After a brief respite the first week of January Congress is back in session and once again roiling markets. One question though: while fiscal policy is laudable, what does Congress hope to achieve with the other $350 billion of TARP money?
Thanks to James Aitken at UBS who brought the graph below to my attention yesterday. The graph shows the money multiplier, that is, the multiplicative effect of injecting a new dollar into the money supply. The idea is that the dollar is lent out in credit, and then re-lent, and re-lent again and again, translating into (in the recent past) about $1.8 of cash and demand deposits, representing the economic growth underlying the new dollar injection. (More goes into savings accounts, money market funds, investments, and the like but that would be represented in a broader multiplier.)
Of course, with markets pretty much shut down, you inject a new dollar and you get a dollar of economic growth. Even worse today, with markets continually spooked you inject a new dollar and you get less than a dollar – as of December 31, 2008, $0.945 – in economic growth. Hence, if we spend $1 trillion on fiscal policy right now we can expect to get some $950 billion in economic growth in return: not a good bargain when we could have gotten roughly $2 trillion a short time ago.
So what can Congress do? Well, both the incoming and outgoing Administrations need to realize that the market disruption is partially of their own making. In a particularly scathing analysis recently, John Taylor of Stanford University (“The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,” November 2008) showed convincingly that if you assume the Libor-OIS spread is a good indicator of the severity of the crisis, the crisis really only began with the evolution of TARP uncertainty.
Previous spikes in the Libor-OIS spread, Taylor maintains, are within statistical bounds of reasonability, given previous spread volatility. The one movement beyond reasonably expected statistical bounds begins with the Lehman bankruptcy, but then turns downward soon after. Upon announcement of the TARP program, the spread turns back up, accelerating through the September 23 Bernanke and Paulson Testimony that convinced Congress (and perhaps the rest of the public) how bad the situation was, and peaked October 13 with the announcement of the TARP equity plan.
While spread volatility fell after the TARP equity plan, it still remains in the high part of the band of statistical reasonability. The reason, in my view, is the continued Congressional infighting about not only how to address the problem, but what the problem is. While, for instance, the European Union Parliament sat down last summer and worked out their best understanding (right or wrong) of the causes of the crisis and are now working to build policy on that shared understanding, nearly two years into the crisis US policymakers still have no shared understanding, much less a coordinated policy to present to frightened markets and citizens.
While you might think a coordinated policy is optional, consider the findings of a recent OECD article in their Financial Market Trends series, “Resolutions of Weak Institutions: Lessons Learned from Previous Crises.” The paper concludes, in part, that while there is no set of “best practices” defining how to deal with crises overall, countries seem to move out of crisis when a comprehensive, well-articulated, strategic policy is adopted.
The paper lays out three stages of crisis responses:
• In the early stages, the measures introduced have generally been designed to prevent runs and restore public confidence in the system as a whole (“financial restructuring”);
• In the medium term, the focus shifts to re-capitalising institutions and addressing any associated nonperforming assets problem (“operational restructuring”);
• Longer-term measures are more strategic and have typically been addressed to improving the institutional framework, including as required the accounting, disclosure, legal and regulatory environment (“institutional restructuring”). (at 6)
Last year we moved through stage one, and the TARP equity plan put us squarely in stage two. The question is when Congress and regulators will exhibit the courage to enter stage three, engaging in the institutional restructuring that is necessary, but is disliked by the large bank and Wall Street donors that keep Congress funded.
Unfortunately, staling at stage two – as we are – is fraught with risks. As Luc Laeven and Fabian Valencia put it in their November 2008 IMF working paper, “Central to identifying sound policy approaches to financial crises is the recognition that policy responses that reallocate wealth toward banks and debtors and away from taxpayers face a key trade-off. “ Those reallocations can help to restart productive investment, but at the direct cost of taxpayers’ wealth that is spent on financial assistance and myriad indirect costs arising from misallocations of capital and distortions to incentives as “…banks and firms to abuse government protections. Those distortions may worsen capital allocation and risk management after the resolution of the crisis,” restricting economic growth and the ability to affect a full recovery.
Is Congress ready to move beyond crony capitalism to real economic growth?