The American economy is going through a profound restructuring. Less money will be spent on home construction in the future. American car companies will be smaller in the near term. The financial sector will employ fewer people. Such restructurings are painful because they are associated with layoffs and bankruptcies. But there are many ways for the government to mitigate the effects of this economic correction without risking trillions of dollars on bailouts. Below I outline a 5 part approach to coping with the current economic crisis and the financial sector's problems. Compared to the Obama administration's approach, this plan devotes less money to the financial sector and more money to the social safety net and job creation.
1) Restore Confidence: The most efficient way to restore confidence is to greatly expand unemployment benefits and the affordability of health care. Compared to many other developed countries, the United States has a weak social safety net. Parents who are worried that their children may lose access to medical treatments have every reason to drastically cut spending, causing an especially severe economic contraction. If Americans were more confident that they could maintain a decent standard of living, economic activity would be higher. This policy does not mean that we have to adopt a European style economy. The U.S.A. can skip the restrictive labor rules found across the pond because they hamper economic growth. We should just borrow the good stuff (the safety net) and we should do it as soon as possible.
2) Fight Unemployment: There are millions of unemployed Americans out there right now who want to work. Many businesses are shrinking. Eventually, other businesses will expand to fill the gap. But that can be a slow process. In the meantime, the government should use this excess supply of labor to modernize American infrastructure so that the country enters the next global economic expansion on a competitive footing. We need more stimulus money.
3) Maintain Price Stability: The Federal Reserve has done a good job fighting deflation so far. Under Bernanke's direction, the Fed has expanded the monetary base to help prevent a dangerous drop in prices. However, the Fed should be more cognizant of inflation risk. Bernanke ought to be more conservative in the assets he acquires during this monetary expansion because he may need to sell the assets quickly - thereby reducing the monetary base - to fight inflation. The Federal Reserve should conduct monetary policy. It has no business assuming massive credit and interest rate risks.
4) Ensure That There Is A Viable Financial Sector: This does not mean that huge banks need to be bailed out. The economy will benefit if a competitive group of healthy financial institutions exist to provide credit to people and businesses. The government can intervene if such a group does not exist. But that intervention should not take the form of pumping cash into failing banks. Rather, the money should be used to better capitalize the healthiest banks. Such a policy has a higher chance of ending in full repayment to the government and in an expansion of credit.
5) Impose Harsher Terms On Bailout Recipients: Many commentators argue that some banks are too big to fail. One argument for saving failing financial institutions is that their failure would be catastrophic to other institutions, setting off a dangerous chain reaction. I would like to see more evidence on this point. But even if one does assume that a firm's failure would be intolerably harmful to the economy, it does not follow that the government needs to spend billions of dollars to save investors in the firm. The government can guarantee the failing firm's obligations to customers and counterparties, but allow bondholders and equity investors to suffer losses. While discussing such an approach, market commentator and fund manager John Hussman wrote:
"Ultimately, if a financial institution is not capable of surviving without large and constant infusions of public capital, the stockholders and bondholders of that company – not the public – should be responsible for the losses incurred. . . . [T]his can be achieved without customer losses or a disorganized Lehman-style unwinding." (Here's the link.)
In conclusion, the Obama administration needs to rethink its approach to the current economic crisis. More money should be spent on the social safety net and building infrastructure. Less money should be spent on saving investors in financial institutions. Both can be accomplished without stifling the free market and without financial market chaos.
Tuesday, March 31, 2009
Sunday, March 22, 2009
Bernanke's Gamble
Most Americans have heard of the Federal Reserve (often referred to as "the Fed"). And most Americans probably know that the Fed can influence interest rates. But I suspect that many people are unaware of the Fed's most awesome power: The Federal Reserve can create U.S. dollars without the consent of even one democratically elected official. Recently, Ben Bernanke has created an astounding number of U.S. dollars. In fact, the monetary base (the sum of U.S. dollars in circulation plus banks' deposits at the Federal Reserve) has nearly doubled since the economic crisis began. In layman's terms, the Federal Reserve DOUBLED the amount of money out there. Earlier this week, the Fed announced that it would create another 1 trillion dollars and use that money to buy U.S. Treasuries, mortgage bonds and agency bonds. It seems that within a few months, the monetary base will have at least tripled. If the T.A.L.F. becomes a 1 trillion dollar program, as Geithner has suggested, the monetary base might just quadruple.
