Economics

Those of you who know me well enough will understand my glee when I read this article from today’s New York Times: Rescue of Banks Hints at Nationalization

I have said all through this crisis that the cleanest and quickest way to bail out the banks is to inject capital. The plan would be for the government to take a shareholding position in return for the money it puts into the bank. Citibank is a prime example: their losses are now so large that the amount of capital required to bail them out is sufficient for the government to become the majority shareholder. So the question becomes should the government own stock in return for its cash, or should it take some other form of position, like a loan? I say stock.

Nationalization of banks has been done before. I have mentioned the Swedish example in the past. During the 1990’s Sweden went through a massive credit crisis. The Swedish government was forced to step in and bail out the local banks. So large had the crisis become that eventually the government ended up owning the banks, which it then ran for two or three years while the crisis ebbed. After the problems had all been dealt with the banks were then sold back into private hands. So the nationalization was a temporary solution and not a permanent intrusion by the government into the market place. And it worked like a charm.

This is the solution I have been advocating for America. Quick, easy, direct and painless. The issue here is that the word ‘nationalization’ is such an anathema. It conjures up all sorts of demonic images of European style capitalism that Republicans break out immediately into a frenzy of patriotic Euro bashing that muddies the waters.

My view is that the all American style capitalism of the Reagan era is dead anyway. It died in the aftermath of its two great bubbles: the dot com and real estate bubbles of the past two decades. The wealth created during those years was an illusion. The shining city on the hill was actually suspended in midair without a solid foundation. It’s time to admit as much and move on before we hurt ourselves any more.

In this regard nationalization emerges as a viable and temporary problem solving device. It works. Let’s do it and get on with rebuilding the economy rather than waste away a few more valuable months dithering over attempts to salvage Reaganomics from its proper resting place: the garbage dump.

I mentioned yesterday that we should evaluate the effects of any stimulus package through the lens of the ‘multiplier effect’. The notion is that any money spent by the government passes through several pairs of hands as it circulates the economy. Spending creates demand which creates jobs and thus more demand. And so on.

One result of this I did not mention is that the multiplier also increases the taxes that the government will collect exactly because it has increased incomes. So some of the stimulus will be paid for by that tax revenue income. Consequently a stimulus of $1 trillion will end up costing less as the tax revenues flow in. Take this into account and the multiplier is even more magnified. Furthermore, the differential between ‘good’ stimulus a like direct spending and ‘bad’ stimulus like tax cuts is amplified, undermining the case for tax cuts even more.

Here’s the blog link where this idea is explained in more detail: Multiplier Explained

Some of you have complained that banks are wrong not to have loaned the money they received from the government bailout program [‘TARP’ for short]. There is plenty of angst in Congress over the same issue, so let me explain what I think has been going on.

Only about half of the money set aside has been used so far [$350 billion out of $700 billion], and about 100 banks have received money as part of the TARP program. Originally Congress set aside the money so that the Treasury Department could buy bad assets from banks and thereby enable the banks to concentrate on lending rather than worrying about what to do with bad assets. The banks had already been taking an unprecedented battering to their capital, so the idea was that getting rid of the potentially bad assets would prevent further damage to capital ratios.

Remember that banks lend a multiple of their capital and are required by the various regulatory authorities to keep plenty of capital to absorb losses. So from a bank’s perspective its capital is its own ‘safety net’ that must be preserved at all costs. Without adequate capital a bank simply won’t lend. Instead it will hoard its income in order to build back until it has an adequate capital base again. Then it will restart lending.

The flood of losses, mainly from bad housing loans, that swept through banking in late 2007 and early 2008 reduced bank capital to a threadbare minimum. The effects of these losses on the capital markets [a generic phrase covering a variety of specialty markets] was to undermine confidence. Banks became fearful of doing business with each other because they had no idea whether they would get their money back. The result was to drive interbank interest rates up to historic highs with some money markets stopping altogether. Since the credit markets are central to the economy as a source of funding business immediately suffered.

TARP was designed to help restore confidence by eliminating bad assets and thus reassuring the banking system that interbank trade could return to normal. Once that happened the notion was that markets would calm and business could also return to normal.

