Friday Can’t Come Soon Enough, by Tim Duy: A wild week is coming to an end, with news that US policymakers are preparing a comprehensive approach the financial crisis – see the prophetic Mark Thoma below. Details are thin at this point, although the central feature is expected to be a mechanism that will extract the bad assets from Wall Street’s balance sheets. The devil, of course, is in the details. A critical element, as described by the Wall Street Journal:
A big question still to be answered is how the government will value the assets it takes onto its books. One possible avenue could be some sort of auction facility, so that the government would not have to be involved in negotiating asset values with companies. Financial companies would likely take big losses.
But Calculated Risk makes an important point about this approach – it appears to deal with only one side of the balance sheet:
Details of how this will work aren’t available yet. But one of the key problems – in addition to the risk to the taxpayer – is that this program will actually reduce regulatory capital as losses are realized. The opposite of the goal!
So even after the bad assets are removed, the affected firms still need to be recapitalized, presumably via taxpayer infusions. What exactly will the taxpayer receive in return? Preferred stock? Since we are already moving toward an overarching solution, maybe we should just follow the example of Sweden. Via Yves Smith:
But in this skeletal form, this seems like a world class bad idea. The only successful example of dealing with a financial crisis is Sweden, which did not try to prop up troubled banks, but instead nationalized them, wiping out equity, brought in new top executives, and recapitalized them. The cost of failure was high to the incumbents and the solution was comprehensive, not piecemeal.
Such a high cost of failure should address moral hazard concerns, especially if the nationalization was followed by a reevaluation of regulation that left financial industry lobbyist out in the cold. With that in mind, don’t forget to visit The Big Picture for a glimpse at the inner logic of this Administration:
…the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.
Instead, the 2004 exemption — given only to 5 firms — allowed them to lever up 30 and even 40 to 1.
Who were the five that received this special exemption? You won’t be surprised to learn that they were Goldman, and Morgan Stanley.
Mark cites this below, but it is so telling that it needs to be repeated. Again. And again.
Moving back to this new plan for the crisis, we also need to think about who will fund this operation. Yves Smith, in the piece noted above, remarks that the US government appears to believe that our foreign creditors will continue to step up to the plate and absorb upwards of $1 trillion dollars of fresh deficit spending, maybe more. And, according to Brad Setser, it really is entirely foreign official inflows that are holding the US ship together; he is banishing the illusion that private investors have much if any desire to accumulate US assets at this point:
That implies that official inflows are really more like $550-600b, and private inflows are deeply negative – not zero. And the survey also misses some official flows, notably from the Gulf.
Negative private inflows is another name for private outflows. For emerging economies, those outflows are called capital flight.
Try as policymakers might, they cannot forever ignore the fact that we are not Japan; we do not have excess domestic savings to fund such a program. Eventually that fact will come home to roost. Perhaps it already has, as pressure from the Chinese appears had some role in the Freddie/Fannie bailout. And Americans may have to recognize that the remaining storied investment banks, names that drove American capitalism for generations, may soon be substantially owned by China. Indeed if the Bank of China continues to be a dominant financer of US excess, they have found a way to dominate the US in a way that could never have been achieved militarily. They will have effectively exploited a gaping hole in the international financial architecture opened increasingly wider by US policymakers over the last 28 years. But, US citizens all get cheap flat screen TVs, so who cares?
And China is just one of the nations financing the US. We remain lucky that these counterparties have yet to ask for the restructuring program the US Treasury demanded during the Asian Financial Crisis.
What is the alternative? A tax increase? Tell Americans six weeks before an election that they need to accept a lower standard of living? I don’t see that happening. It won’t happen until the foreign credit is turned off. Otherwise, policymakers will continue to behave as if deficits don’t matter.
All of which leaves me a bit depressed tonight. To be sure, I am happy that policymakers look to be on the offensive, trying to engineer a comprehensive response to the crisis. The crisis will not end until the bad assets are eliminated and banks are recapitalized. But policymakers need to be honest that such a solution will not be painless. I have yet to see such honesty.
Maybe the final plan, likely to be revealed this weekend, before Asian markets open Monday, will ease my concerns. One can only hope; perhaps I just worry too much. I should just go to Best Buy and get a flat screen TV for myself.
Originally published at Economist View‘s and reproduced here with the author’s permission.