Topic: Finance, Banking & Monetary Policy

Bailouts Could Hit $24 Trillion?

ABC News reports:

“The total potential federal government support could reach up to $23.7 trillion,” says Neil Barofsky, the special inspector general for the Troubled Asset Relief Program, in a new report obtained Monday by ABC News on the government’s efforts to fix the financial system.

Yes, $23.7 trillion.

“The potential financial commitment the American taxpayers could be responsible for is of a size and scope that isn’t even imaginable,” said Rep. Darrell Issa, R-Calif., ranking member on the House Oversight and Government Reform Committee. “If you spent a million dollars a day going back to the birth of Christ, that wouldn’t even come close to just $1 trillion – $23.7 trillion is a staggering figure.”

Granted, Barofsky is not saying that the government will definitely spend that much money. He is saying that potentially, it could.

At present, the government has about 50 different programs to fight the current recession, including programs to bail out ailing banks and automakers, boost lending and beat back the housing crisis.

We used to complain that George W. Bush had increased spending by ONE TRILLION DOLLARS in seven years. Who could have even imagined new government commitments of $24 trillion in mere months? These promises could make the implosion of Fannie Mae and Freddie Mac look like a lemonade stand closing.

Is an Independent Fed Better?

Rep. Ron Paul now has a majority of the House of Representatives supporting his bill for an independent audit of the Federal Reserve System. He presented his case at a Cato Policy Forum recently, with vigorous responses from Bert Ely and Gilbert Schwartz.

Now more than 200 economists have signed a petition calling on Congress to “defend the independence of the Federal Reserve System as a foundation of U.S. economic stability.” The petition seems implicitly a rebuttal to Paul’s bill.

Allan Meltzer, a leading monetary scholar and frequent participant in Cato’s annual monetary conferences, declined to sign the petition and explained why: “I wrote them back and said, ‘the Fed has rarely been independent and it strikes me that being independent is very unlikely’” in the current environment.

Cato senior fellow Gerald O’Driscoll adds:

it is not the critics of the Fed who threaten its independence, but the Fed’s own actions.  Its intervention in the economy is unprecedented in size and scope. It is inevitable that those actions would lead to calls for further Congressional oversight and control. 

One of the lessons here is that once you create powerful government agencies, from tax-funded schools to central banks, there are no perfect libertarian rules for how they should be run. The way to protect freedom is to let people make their own decisions in civil society.  Schools have to decide what to teach, offending the values of some parents and taxpayers. The Fed can be independent and unaccountable and undemocratic, or it can be subject to the political whims of elected officials; neither is a very attractive prospect.

What Fed Independence?

More than 250 economists have signed an “Open Letter to Congress and the Executive Branch” calling upon them to “defend the independence of the Federal Reserve System as a foundation of U.S. economic stability.”

Allan Meltzer is not a signatory to the petition and he has explained why not.  The Fed has frequently not shown independence in the past, and there is no reason to expect it to do so reliably in the future.  Professor Meltzer has just completed a multi-volume history of the Fed and knows all-too-well of the Fed’s willingness to accommodate the policies of administrations from FDRs to Lyndon Johnson’s. 

I would add that the Fed’s behavior under Chairman Bernanke breaks new ground in aligning the central bank’s policy with Treasury’s.  Much of what the Fed has done, first under Bush/Paulson, and now under Obama/Geithner, involves credit allocation.  Since that ultimately involves the provision of public money for private purpose, it is pre-eminently fiscal policy.  Central bank independence is a fuzzy concept.  If it means anything, however, it is that monetary policy is conducted independently of Treasury’s fiscal policy.

In short, it is not the critics of the Fed who threaten its independence, but the Fed’s own actions.  Its intervention in the economy is unprecedented in size and scope. It is inevitable that those actions would lead to calls for further Congressional oversight and control.  The Fed is a creature of Congress and ultimately answerable to that body. 