The problem was that banks were then facing a different issue. The non-financial economy began to slide into recession. This is a separate, though obviously related, problem. The financial crisis TARP was supposed to deal with was restricted to the credit system, but now the ‘real economy’ was also in decline. This meant that banks would have to deal with a second wave of losses from commercial and personal loans. That second wave would undo all the good work that TARP had fixed.

When it realized this story was unfolding the Treasury Department backed away from the original plan. In fact it never implemented it. Instead it switched to a plan of using the TARP money to inject capital directly into banks via a number of means including the purchase of preferred stock. So the government began to become a shareholder of some of largest banks rather than an owner of wads of bad assets.

This switch is the core of the problem. Banks have been given infusions of cash, but they have been slow to lend it because they are waiting for business conditions to improve – they want to be repaid – and they are still concerned that they need to hoard capital in the face of the mounting second wave of expected loan losses. So the banks have acted prudently [its about time!], but have frustrated lawmakers who thought the money in TARP was going to flow into the economy in the form of loans.

It seems that lawmakers don’t understand banking. If they had wanted to make sure loans were gong to be made they should have relieved the banks of having to keep capital. The best way to do this is to nationalize them. State owned banks don’t care about hoarding capital because they know the government can always print more money to replace any losses they incur. Privately owned banks don’t have that luxury. Private shareholders want to know that the banks they own are acting to preserve capital and are not being profligate with shareholder funds. So TARP ran afoul of sensible banking. What it has achieved is to prevent some banks going bankrupt and to provide a temporary bulwark against the erosion of capital. It could never have created lending because banks simply want to stay afloat through the recession and the best way to do that is not to lend. Because America won’t nationalize its banks [other countries like Britain and Sweden don’t worry about nationalization] it has to muddle through by injecting enough capital into the system to ensure its solvency. By my estimate that means that the bailout is only half done. The potential for losses is still there as the economy wallows in recession. That means banks will take hits to capital from loans they have already made. They have no incentive to add to the problem. Until business conditions improve the Treasury Department will have to pump money into banks and accept that no new loans will be made.

So my advice to lawmakers: get the economy rolling again and stop fussing about lending. Support the stimulus package. A healthy economy will find that bank loans are plentiful.

Note:

Bernanke made a speech at the London School of Economics [gotta plug the alma mater] during which he raised to prospect of more bank bailout money being needed. Here’s the story from the New York Times: Banks In Need of More Bailout Money?

The collapse of retail sales continued into December. The size of the decline surprised most analysts who had been expecting the slide to extend to the end of the year, but had not anticipated quite the drop we saw. Here’s the press release from the government: ADVANCE MONTHLY SALES FOR RETAIL AND FOOD SERVICES:

The decline was very sharp, down 2.7% from November and down a whopping 9.8% since December 2007. What makes matters worse is that November’s figures were revised to show a sharper fall from October than had been reported before [the October to November decline was increased from 1.8% to 2.1%].

Leading the way was decline of 35.5% from December 2007 in gasoline sales, and 22.4% in auto and auto parts sales. While retail stores saw a 2.7% decline in the same period.

These numbers are bad. They confirm the overall grim picture of continued contraction in the economy. Because personal consumption is about two thirds of the total economy the slump in spending means that the economy is still contracting. Thus the recession is still deepening with no end in sight. Most forecasters are now arguing that the recession may last all year and that we will not get much if any growth until the early part of 2010. If this outlook is correct then we are experiencing the worst recession since the Depression without any doubt.

Consumer confidence is obviously very low. The collapse in home prices and the potential loss of jobs are forcing the average American to retrench rather than buy. This has set in motion the classic ‘paradox of thrift’ where one person’s retrenchment is another person’s lost job. This vicious cycle can only be broken by a recovery in confidence and the loss of fear. Banks are loth to lend for fear of losing their money; businesses are cutting back jobs in order to maintain profitability; and families are being forced to reduce spending in order to make ends meet. Unfortunately this is the picture we are likely to see all year long. This morning’s sales figures only confirm the story.

All of which reinforce the need for urgent and strong action from Congress. The stimulus package must be enacted quickly. And it must be adequately sized. This is not a time for timidity or penny pinching concern over the long run impact of government borrowing. As Lord Keynes famously replied when asked whether he feared the long run effects of government deficit spending: ‘In the long run we are all dead’.

We have managed to put ourselves in peril. So fussing over budget deficits has become a foolish diversion. Right now we need to bail the water out. When we have stopped sinking we can worry about the details of the ship.

