A “deal” mentality is bad macroeconomics
Ricardo Caballero 05 March 2009
The Obama team’s strong words are accompanied by policies focused on obtaining a ‘deal’ for taxpayers. Here among the world’s leading macroeconomists argues that squeezing current stakeholders for political appearance is short-sighted and self-defeating. Before systemic panic is alleviated, the crisis will continue. This involves the investment of massive political capital at this time; we are running out of time.
We are running out of time and there is absolutely no result in sight unless massive political capital is jeopardized now. We have an excellent team of economists and technicians, but their voices all appear to have already been lost. I recall Larry Summers rightly claiming that if markets over-react, the federal government has to over-react a lot more. Secretary Geithner, even in his much criticized first announcement, sounded if you ask me such as a man of principles, the proper principles. We should stabilize the economic climate, irrespective of cost, was the message delivered with clenched teeth. However, Geithner’s and Summer’s actions usually do not match their own strong rhetoric. It isn’t that they don’t draw lines in the sand when confronted with political pressures, but instead, they appear to be spending a lot of their energy tackling political hurdles instead of facing head-on the financial meltdown.
We are coping with a massive issue of uncertainty and fear. There are, for certain, important real problems to resolve, especially inside our main finance institutions, but these are issues that are hard enough to resolve in normal circumstances, plus they are insurmountable unless panic is put to rest. Regardless of just how many inefficient contortions, liquidations, and conversions individual finance institutions may do, before issue of systemic panic is resolved, it really is only a matter of time before next crisis blows up inside our faces. Those that believe that solving the problems of 1 bank, by nationalizing it or elsewhere, will restore confidence, fall into an extreme fallacy of composition. What could be the right solution for an isolated case, isn’t, or could even backfire, for a systemic problem.
Last week, most of us saw the need for confidence within an environment gripped by fear. As chairman Bernanke testified before the Senate Banking Committee, markets started to rise. It was not merely his clear message and sense of competence, nonetheless it was also the change in tone of the complete debate – somehow political posturing vanished as the Q&A progressed, and the exchange became responsible and focused.
However the mood changed with the conversion-deal Citi was, directly or indirectly, forced into. The main element word is “deal.” Our government is apparently so terrified of a political backlash from being regarded as favouring banks over taxpayers (as though that indeed was an available tradeoff!), that it’s approaching financial policy with a “deal” mentality rather with a systemic and medium-run perspective. “Are we obtaining a great deal for the taxpayer in this specific transaction?” isn’t the proper question to ask. Instead, the proper question is “What’s the best solution which will enable us to recuperate immediately?” Trillions of dollars of wealth and income are being sacrificed for political appearance sake.
I want to contrast this Citi deal and the financial panic it triggered with an alternative solution I proposed the other day in a Washington Post article (and in an extended version in Roubini’s RGEMonitor and in Baldwin’s VoxEU). There I argued an effective mechanism to avoid the current unpredictable manner in equity markets will be that the federal government guarantees the very least price in some of the shares a couple of years from now. The mechanism functions by what economists call backward-induction: If we realize that the purchase price will be at least something later on, and there can be an upside potential aswell, then the price should be even higher today. Since the other day I have exercised with Pablo Kurlat, an MIT Ph.D. student, just a little model that yields some interesting numbers. That is room for details, nonetheless it suffices to state that among the conclusions that arrived of it really is that had the federal government offered the very least future share price guarantee to new equity holders of $2.7, it could have boosted share prices today to $6.8 and invite Citi to attract all the private capital that it could dependence on an extreme scenario.
It gets more interesting than this however. Because investors are so scared, the federal government can make an excellent business by selling insurance. Guess that rather than the $2.7 guarantee, the federal government decides to provide a super-guarantee on the brand new equity of $5.8 per share. This guarantee would immediately raise the share prices to $8.4 (even of the old shares, that are not directly guaranteed) and invite the bank not merely to improve enough private capital to fight a potential liquidity shock, but also to settle $17b of the government’s preferred shares. This policy comes with an expected net gain for the federal government of $3.8b and a lower risk exposure than direct equity holding. Of course they are very rough estimates, but their qualitative features are robust. Essentially, through the insurance mechanism the federal government transforms heavily discounted equity right into a treasury bond and also a call option on the upside of the lender. By doing so it creates it easy for banks to improve capital through equity issuance at reasonable prices, also to repay the Treasury because of its insurance provision service.
More important than this type of proposal, the main element message I hope to mention is that squeezing current stakeholders for political appearance is short-sighted and self-defeating. Conversely, doing the opposite is just about the only hope we’ve for a (mostly) private sector solution to the problem, and therefore for a genuine and permanent solution.
At this time of the crisis, bad news spread quickly over the financial network. Recall that Citi’s share prices crashed by 40% after last week’s conversion, however the demise didn’t visit Citi, as Bank of America’s shares fell by a lot more than 20%, Wells Fargo by 16%, and so forth. It is imperative that people reverse this contagion mechanism. For instance, it isn’t too farfetched to believe that had the equity insurance coverage been adopted for Citi rather than the conversion plan, the cost of the other financials also could have risen sharply – after knowing that the government is actually focused on supporting wealth enhancing private solutions. All of those other market could have risen, thus triggering an excellent feedback mechanism. Policy must focus on mechanisms which have the potential to spread very good news through the entire system.
Taxpayers usually do not go on the moon and therefore are exposed to the expenses of financial catastrophes aswell. Across the world governments are hoping that small repairs (in accordance with the magnitude of the crisis) will suffice, and interactions have become more virulent each day. It’s time to eliminate this madness also to match the strong rhetoric with equally strong ammunition, that will require using political capital in the short run. There is absolutely no spot to hide. However, the return from reversing the unpredictable manner will be enormous. Here is the North to bear in mind.