Economics

We seem to be stuck in a remarkable twilight zone of mixed emotions, ideologies, and political calculations whenever the word ‘nationalization’ creeps into discussion. It is increasingly difficult to keep all the cross currents and strange alliances orderly. We have an, ostensibly, left of center administration desperately trying to talk down the nationalization alternative, while some of our most ardent conservatives have thrown in their lot backing it.

What is going on?

I can only think that the administration is so in the thrall of market driven thinking that it cannot see the simple efficacy of socializing not just the losses that are making the banks insolvent, but also the gains that will inevitably accrue in a few years in the aftermath of recovery.

Take Geithner’s argument this week. He cautioned against what he decried as ‘hasty’ action because the so-called toxic assets will have a higher price in the future. This is an extremely odd statement. I am not, as you are all aware, a huge fan of free market economics, but there has to be a logic to the current low valuation placed on those assets. Geithner says it’s because no one wants to buy them. Well duh! That’s why they aren’t worth anything Tim. Then he really wanders off the textbook message by arguing that they are ‘worth more than their current price’. Ummm. I was taught that something is ‘worth’ what it will fetch in the market. For Geithner to be correct these toxic assets have to have an intrinsic value that no one can quite discern at the moment. He’s spouting rotten economics. Really rotten. And it’s even quite bad accounting.

What the administration seems to be arguing is that we should fork over lots of money to the shareholders of the banks so that the assets can be written down to today’s, incorrect, level, and then applaud when those self same shareholders gather in the windfall profits that will inevitably arrive once the market gets over its temporary inability to understand what those assets are worth. It’s the ‘wait until the market comes to its senses’ policy.

The problem is that the market won’t come to its senses until the banks are healthy. No one believes that the assets are worth much except for Tim and the banks. Claiming that the market is wrong doesn’t seem like leadership to me. It seems like avoidance. Plus for the Treasury Department to think that the market is failing doesn’t give me a warm feeling about its ability to handle the essential tasks of helping manage those markets.

I have no doubt that the toxic assets weighing down on Citibank and the others will eventually be sold for more than they can today. The point is, though, that until they are off the banks balance sheets the banks can’t afford to lend They will wobble along as ‘zombies’ neither dead nor alive.

The whole point of a bailout is to prevent the zombie bank syndrome from hampering the economy’s recovery. The assets won’t go up in value the way Geithner wants them to until the economy recovers. There will not be a recovery until the banks are healthy. The banks won’t get healthy until the assets are sold off.

Geithner doesn’t seem to notice this elementary circular argument. Perhaps he thinks the economy will recover anyway. Perhaps he hasn’t a clue. Or perhaps the administration just wants the whole problem to go away of its own accord.

That sounds a lot like Bush. I thought we had voted for change.

Meantime here’s a great article by Martin Wolf of the Financial Times explaining why the administration is totally misguided:
FT.com / Columnists / Martin Wolf – To nationalise or not, that is the question

The big point to look for in Wolf’s article is the concentration of assets: the ‘big four’ American banks [Citi; JP Morgan Chase; B of A; and Wells Fargo] have 64% of all banking assets. You fix them, you fix banking. Simple. So nationalize any two. That will get the market’s attention and free up credit flows very quickly – after the initial shock of course. Why wait for Tim’s mystery valuations to turn up?

Nationalize now. Every day is a wasted opportunity to get things back to normal.

I don’t want to wander too far into the purely political realm, but I am beginning to get annoyed at the Republican party and its attitude toward deficit spending.

It’s one thing to be an ardent fiscal conservative and abhor deficits. That I understand. It would be very bad economics in the depths of a recession and even worse in a depression, but it would be a coherent position.