Printing money is risky business. Many countries that have tried to print their way out of economic trouble have suffered economic collapse. So far, Bernanke has managed to get away with it. The sharp economic contraction has counteracted the inflationary effects of the greatly expanded monetary base. And the global perception that the U.S. dollar is safe has helped to keep the dollar strong vs. other currencies. However, there are signs of weakness. Since Bernanke announced that he would create another 1 trillion dollars on Wednesday, the U.S. dollar has taken a bit of a beating in foreign exchange markets and commodity prices are higher.
Bernanke argues that if inflation becomes a problem, he can reduce the monetary base. This is true. When the Federal Reserve creates and then disburses money, it acquires financial securities (like mortgage bonds and U.S. Treasury bonds) in exchange. The Fed also makes short term collateralized loans to banks. Bernanke believes that it will be a straightforward affair to sell these securities and to terminate loans to banks if the dollar begins to weaken. When the Fed sells those securities or terminates the loans, it will get its greenbacks back. And the monetary base will shrink again.
Bernanke is counting on the theory that if the economy improves and lending increases, it will be easy to unwind the Fed's expansive new programs. However, another scenario is possible. The economy could begin to improve while a group of healthy financial institutions could help increase the use of credit in the country. But at the same time, the deficit could continue to run at a record high. Meanwhile, a group of unhealthy financial institutions might continue to depend on Fed lending. If that happens, it would be quite problematic for the Fed to reduce the monetary base because yields on treasury bonds and mortgage bonds would probably be much higher than they are today. (The yields on treasuries and mortgages usually increase during economic expansions and when governments need to borrow a lot of money. And when yields increase, the prices of bonds go down.) The Fed would have to sell the Treasuries and mortgage bonds for less than it paid. So it would be impossible for Bernanke to sell the assets and get back all the money he printed. And terminating the bank loans to unhealthy banks could bankrupt those institutions, meaning the Fed would be repaid with collateral as opposed to cash. Then the Fed would need to sell even more securities at a discount in order to reduce the monetary base. But it would not be able to get all the money back if it were selling them for less than it paid. Yet another scary prospect is that political factions try to influence Fed decisions, which seems increasingly likely given recent behavior by Congress. Anything is possible there.
The point here is not that Bernanke has made a mistake by increasing the monetary base. Rather, there is a strong case for increasing the monetary base during severe economic contractions. However, the methods Bernanke is using to accomplish monetary expansion involve more risk than he would have us believe. A more realistic assessment of the risks involved might lead to a safer course of action by the Fed. For instance, Bernanke could focus his purchases on securities with shorter maturities, which have less risk. He could also require banks to post higher quality collateral on their loans. Hopefully, Bernanke is correct and the U.S. Dollar is not at risk. But it is unsettling to hear him gloss over the risks as minimal.
To learn what Bernanke has to say on this matter, follow the link below. The sections titled "The Federal Reserve's Policies and its Balance Sheet" and "Credit Risk and Transparency" focus on the issues discussed above.
Bernanke discusses the risks of recent Fed actions
Printing money is risky business. Many countries that have tried to print their way out of economic trouble have suffered economic collapse. So far, Bernanke has managed to get away with it. The sharp economic contraction has counteracted the inflationary effects of the greatly expanded monetary base. And the global perception that the U.S. dollar is safe has helped to keep the dollar strong vs. other currencies. However, there are signs of weakness. Since Bernanke announced that he would create another 1 trillion dollars on Wednesday, the U.S. dollar has taken a bit of a beating in foreign exchange markets and commodity prices are higher.