The petition raises legitimate concerns about whether the Fed will be able to tighten monetary policy when the time comes, and exit from its interventions in credit markets.  But it is precisely the Fed’s own recent actions that raise those problems.  Critics of recent Fed policy actions have for some time complained that the Fed has no exit strategy.  Apparently the critics are now going to be blamed for the Fed’s inability to extricate itself from its interventions.

Cross-posted at ThinkMarkets

End the Credit Rating Monopoly

Earlier this week, SEC Chair Mary Shapiro appeared before Congress to suggest ways to fix the failings in our credit rating agencies.   Sadly her proposals miss the market, although that shouldn’t be so surprising as her suggestions appear to rest upon a misunderstanding of the problem.

The thrust of the SEC’s current approach is more disclosure, such as releasing “pre-ratings” that debt issuers may get before final issuance.  Additional disclosure of ratings methodology and assumptions is likely to be useless.  Almost all that information was available during the building housing bubble.  The problem is that the rating agencies had little incentive to go beyond the consensus forecasts of increasing to at most modest declines in home prices.  These same assumptions were the foundation of almost all government economic forecasting as well, yet few believe that forcing CBO or OMB to disclosure more of their forecasts will cure our budget imbalances.  What is needed is a change in incentives.

Here again the SEC seems to misunderstand the incentives at work, but then recognizing such would force the SEC to admit its own role in creating those some perverse incentives.  The SEC’s notion that agencies issue favorable ratings in order to gain business misses the most basic fact of the ratings business - they don’t have to compete for business, any debt issuer wanting to place “investment grade” debt has to use the agencies, and often has to use more than one of them.  Due to a variety of SEC and bank regulations, there is almost no competition among the rating agencies.  They have been given a government created monopoly.  If the rating agencies were, as the SEC proposes, competing strongly for business, then they wouldn’t have been earning huge profits on that business.  Competition erodes a business’ profits.  During the housing boom, the rating agencies continued to make ever more profits - more the sign of a monopoly than one of competition.

The truth is not that the agencies were captive to the debt issuers, but the other way around.  And like any monopolist, the agencies became lazy, slow and fat.  The real fix for the failure of the credit raters is to reduce the excessive reliance on their judgements inherent in most securities, banking and insurance regulations.  An investment grade rating should never serve as a substitute for appropriate due diligence on the part of investors (especially pension fund managers) or regulators.

Bernanke’s Part in the Housing Bubble

bernankeRecent weeks have seen a swirl of speculation over whether President Obama will or will not re-appoint Ben Bernanke to the Chairmanship of the Federal Reserve Board, when his current term as Chair expires in January 2010. Almost all of the debate has centered on his actions as Chairman. This narrow focus misses an important piece: his actions, and words, as a Fed governor during the build-up of the housing bubble.

What should have been Bernanke’s greatest strength as a Fed governor and later chair, his understanding of monetary theory and his knowledge of the Great Depression, has ended up being a weakness. While correct in his analysis of the role of “debt deflation” – where the deflation increases the real burden of debts and correspondingly weakens the balance sheet of both households and businesses – in the deepening of the Great Depression; his obsession with slaying the Great White Whale of Deflation provided intellectual cover for the Fed’s ignoring and contributing to the housing bubble. Like the proverbial general, he was fighting yesterday’s battle, rather than today’s.

While core inflation was moderate and increasing at a decreasing rate between 2001 and 2005, this measure ignores the dramatic up-tick in house prices during those years. First, housing makes up the single largest expense for most households, ignoring housing, especially after one subtracts out energy and food from the definition of inflation, gives a narrow and distorted picture of inflation. Even if one were to focus solely on rents, the 2000s were an era of increasing housing costs.

Separate from the impact of housing prices on inflation is the role which housing plays as the collateral for the primary piece of household debt: a mortgage. Even were the US to suffer a bout of mild deflation and the real burden of their mortgages increased, this would likely have little impact on household balance sheets in an environment of increasing home prices.