But it is quite another to announce as some leading Republicans are now doing that they are opposed to the current administration’s stimulus package because it increases the Federal deficit. My confusion and annoyance stems from the simple fact that the largest non-wartime deficits in American history have been those of Reagan and the most recent Bush. I recall the Republicans telling those who criticized running up the deficits in peace time that the tax cuts ‘would pay for themselves’ due to the stimulus they would create and the subsequent increase in tax revenues we would collect. We were also told by none other than Dick Cheney, a Republican I believe, that ‘deficits don’t matter’. So why is it that Bobby Jindal can go on TV and say he hopes Obama fails because the stimulus package creates a deficit and Republicans object to spending more than we take in? Are we not to notice the budget numbers for the past eight years?

It used to be that the Republican economic dogma bore a vague resemblance to standard Chicago School economic theory. Milton Friedman and his successors at Chicago developed the dominant form of economics – that kind you find in the standard textbooks – which has a decidedly ‘free market’ bias to it. The fit with old fashioned Republican ‘individualism’ was perfect. But with Laffer and his heirs the link with the textbook was broken and the GOP wandered off into a parallel universe where deficits created by massive tax cuts are OK, but deficits created by government programs like unemployment insurance, are wicked.

To be fair it isn’t just the Republicans who have their underwear in a twist at the moment. The Chicago School is under attack too. The most recent form of Chicago economics developed by Bob Lucas tells us that fiscal policy, i.e. running a deficit, won’t work because consumers are rational: they will realize that the near term deficit merely means medium term increases in taxes so they will save more to offset that future tax bill. The implied reduction in consumption, according to Lucas, will, exactly offset the increase in government spending and, consequently, negate any stimulative effect it might have had. This ‘Lucasian’ theory displaced Keynesian theory and became the dominant approach at the Federal Reserve Board and Treasury department. The pervasive adoption of Lucasian economics explains why, even now, getting a consensus amongst economists to support massive government spending has been difficult. The Chicago folks are fighting a fierce intellectual rearguard action which helps explain the ferocity of the criticism people like Paul Krugman [a committed Keynesian theorist] gets from erstwhile colleagues in academia.

The point of my short foray into the internecine struggles within economics is to bring to the surface that the Republicans are losing their intellectual legitimacy. To the extent that they relied upon Friedman and Lucas to provide heft to their ideas, they will now need to search for something else. This might explain why they sound so hapless currently. They are adrift and out of step not just with the country’s emotional center, but with their notional intellectual roots.

Time for some new ideas?

Or, at least, less of the hypocrisy that has been so annoying lately.

It seems to me that there is a great gap between the reality I perceive and the reality that the administration perceives. Form my vantage point the economy is poised at the edge of a prolonged and hugely damaging recession/depression. It could take years to undo the damage of the last three decades and to correct all the imbalances in the economy. During that time we might see vast numbers of people here and abroad suffer through unemployment, loss of income, loss of savings, and constant fear. The potential social cost of this experience could be very large indeed. We only have to go back to the 1930’s to understand what economic uncertainty can do to undermine a nation’s social fabric. During that decade it was by no means certain that either liberal democracy or capitalism would survive the onslaught of populism. Fascism and Communism both approached their high water marks while the market economies all wallowed in depression.

So why is it that our leaders seem to be incapable of taking bold action to clean up the financial system? After all it is in the credit system that this recession began and continues to linger most strongly.

My argument for nationalizing the banks is a case in point. It’s not as if I am alone. Paul Krugman says it here: Failing the test – Paul Krugman Blog

I pointed out last week that I thought there was a danger that the Treasury Department was rigging the risk stress testing it is carrying out to make sure that the big banks pass and thus remain in private hands. This is hardly sensible policy. The reticence to confront issues squarely and aggressively is the hallmark of failing leadership. There is nothing strong about circumspection when the damage is accruing at a rapid pace. Sometimes a leader has to step up and take the chance that a quick decision will cause a loss of support. Sometimes leadership consists of making a decision that turns out to be an error when hindsight can be applied. But in most cases, such as those of today, boldness itself mitigates the error.

I think nationalization falls into this category.

