The short-run: what is at stake?
Presumably, the reason why we have seen so much intervention in the banking sector is to avoid some catastrophy of macroeconomic significance. To me, the puzzling question is: what sort of catastrophy? We do not learn much about catastrophies in our economics classes and I wonder what the basis for such a fear is.
In the models that we are taught in graduate schools, there is something called the “financial accelerator”. It says that when there is more wealth around, borrowers have more collateral and get better terms. As a result there is more investment and thus more economic activity.
Under certain conditions, this wealth includes something like a housing bubble and therefore when it evaporates there is indeed less wealth and less collateral – banks ask for a higher interest rate, investment falls, and there is a recession. But a recession is not a catastrophy especially if we believe that the growth rates of the last decade were too high, because of the artificial financial accelerator generated by the bubble. If US GDP falls by say 3 % (and we have seen none of that), then it will be at the same level as if it had grown by 0.3 points less each year in the past ten years – still a magnificent growth performance for an advanced economy.
It is written nowhere that a recession must be avoided at all cost. Just because the recession originates in the financial accelerator does not mean we should stimulate the economy more than, say, if it originated in an equivalent fall in consumer confidence. Furthermore, the bubble has to burst. It does not make sense to issue an equivalent amount of public debt every time a bubble bursts, just because there is a financial accelerator.
In exchange for the associated pains, a recession would
-bring back US private consumption to sustainable levels, thus restoring the much damaged external accounts.
-depreciate the real value of the dollar to support the needed reallocation of activity toward the export sector
-bring back the ridiculously high house prices to levels that truly reflect fundamentals
-bring back the stock market to sound fundamental values (although this may happen quickly)
In short, the US economy would exit a period of misallocation of resources that was due to wrong prices – wrong interest rates, wrong asset values, wrong exchange rates. So if the socialization of the financial sector that we are witnessing is just there to avoid a recession, I say it is a pretty poor idea.
Furthemore, the real economy has deteriorated only very recently. According to the Bureau of Economic Analysis (and to my astonishment), the annual rate of GDP growth was a strong 3.3 % in the second quarter, following a weaker 0.9 %. This hardly looks like the Great Depression, and not even like a recession as conventionally defined – granted, the third quarter is going to be worse. Also, the weakening dollar is working its way into a healthier structure of demand: imports are falling and exports are raising, thus contributing to correct the abysmal trade deficit. Private consumption is probably still too high though, partly due to the administration fiscal stimulus package.
An entirely different story is that the “payment system” may collapse. This would happen if there is a run on deposits and accordingly if businesses become unable to finance their short term liabilities. Then the consequences would be a massive disruption of economic activity. The payment system is a public good which is produced by private banks jointly with the allocation of savings to investment, which is a private activity. As the recent take-over by the Fed of the commercial paper market shows, the payment system is now in danger. The preferred policy is to save the payment system by saving the banks, and to save the banks by bailing out cynical lenders and imprudent borrowers with the money of the tax payer, while not conceptually separating the payment system from the banking system. But let us ask the following question: why is it that right now perfectly sound firm A, in need of cash, cannot finance itself by borrowing from firm B, which has too much cash? I do not know the answer to this mystery but I speculate that this is because the money lent to A will first of all be deposited…in a bank! If instead it were deposited in some public agency in charge of the payment system, firm B will not hesitate to lend to firm A. And the Fed would not have to take over the CP market to save the payment system. Nor would the Treasury have to spend the public’s money to bail out banks, it could instead let them fail without touching the payment system. In some sense I am advocating the Hayekian proposal of 100 % reserve money (M3=H). Hayek was hysterical about the role of the total money stock, and thought that 100 % reserve was the only way to maintain it fixed. Modern economists think that the money stock is not that important, what matter are the relevant associated prices (interest rates, inflation rate, asset prices…). However, the Hayekian proposal allows to separate the payment system – a public good – from the banking activity – a private good. By doing so, it reduces public incentives to bail out the banks in case of trouble, thus enforcing sound loans and individual responsibility.
The medium run: Two scenarios
In the medium run, assuming we survive past doomsday, i.e. that the payment system survives, what are the macroeconomic consequences of the crisis? Authorities are presumably aiming at 2.5 % growth, constant employment, and are accordingly “fine-tuning” the economy by stimulating both aggregate demand (low interest rates, fiscal injections) and aggregate supply (injecting money in banks).