Bernanke argues that if inflation becomes a problem, he can reduce the monetary base. This is true. When the Federal Reserve creates and then disburses money, it acquires financial securities (like mortgage bonds and U.S. Treasury bonds) in exchange. The Fed also makes short term collateralized loans to banks. Bernanke believes that it will be a straightforward affair to sell these securities and to terminate loans to banks if the dollar begins to weaken. When the Fed sells those securities or terminates the loans, it will get its greenbacks back. And the monetary base will shrink again.
Bernanke is counting on the theory that if the economy improves and lending increases, it will be easy to unwind the Fed's expansive new programs. However, another scenario is possible. The economy could begin to improve while a group of healthy financial institutions could help increase the use of credit in the country. But at the same time, the deficit could continue to run at a record high. Meanwhile, a group of unhealthy financial institutions might continue to depend on Fed lending. If that happens, it would be quite problematic for the Fed to reduce the monetary base because yields on treasury bonds and mortgage bonds would probably be much higher than they are today. (The yields on treasuries and mortgages usually increase during economic expansions and when governments need to borrow a lot of money. And when yields increase, the prices of bonds go down.) The Fed would have to sell the Treasuries and mortgage bonds for less than it paid. So it would be impossible for Bernanke to sell the assets and get back all the money he printed. And terminating the bank loans to unhealthy banks could bankrupt those institutions, meaning the Fed would be repaid with collateral as opposed to cash. Then the Fed would need to sell even more securities at a discount in order to reduce the monetary base. But it would not be able to get all the money back if it were selling them for less than it paid. Yet another scary prospect is that political factions try to influence Fed decisions, which seems increasingly likely given recent behavior by Congress. Anything is possible there.
The point here is not that Bernanke has made a mistake by increasing the monetary base. Rather, there is a strong case for increasing the monetary base during severe economic contractions. However, the methods Bernanke is using to accomplish monetary expansion involve more risk than he would have us believe. A more realistic assessment of the risks involved might lead to a safer course of action by the Fed. For instance, Bernanke could focus his purchases on securities with shorter maturities, which have less risk. He could also require banks to post higher quality collateral on their loans. Hopefully, Bernanke is correct and the U.S. Dollar is not at risk. But it is unsettling to hear him gloss over the risks as minimal.
To learn what Bernanke has to say on this matter, follow the link below. The sections titled "The Federal Reserve's Policies and its Balance Sheet" and "Credit Risk and Transparency" focus on the issues discussed above.
Bernanke discusses the risks of recent Fed actions
Tuesday, March 17, 2009
Two Observations On The A.I.G. Bonus Circus
Congress and the Obama administration seem to be in a bit of a tizzy over the $165 million of bonuses being handed out to A.I.G. employees. How a measly $165 million managed to garner quite so much attention in times like these is beyond me. Nonetheless, there are two important points that I found myself pondering after reading a few of the articles on the bonus scandal.
1) Bankruptcy is very useful. The problem with not letting firms like A.I.G. go bankrupt is that they are still bound by their contractual obligations, even when that means paying lavish bonuses to executives. Had the government allowed A.I.G. to go bankrupt, such contracts could have been suspended. And the government could still have stepped in to pay those of A.I.G.'s obligations that it deemed important to the American economy.
2) Treasury Secretary Geithner is willing to stretch the truth pretty far. In his March 17 letter to Nancy Pelosi regarding the Treasury's handling of the bonus situation, he proclaimed, "We also want to insure that taxpayers are compensated for any monies we cannot recover. Therefore, as part of our provision of recently announced taxpayer funds, we will impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of the retention awards just paid." Am I taking crazy pills? The United States government owns A.I.G. And the company has just received another government lifeline. So, a candid translation of Geithner's statement would be something like: In order to pay back the taxpayers, we will take money from the company owned by the taxpayers (which, by the way, does not have any extra money) and give it to the taxpayers. Nonsense.
