Everyone Get in Line

For months now, Ricardo Caballero has been proposing yet another solution to the toxic-asset problem: universal, government-provided insurance for the assets. He recently let loose a double-barrelled volley in both the FT’s Economists’ Forum and the WSJ’s Real-Time Economics blogs. I believe he is correct that this would solve the problem: if the government is insuring any bank assets that the banks want them to insure, then the banks are protected from any further write-downs, and they are healthy by construction. However, there are other ways of getting to the same outcome. One would be for the government to pay face value (or current book value) for any assets that the banks would want to sell. Another would be to take over every single bank that fails Mr Geithner’s stress test, pull out all of their bad assets, and reprivatize them. All of these solutions will result in banks that are not encumbered by the fear of further writedowns on toxic assets.

In judging between these options, we need to look at the details. For Caballero’s asset insurance proposal, this means looking at the price of the insurance. Remember, banks could buy this insurance right now on the free market if they wanted to. The problem is that the insurance is too expensive. Caballero’s proposal is only a solution if the government offers insurance at a lower price than the market (a subsidy, in other words). And this is precisely what he is suggesting:

The price of the insurance should be set at pre-crisis levels for the corresponding asset class. If there is a sense that these assets were over-rated to begin with, then we should adjust the prices accordingly (for example, use AA pre-crisis insurance prices for overly-rated AAA assets).

This arrangement should be coupled with tight monitoring of the insured institutions and with retroactive fines a few years down the road to those institutions (and their management) whose assets underperform relative to their asset class.

Essentially, this relies on the assumption that the assets will turn out better than we currently think. (”[T]here is no need to resolve the thorny issue of the insurance price and the quality of the assets right now. We can wait for the passage of time and a return to normality to determine whether their assets were worse than the representative asset in the corresponding asset class.”) If they do, then everything will turn out OK. If they don’t, then we will charge the banks fines to reflect the difference. It seems to me that those fines represent an uncertain liability that will still be hanging over the banks; or, alternatively, the fines will be so small that they won’t affect the banks materially.

In the end, this looks the same to me as the plans in which the government simply buys the bad assets. In Caballero’s plan, the government doesn’t lay out cash, but provides underpriced insurance that creates large potential liabilities. In the asset-buying plans (including Geithner’s public-private partnership), the government does lay out cash, but gets assets that have some value, and could have more value in the future. In either case, the ultimate size of the bill depends on whether or not the assets recover in price; once the risk has been transferred to the government, the rest is just details.

Now, that doesn’t make this option necessarily any worse than the others. I believe the goal is to have healthy banks, and the taxpayer will pay one way or another. So the asset insurance proposal deserves consideration.

But what I really don’t understand is Caballero’s framing of the discussion. In the FT:

In all likelihood, political constraints severely limited the ambition and effectiveness of the US financial stability package. Economists need to unite behind relaxing these constraints. Talking lightly about nationalisation, as is increasingly taking place, does exactly the opposite.

There are two types of arguments for nationalisation. One argument is a gut reaction that enough-is-enough and we must stop transferring resources to Wall Street’s “crooks and oligarchs.” This reaction only adds fuel to the fire and exacerbates self-destructive mob-mentality behaviour.

We need to stop this.

And on Real-Time Economics:

It is true that the recent announcements are lacking specific details, and perhaps revealed that the Treasury’s economic team overestimated people’s ability to distill the good news in an abstract message of principles when in panic mode. But there is good news in them, as they reflect a much deeper understanding of the fundamental uncertainty problem ravaging insurance and credit markets than commentators and politicians have. It is time for all of us to focus on facilitating their difficult task and to try to fill some of the gaps.

It seems to me that Caballero is saying that the proponents of nationalization – recently joined by Alan Greenspan – are irresponsible, and that the correct path is to support Tim Geithner and his plan – which, according to Caballero, is basically the same as his plan. (”US Treasury Secretary Tim Geithner’s proposal . . . is probably as much as he could get in a heavily-politicised environment. Coupled with the bad bank arrangement and guarantees for private asset buyers, it resembles the insurance solution described above.”) This claim is confusing to me, since Geithner’s plan is for private capital, backed by government loans, to buy up toxic assets. But there’s no need to debate that here.

The important point is that Caballero’s proposal is one that would probably be welcomed by most banks, since it allows them to continue in their current form while transferring their risks to the government. This enables Caballero to write off political considerations as unwelcome intrusions into the sphere of economic reason. However, if you support a solution – like nationalization (or, as Simon prefers to call it, “reprivatization”) – that would not be welcomed by the banks, then political considerations become part of the story. In any case, I find it surprising that an MIT professor would call on his academic colleagues to stop criticizing the Treasury Department because they are “exacerbat[ing] self-destructive mob-mentality behaviour.”

Insert your own historical analogy here.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.