OK here’s an interesting article brought to my attention today: Time For Tax Hikes | CommonDreams.org

Interesting thesis, and certainly controversial at the moment when we are all running around in a frenzy of Keynesian deficit spending.

Here’s my take:

I am not sure that higher taxes automatically means higher growth. The old adage ‘correlation is not causation’ has real meaning in this case. The fact that higher taxes seem to occur at times when growth is higher doesn’t mean that there was any cause and effect.

Having said that: it is absolutely clear that the ‘trickle down’ or “Laffer” curve theory is totally bogus. There is no evidence at all that lower taxes automatically increase growth. This is because lowering taxes usually only affects the well off who don’t then rush out and spend the extra money they now have, but rather they save it. So lower taxes has a low stimulative impact on the economy [remember that growth is an increase in spending and investment less net exports].

The Laffer theory was based on the notion that the money saved through lower taxes would go towards investment, which would then increase productivity which consequently increases wealth in the future [investment increases the capacity of an economy to generate wealth in the form of additional jobs etc]. In other words the cut taxes would ‘trickle’ through investment and end up as higher wages.

One of the problems of the past few years is that the investment went overseas and so created wealth elsewhere … it was more profitable to invest in low wage countries. But the main reason that investment supposedly flowing from the Bush tax cuts seems to have been ineffective is touched upon in the article: money flooded into non-productive areas like real estate. This provides a temporary stimulus only through construction jobs and subsequent furnishing purchases, but does not contribute to a more permanent productivity growth and hence future wage growth. This is one of the reasons wage growth was so poor over the past decades: investment was not going to productivity enhancement.

So the extra liquidity caused a bubble, not productive asset acquisition.

Raising taxes today would have a stimulative impact only if the government then went and spent the money on something. The Kennedy/Johnson tax increases were designed to offset the cost of the Vietnam war … wars always stimulate the economy because governments spend money on non-productive material like guns etc. In other words the economy was being stimulated by defense spending not the higher taxes per se.

Also bear in mind that any tax increase would reduce, potentially, spending by the wealthy so the increase in government spending could be offset by the reduction in private spending. Economists have measures for things like this. They measure the ripple effect of money being spent as it works its way through the system. As money is first spent, say in a store, it enables jobs to be created and therefore wages paid. those wages then get spent … and so on. The effect means that a single dollar spent provides more than one dollar’s worth of economic activity. The net effect is called the ‘multiplier effect’. Right now a good estimate is that one dollar of government spending has a multiplier effect of roughly 1.5. So a $1 billion of spending grows the economy by roughly $1.5 billion when all is said and done. Tax cuts are far less efficient, they have a multiplier of less than 1 and so are much less effective as a stimulus. One last thing on multiplier effects: the wealthy tend to spend less of their income as a percentage. This means that a tax increase on the wealthy has less of a drag on spending than a tax increase on the poor [who, for obvious reasons, spend most if not all their after tax income]. The thesis of the article relies heavily on this fact. The notion is that the wealthy would still spend even if their taxes went up, so the negative growth impact would be minimal.

For the thesis of this article to hold we would have to have large scale government spending on education, roads, rail etc [hopefully not a war]. Presumably these would be paid for by tax increases on the wealthy. But the various multiplied impacts suggest that the increase in growth from the government spending would be at least partially offset by the decrease in spending the wealthy [the data suggests that the wealthy are cutting back more than normal due to the reduction in their wealth held in the stock market and in real estate]. So it’s a pretty bad idea right now.

Ironically that is one reason not to get out of Iraq right now: the reduction in defense spending would adversely affect the economy just as we are trying to stimulate it!!

Lastly it probably is a bad idea to drain cash out of private hands at the moment: we need every penny we can get spent in stores to stimulate the economy. This is also why cutting taxes as part of a stimulus package makes no sense, people would simply save the cash rather than spend it.

In more regular times, and lets hope we get back to such times soon, a progressive tax code provides a balanced way to provide revenue for heavy government spending without causing a huge drag on growth. The article is correct in pointing out that high taxes and strong growth often occur together. There is no cause and effect there though. It is simply that during periods of strong economic performance the government has been able to raise taxes without causing a slowdown.

Nice try though.

Note:

Thanks go to Tom for sending the article!