1) Bankruptcy is very useful. The problem with not letting firms like A.I.G. go bankrupt is that they are still bound by their contractual obligations, even when that means paying lavish bonuses to executives. Had the government allowed A.I.G. to go bankrupt, such contracts could have been suspended. And the government could still have stepped in to pay those of A.I.G.'s obligations that it deemed important to the American economy.
2) Treasury Secretary Geithner is willing to stretch the truth pretty far. In his March 17 letter to Nancy Pelosi regarding the Treasury's handling of the bonus situation, he proclaimed, "We also want to insure that taxpayers are compensated for any monies we cannot recover. Therefore, as part of our provision of recently announced taxpayer funds, we will impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of the retention awards just paid." Am I taking crazy pills? The United States government owns A.I.G. And the company has just received another government lifeline. So, a candid translation of Geithner's statement would be something like: In order to pay back the taxpayers, we will take money from the company owned by the taxpayers (which, by the way, does not have any extra money) and give it to the taxpayers. Nonsense.
Sunday, March 15, 2009
The Bonus Problem
Many Americans are enraged that the same Wall Street firms that received infusions of taxpayer dollars continue to dole out huge bonuses. In January, President Obama remarked that the large amount of bonus dollars handed out this year is the "height of irresponsibility. It is shameful." Strong words. But we have not seen much strong action.
Perhaps this is because the administration largely accepts what Wall Street says about its compensation practices:
1) Some bonuses are contractually required.
2) Employees will underperform and even quit if not properly incentivized.
These arguments are valid, but they do not imply that the Obama administration should forgo a much tougher stance on Wall Street bonuses. The first point probably has the most validity. It is difficult to get out of a contract without filing for bankruptcy. It should be noted, however, that the government was not too shy about forcing the auto companies to renegotiate compensation contracts with their employees as a condition for aid.
The second point, however, seems to be the hardest to swallow. There are many steps the government could make that would better protect taxpayers without obliterating the incentive structure on Wall Street. An easy first step would be the establishment of a tougher vesting schedule for bonuses. Rather than just handing over so much money to wealthy finance guys, the bonus money should be locked in an account. Bonus recipients should not be able to withdraw from that account until they have stayed at their firms for at least one year. What is the point of paying people handfuls of cash if they are just going to quit a few days later? If bonuses are really required to keep people working, the administration should require bailout recipients to structure bonuses so that people are incentivized to actually stay at their firms. Another option would be to lock up at least a portion of those accounts until the government is repaid.
Thus far, it seems that the Obama administration has really just paid lip service to this issue. We have heard some tough words from the president. And a few rules have been implemented regarding compensation for the top five executives at some firms that receive government money. But we could be doing much more to protect taxpayer interests without causing irreparable harm to Wall Street's incentive structure.
Perhaps this is because the administration largely accepts what Wall Street says about its compensation practices:
1) Some bonuses are contractually required.
2) Employees will underperform and even quit if not properly incentivized.
These arguments are valid, but they do not imply that the Obama administration should forgo a much tougher stance on Wall Street bonuses. The first point probably has the most validity. It is difficult to get out of a contract without filing for bankruptcy. It should be noted, however, that the government was not too shy about forcing the auto companies to renegotiate compensation contracts with their employees as a condition for aid.
The second point, however, seems to be the hardest to swallow. There are many steps the government could make that would better protect taxpayers without obliterating the incentive structure on Wall Street. An easy first step would be the establishment of a tougher vesting schedule for bonuses. Rather than just handing over so much money to wealthy finance guys, the bonus money should be locked in an account. Bonus recipients should not be able to withdraw from that account until they have stayed at their firms for at least one year. What is the point of paying people handfuls of cash if they are just going to quit a few days later? If bonuses are really required to keep people working, the administration should require bailout recipients to structure bonuses so that people are incentivized to actually stay at their firms. Another option would be to lock up at least a portion of those accounts until the government is repaid.