But there are two other scenarios, which, despite contradicting each other are real possibilities:
A. Deflation, aka the Japanese syndrome. We already observe that reduction in interest rates and injections of liquidity do not work well because people prefer to hoard money. Inflationary expectations as measured by yields on inflation-indexed bonds have also fallen. If the fall in aggregate demand triggered by stumbling consumer confidence, falling house prices and defaults on mortgages is strong enough, the economy may enter a deflationary spiral. Interest rates would fall to zero but people would still hoard liquidity, as they would get good return on that thanks to falling prices. Monetary policy would be ineffective. The government would likely counter that with public spending and fiscal deficits. The Japanese experience, where public debt increased from say 70 % of GDP to 160 % during the crisis, to no effect, suggests that this may be quite problematic. Past a certain level, people react to public debt in a perverse way by anticipating highly distortionary taxes in the future: they react to increases in public debt by saving more and fiscal policy becomes as impotent as monetary policy. Of course, the government may tax more and use the proceeds to dig holes in the ground (a procedure known as the Haavelmo theorem)…
B. Inflation. This would not be a result of the crisis itself but of the public handling of the crisis. We observe that Fed is swapping dollar bills and treasury bills in exchange for toxic mortgage-based assets and more recently, commercial paper. Isn’t that a “monetization of debt”, and a “deterioration of the Fed’s balance sheet”, likely to lead to inflation? In principle, the answer is no. The reason is that the Fed is not a bank. The Fed’s commitment is to issue fiat money which is used as a medium of exchange. Money as a medium of exchange is not backed by the assets of the Fed. It is backed by its commitment to low inflation. In principle, the swaps that have been used do not alter that commitment, as long as the Fed is expected to target the same inflation levels in the medium run. In other words, there is no difference between the Fed swapping T- bills for CDOs vs; the Treasury doing so. In both cases what we have is a public bail out of bad loans. Similarly, when the Fed is providing liquidity by lending to banks as the interbank market shuts down, it is transforming M3 money (money created by banks when they lend out of their deposits) into high-powered money. This leaves the total money stock unaffected. So in principle that should be non-inflationary too: we are actually moving toward the Hayekian ideal of 100% reserve money. However, there are two caveats:
First, an explosion in M3 as lending resumes should the economy exit the crisis; this would boost spending and fuel inflation. This should be offset by open-market operations to withdraw the High powered money that was issued during the crisis. But to engineer such an open market operation the Fed needs to sell assets, which makes it problematic if all it has in its balance sheet is worthless MBS…Alternatively, one may want to simply increase the currency reserve requirements of the banks, moving us again in the Hayekian direction. In all cases, there will be a delicate transition.
Second, there must be a reason why central banks only accept good collateral when supplying liquidity to the private sector: If they accept any junk the private sector will then happily generate such junk in order to fund bad loans and Ponzi schemes. This could lead to another misallocated “boom” of the housing bubble kind.
Another potential source of (hyper) inflation, rather than monetary policy, is the use of fiscalpolicy during the crisis. There is the hint that public authorities are willing to go to any length to preserve the system. The cost of the bail out may be a blip in public debt by say 10-20 % of GDP (it is of the order of magnitude of the housing bubble itself), to which should be added fiscal stimulus measures and foregone earnings due to the recession. As public debt rises, part of its financing may well be through the inflation tax (it is in fact optimal from a tax perspective to increase inflation a little bit when the burden of debt is higher). Such an expectation will lead to a move out of dollar-denominated assets, eventually forcing the fed to increase interest rates. This reinforced by the incentives for the US to engineer partial implicit default on its dollar-denominated debt by depreciating its own currency.
Does that mean “some more inflation” or “much more inflation”. I suppose this would mean an inflation rate reaching 6 to 7 % in a couple of years. However, things could be nastier if there was a massive run on the dollar. Can the current increase in public debt lead to such a run? A week ago, I would have said that this possibility is unlikely. Now I am not so sure. At least one serious economist (Larry Kotlikoff) deems it inevitable.
One stabilizing factor is that there is less room for a self-fulfilling run because US government liabilities are denominated in dollars. if there is a run, a country indebted in foreign currency will have trouble fulfilling its claims because of its depreciated money and the associated deterioration in the terms of trade. On the contrary, if there is a run on the dollar, the U.S. balance sheet improves, so it will have less problems satisfying its obligations. This is stabilizing, but it remains nevertheless true that the dollar has depreciated and that those who sold their dollar assets first are better-off than the others.