No one wants the banks to be run long term by the government. At the same time no one wants to linger in the slow death spiral we seem to be tolerating so as not to upset or interfere with the shareholders of our banks. Frankly the time for polite respect for private ownership has long gone. Let’s face it: the shareholders let this mess develop. They were more than willing to accept the high risks embedded in the banks’ balance sheets as long as it produced high returns. Now they have to accept the concomitant losses that high risk usually also produces. Tough. That’s the way of a market.

We have plentiful evidence that a weak response to a credit crisis makes matters much worse. Temporizing only delays having to do the dirty work. We have now arrived close to the day that inaction will tip our recession into a depression.

Obama, Geithner, Summers and the rest of them had better wake up and stop the palliative approach. Bring out the hammer and be done with it.

Now.

How about this for effort? AIG reported this morning that it managed to lose $61.7 billion in the fourth quarter of 2008. Here’s the New York Times report: A.I.G. Reports Loss of $61.7 Billion as U.S. Gives More Aid

Think about that. $61.7 billion in one quarter. Astonishing. Floyd Norris, also at the NYT, has calculated that this means that AIG contrived to lose $465,421 a minute for the entire quarter.

You just have to stand back in awe at the stupendous dimensions of the incompetency that produces a calamity of that proportion. These people weren’t just stupid, they went for the universal gold medal for ridiculous stupidity. It’s breathtaking to think that any of those responsible at AIG for this mess aren’t in jail.

What were they thinking?

Well apparently not much other than how to book fees as fast as possible.

The employees who created the book of business that is now imploding with global ramifications were obviously idiots. But they were the kind of idiots that you only come across in the financial markets. They were immensely self assured and clever idiots. they should all be banned for life from finance and made to sweep streets for the remainder of their miserable lives.

What did they do?

They created a business around a product called ‘credit default swaps’. This little toxic piece of financial jiggery pokery allows traders at a financial company, such as the imbeciles at Citibank, to buy insurance on their low quality assets such that AIG will reimburse for any losses. Hey presto! The low quality assets can now be sold as pristine AAA rated assets because AIG’s rating was AAA [not now I guess!] and it has insured any buyer of those assets against loss. For a very large fee of course.

So far so good.

Both the sets of traders have met their bonus pool goals and can now buy a Hamptons home. Great. But this scheme [scam?] only works in a parallel universe where assets like homes have prices that only ever go up. Who cares about that little detail? Not the traders because they’ve received their bonuses. Not the executives, because they’ve also been paid lavishly and they’ve been lionized in the press fro having delivered fat returns to their shareholders. Not the SEC, who signed off on the scheme [scam] because it was ideologically driven to applaud the innovative power of unregulated markets. Not the Bush administration. Not the rating agencies who kept AIG’s rating at AAA even as the tsunami gathered pace and power. No, no one cared. The indifference to the impending disaster was stunning, but mainly for the fact that no one seems to have realized that it was a monumentally stupid business model with catastrophic potential not just for the investors stuck with the toxic assets that were later proven to be awful, but the public as well. After all we are the ones paying for those jackasses who built the scheme.

As an example of the lunacy that gripped the markets back in those distant days: the appropriate government agency to bail AIG out is the Treasury Department. Did they? No. Under Paulsen they were quite content to let AIG wallow. It was the New York Fed that stepped in to bail out AIG and stop the cascading collapse that would necessarily have followed a default. The Fed has no official jurisdiction over AIG because it is an insurance company. It was the damage that an AIG default would do to the banks that impelled the Fed to act outside its remit.

From the perspective of the worldwide credit markets it is AIG that towers above all else as the center of the disaster.

And that says a lot when you look at the stupidity of the sub-prime mortgage mess. It really takes some doing to one up the mortgage lenders. But as this horrendous quarterly result, and the ongoing bail out operation, demonstrate AIG’s incompetent executives seemed to have pulled off the impossible.

$61.7 billion in one quarter. Now that’s what we call a loss. Makes Citibank seem half-hearted doesn’t it?