Thus far, it seems that the Obama administration has really just paid lip service to this issue. We have heard some tough words from the president. And a few rules have been implemented regarding compensation for the top five executives at some firms that receive government money. But we could be doing much more to protect taxpayer interests without causing irreparable harm to Wall Street's incentive structure.
Tuesday, March 3, 2009
Portfolio Update
Proponents of the various Wall Street bailout schemes often make the point that the American government is not just giving all the money away. Rather, the Treasury is buying stuff with the billions of dollars it disburses. American taxpayers now own mortgage backed securities, common stock, preferred shares and many other financial instruments. In order to help quell opposition to the bailouts, many of our Congressional leaders insisted that we might actually be able to make some money on such investments.
Last September, for instance, Nancy Pelosi insisted that the $700 billion dollar T.A.R.P. "investment" would "protect taxpayers" and provide "upside" (Pelosi Clip). Representative James Moran of Virginia went even further, explaining that "this is the time to be buying, when everyone else wants to sell." He also proclaimed that "the taxpayer is likely to recoup a 25 - 30% capital gain." (Moran Clip, starting around minute 33). I figured it was time for a portfolio update.
The news is not good. Let's start with our investment in Citigroup. Back in October, we paid $25 billion for preferred shares in Citi. A few days ago, the U.S. Treasury converted our preferred shares into just over 7.69 million shares of common stock. As of the market close on March 3, those shares are worth less than $9.5 billion. So we are down over 60% on that trade.
The Treasury owns billions of preferred shares in other financial firms. This investment has not fared well either. Obtaining precise numbers is difficult because the shares we own do not trade in the open market. But calculating a rough estimate is straightforward: The S&P Preferred Stock Index Fund is down over 30% since mid October, when the government began purchasing shares. And we know that the government paid an above market price for its shares. So, we probably lost over 30% on our preferred equity stakes.
I do not know how to go about valuing America's $163 billion investment in A.I.G. Despite receiving such a large cash infusion, the firm continues to deteriorate. A near total loss of our investment should not be ruled out.
In sum, our investment portfolio has done very poorly. Many supporters of the bailout used assurances that taxpayers would be protected and that they could expect substantial gains to help get the $700 billion T.A.R.P. through Congress. Thus far, the government has suffered losses upwards of 30% on its portfolio.
Last September, for instance, Nancy Pelosi insisted that the $700 billion dollar T.A.R.P. "investment" would "protect taxpayers" and provide "upside" (Pelosi Clip). Representative James Moran of Virginia went even further, explaining that "this is the time to be buying, when everyone else wants to sell." He also proclaimed that "the taxpayer is likely to recoup a 25 - 30% capital gain." (Moran Clip, starting around minute 33). I figured it was time for a portfolio update.
The news is not good. Let's start with our investment in Citigroup. Back in October, we paid $25 billion for preferred shares in Citi. A few days ago, the U.S. Treasury converted our preferred shares into just over 7.69 million shares of common stock. As of the market close on March 3, those shares are worth less than $9.5 billion. So we are down over 60% on that trade.
The Treasury owns billions of preferred shares in other financial firms. This investment has not fared well either. Obtaining precise numbers is difficult because the shares we own do not trade in the open market. But calculating a rough estimate is straightforward: The S&P Preferred Stock Index Fund is down over 30% since mid October, when the government began purchasing shares. And we know that the government paid an above market price for its shares. So, we probably lost over 30% on our preferred equity stakes.
I do not know how to go about valuing America's $163 billion investment in A.I.G. Despite receiving such a large cash infusion, the firm continues to deteriorate. A near total loss of our investment should not be ruled out.
In sum, our investment portfolio has done very poorly. Many supporters of the bailout used assurances that taxpayers would be protected and that they could expect substantial gains to help get the $700 billion T.A.R.P. through Congress. Thus far, the government has suffered losses upwards of 30% on its portfolio.
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