What makes a run on the dollar a possibility is the following: As someone rightly pointed out on the web, the pool of foreign holders of US treasury bonds is a cartel. They keep buying (or not selling) ,them to prevent their real value from falling, which would inflict a severe capital loss to them. But in each cartel there is an incentive to deviate and sell one’s bonds before the others. When somebody deviates, the cartel collapses and the price falls brutally. And that incentive is greater if the prospect of the US inflating its debt become more real. In that respect, only a moderate increase in the expected depreciation rate of the dollar may trigger a collapse of the cartel and a sudden run on the dollar.
Which scenario is more likely? I don’t know: the markets and the authorities seem to put a fairly high probability on scenario A and a low probability on scenario B. Yet many antecedents of such crises (for example, Sweden 1992) have been associated with balance-of-payments crises and sharp falls of the currency.
The long run: the return of Socialism?
During the crisis we have witnessed: (i) a rush by public authorities to bail-out, nationalize, take control of various financial institutions, as well as to lower interest rates and to inject fiscal stimulus, and (ii) a blossoming of “I told you so” types in various circles who happily conclude that Capitalism does not work and that the government should regulate and/or manage the financial sector (which sometimes reminds me of Charles de Gaulle’s claim that the market is just good for allocating groceries).
In some sense, there is now a general sense that “the French are right”: the financial sector should be tightly controlled by the government. Worse, since “too big to fail” banks are being rescued, “too big to fail” firms in the industrial sector are rushing to beg for taxpayer’s money.
In that respect, the bail-out of Wall Street can be interpreted as a French-style policy of subsidizing declining industries to preserve jobs. We know that it is typically a bad idea to spend public money on declining industries to protect jobs there. The financial sector is no exception: many goods that it is selling (the sophisticated financial instruments that are at the core of the current crisis) are now “obsolete”, not least because they cannot be priced in the face of systemic shocks like the bursting of a bubble. Presumably one should expect a return to a more rustic way of conducting business. As a result the financial sector is too big and should contract. By pumping money into it, authorities engage in French-style state aid and French-style public management. The French experience suggests that this means poor corporate governance, decisions that disregard customer value, and therefore more future losses to be borne by the tax payer.
The recent take-over of financial institutions by public authorities may save them in the short run, but is not good news for the allocation of capital in the long run. Moral hazard problems are highly exacerbated in publicly controlled firms. In fact part of the current problems stem from excess political involvement in credit markets: Freddie and Fanny have a federal guarantee on their debt. As a result they could issue any amount of debt at a lower cost than their competitors, and no creditor would even think before purchasing it. They indulged in using that money in making poor loans to the housing sector; their public guarantee did not make them more virtuous than the rest of lot, quite the contrary indeed. Furthermore, it seems that Freedie and Fanny were not immune from political pressure to extend loans to poor families despite their likely insolvency.
This does not look too much like “capitalism”, nor do the artificially low interest rates of the early 2000s which contributed to the housing bubble.
It is true, though, that consumer credit and mortgages are less regulated in the US than in, say, France. But it is not clear that irresponsible lending would have taken place in the absence of a government ready to socialize losses and having already done so during the Savings and Loan crisis.
Those whose are enthusiastic for public control of the financial sector should recall the French Crédit Lyonnais scandal when politically acquainted executives spent their publicly owned bank’s capital in all sorts of worthless projects (some of them being pure looting involving organized crime). A number of these projects were located in the electoral districts of highly influential politicians – so that the CEO at that time, Jean-Yves Haberer, defended himself by arguing he was working hand in hand with the politicians to defend French jobs and boost the size of the company. The recent partial nationalizations in the UK are associated with claims by politicians that there will be more lending to fund “small businesses” and home ownership for poor households. This is clearly allocating credit on the basis of a political agenda, and is doing nothing to prevent a subprime crises in the future.
The only advantage that publicly controlled lenders could have over private lenders is that the former could refrain from joining asset bubbles and value collateral at its true fundamental level. As far as housing is concerned, experience shows us that is certainly not the case: political considerations make them even more likely to engage in poor loans.
So the current wave of bail-outs is the next stage of crony social-capitalism with the associated drain on the allocation of capital and a real risk of yet another round of reckless borrowing and another crisis.