next few years could raise the value of real assets. This is what I think the Fed is more or less betting on. So the net effect is a debased US dollar which surprisingly may not be so visible through the exchange rate. Who to compare with? The Europeans? Europe has its own version of sub-prime sitting on it doorstep and sooner or later the ECB will have to bight the bullet and monetize. They are far less flexible in both the goods&services and labor markets so a Euro depreciation will “help” them.

The Japanese? Japan is a complete basket case which ever way you look. In fact the Japanese Yen should be heading to 150 dollar over the next few years.

———

Paul Spot on..

The Chinese are holding $2 trillion of US agency paper and bonds and know exactly what the US will do to them. They (the US) will 1/2 (or more) the value of that paper over the next decade trough inflation. They can’t get out because where are they going to go? Europe? Nope. The euro has surprisingly attracted only about 2% additional reserves over the past 2 years. The Yen? No chance.

Gold? they could start increasing their gold holdings although at this stage they haven’t done so.

Here’s what i think they ought to do and what i think they will begin to do over the next few months. Realizing they can’t get out they’ll begin to use their bond holdings as collateral for loans (or as the bonds mature) to buy into high quality US stocks and other investments around the the world. I’m truly shocked the SOV’s haven’t begun doing so over the past several months as the only way they can protect themselves from a global effort of currency debasement is to seek protection in high grade stocks. What better investment could there be than having say GE come to your door and ask for $20 billion in capital at 10 bucks a share…. :-)

Ingolf:

My bet is that the next move for Yuan is towards a float which should be in about 5 years time. I would say a currency appreciation at the moment would kill them or that how they would perceive it.

Paul Frijters
12 years ago

Hi Ingolf, Jc, Tel_,

we seem to have roughly the same guess as to what will happen and why, i.e. the Chinese are unlikely to sell their US bonds en masse and Chinese policies are firmly dictated by the needs of their exporters. I am skeptical that there is sufficient bad debts around to prevent the money printing from creating inflation. Something has to give when trillions of new money is printed, and particularly when goods production goes down, there is basically more money per product so inflation is bound to pick. Maybe it will only happen towards the end of this year, but when it does I would think it would go up quite fast. This almost necessarily means the ensuing output expansion will be hampered by the high interest rates needed to reduce inflation. If that train of thought holds then the Fed is trying to get the US growing in the short run at the expense of reduced growth in the medium term, which is something they know full well and hence shows how desparate they have become.

Thanks for the link to the Pettis website. I guess I took very different things from his blogs than you did. i didnt think his obvious statement that the US fiscal deficit was too large to be financed by China was the key thing in his blogs. What I noticed was:
1. He makes it clear that policy is virtually entirely dictated by export interests. Instead of revaluation, he talks of devaluation in order to stimulate exports even more. This would need massive floods of money leaving China to achieve. To even contemplate devaluating an already highly undervalued currency at this time just shows how completely export oriented China at this moment is.

2. He has to engage in Kremlin watching, even though he’s a prof at a Chinese university: he cannot even find out how the Chinese central bank treats foreign asset holdings, and he doesnt know who is making the decisions on ‘hot money’. In Australia, the academics would simply look on the website or phone their friends to find out what the accounting rules are of the central bank. It would also be fairly easy here to find out about private money being invested overseas. This is not how it appears to work there and hence he has to make to with vague guesses. This in turn means other outsiders, particularly westeners, have no hope at all of knowing what goes on inside Chinese economic agencies.

3. He is close to officialdom and is eager not to ruffle official feathers. He tows the line that its normally the right thing to recycle the trade surplus into US bonds. Despite not really knowing what goes on in the Chinese central bank, he is also exceptionally careful not to be critical of any official policies at all, not even on disclosure. This shows to me that scholars in China basically feel they cannot say what they want, even if they stick to the economy. In turn this reduces the credibility of the information of their blogs considerably: if you dont know if they are really independent…you even start wondering why they make such a public noise about their website being closed down for short periods….

Paul Frijters
12 years ago

hi Ingolf,

relax. I wasnt trying to pick a fight on this one, merely sharing my impressions of the particular blog you referred me to. You are probably right that he is more outspoken than I am giving him credit for, but I found the particular entry you linked to remarkable for its lack of criticism about disclosure and the ‘normal use’ of the trade surplus. The new one you provided seems more hostile to officialdom, although still somewhat veiled.

With regards to the financing of the deficit, it does seem to me a matter of capacity. What else is he driving at? Surely he is not just making the rather anal point that the US deficit is bought up in dollars and hence needs the other side to have the dollars via a trade deficit? That would just be playing with semantics. Perhaps I am being thick today, but whilst I can immediately see how a 30 billion trade surplus per month is not enough to finance the hundreds of billions in borrowing currently looked for, I dont see what else he might mean.