Admittedly Bernanke was then only a “governor” and not yet Chair of the Fed, but he was the Fed’s loudest voice when it came to combating deflation and arguing for lower rates. Additionally there have been zero public acknowledgements by either Bernanke or the Fed that its policy earlier this decade contributed to the housing bubble and financial crisis. Without admitting to the occasional mistake, we have no way of judging whether Bernanke has learned from any of his mistakes, and hence less likely to repeat them.

In weighing Bernanke’s record at the Fed, judgement should not solely consider his actions as Chair, but also consider his words and deeds while the housing bubble was inflating. How one responds to a impending disaster is as important as to how one helps to clean up after the disaster has struck.

Why Promiscuous Bail-Outs Never Was a Good Idea

Jeffrey A. Miron explains in Reason why a government bail-out of most everyone was neither the only option nor the best option:

When people try to pin the blame for the financial crisis on the introduction of derivatives, or the increase in securitization, or the failure of ratings agencies, it’s important to remember that the magnitude of both boom and bust was increased exponentially because of the notion in the back of everyone’s mind that if things went badly, the government would bail us out. And in fact, that is what the federal government has done. But before critiquing this series of interventions, perhaps we should ask what the alternative was. Lots of people talk as if there was no option other than bailing out financial institutions. But you always have a choice. You may not like the other choices, but you always have a choice. We could have, for example, done nothing.

By doing nothing, I mean we could have done nothing new. Existing policies were available, which means bankruptcy or, in the case of banks, Federal Deposit Insurance Corporation receivership. Some sort of orderly, temporary control of a failing institution for the purpose of either selling off the assets and liquidating them, or, preferably, zeroing out the equity holders, giving the creditors a haircut and making them the new equity holders. Similarly, a bankruptcy or receivership proceeding might sell the institution to some player in the private sector willing to own it for some price.

With that method, taxpayer funds are generally unneeded, or at least needed to a much smaller extent than with the bailout approach. In weighing bankruptcy vs. bailouts, it’s useful to look at the problem from three perspectives: in terms of income distribution, long-run efficiency, and short-term efficiency.

From the distributional perspective, the choice is a no-brainer. Bailouts took money from the taxpayers and gave it to banks that willingly, knowingly, and repeatedly took huge amounts of risk, hoping they’d get bailed out by everyone else. It clearly was an unfair transfer of funds. Under bankruptcy, on the other hand, the people who take most or even all of the loss are the equity holders and creditors of these institutions. This is appropriate, because these are the stakeholders who win on the upside when there’s money to be made. Distributionally, we clearly did the wrong thing.

It’s too late to reverse history.  But it would help if Washington politicians stopped plotting new bail-outs.  At this stage, most every American could argue that they are entitled to a bail-out because most every other American has already received one.

SEC Favors Special Interests in New Corporate Elections Rule

Yesterday, the SEC repealed a long-standing rule which allowed brokers to vote shares on behalf of their investors, unless they obtained written directions from each individual investors.  While investors have long been able to direct the voting of their shares, many do not take the time to.  In these cases, the brokers vote those shares, after all they are the agents of the investors and are hired to act on their behalf.

The direct effect of the rule will be to reduce the voting weight of retail investors, as represented by their brokers.  In voting against the rule, SEC Commissioner Kathy Casey raised the point that the rule would skew voting toward large institutional investors and away from little retail investors.

What did the large institutions investors have to say?  As reported in today’s Financial Times, Ann Yerger, who represents large pension funds claimed that “counting uninstructed broker votes is akin to stuffing the ballot box for management.”  One has to wonder whether the pension funds, which Ms. Yerger represents should have to get written instructions from all the pensioners whose pensions are managed by these funds?  Of course not, treating all agents of investors equally would make too much sense for the SEC.

Then one should not be too surprised to see pension funds be allowed to cast their “uninstructed” votes while brokers cannot.  The largest pension funds manage the retirement of unionized state and local employees, often with the fund management itself representing the interests of the unions.  We witnessed this same favoring of union interests over the common good in the auto bailouts.

The rule once again illustrates that the new bosses in Washington are busy rewarding their allies at the expense of everyone else.