Topic: Finance, Banking & Monetary Policy

Toxic TARP: Mr. Geithner’s Takeover Targets

A front-page story in the February 23 Wall Street Journal describes a plan to let the government convert its preferred shares in Citigroup to common stock, taking 25-40% ownership.

It could be worse.  A brilliant February 19 Journal report by Peter Eavis warned that “Government capital injections sit like ill-disguised Trojan horses in the nation’s largest banks,” showing that under Treasury Secretary Geithner’s socialist scheming the government could seize 74% of Citigroup and 66% of Bank of America. Meanwhile, most other reporters kept claiming bank stocks collapsed simply because Geithner had left out a few details.  On the contrary, he said too much, not too little.

The newer Journal report says, “When federal officials began pumping capital into U.S. banks last October, few experts would have predicted that the government would soon be wrestling with the possibility of taking voting control of large financial institutions… . Citigroup’s low share price already reflects, at least in part, a fear among shareholders that their stakes might be further diluted. A government move to take a big stake could backfire, potentially spurring investors to flee other banks, even healthier ones [emphais added].”

Why is any of this a surprise?  Even before the scary “capital purchase program” was unveiled, I wrote in the October 20, 2008 issue of National Review that, “Conservative legislators who expressed fear about letting the Treasury buy mortgage-backed bonds were strangely enthusiastic about inviting the Treasury to acquire equity in companies.  Critics of derivatives became enthusiasts for warrants … which would give the Treasury secretary virtually unlimited power to confiscate the wealth of stockholders of any company foolhardy enough to play this game.” 

More recently, in a February 11 New York Post piece (subtly titled “A Plan to Kill Banks”) I explained that, “Once a bank or insurance company gets in bed with the government, the property rights of that company’s stockholders become uniquely insecure. When the government jumps into the cockpit, smart stockholders bail out.  And depressed stock prices deflate the banks’ capital cushion.”

If “few experts” predicted these consequences of Treasury purchases of bank preferred shares and warrants, then why are they called experts?

How European Governments Hate Low Taxes

The European Union held a summit over the weekend at which the assembled politicoes announced a variety of steps to increase regulation of European financial markets.  But that isn’t all.

Reports the Daily Telegraph:

The EU communique also called for punitive action against tax havens. “A list of uncooperative jurisdictions and a toolbox of sanctions must be devised as soon as possible,” it said.

Ah, so now we see what is really important to European governments:  squeezing more money out of their peoples.

As Cato’s Dan Mitchell has oft pointed out, competition among taxing jurisdictions is good for everyone other than governments.  Tax havens, so-called, are an important tool for promoting such competition.  Similar efforts are underway in the U.S. with efforts to tax the internet, for instance.

The U.S. Didn’t Cause the World Recession

In the Washington Post, Ricardo Caballero of MIT has a novel and promising idea about “How to Lift a Falling Economy.”  Unfortunately, he echoes the mantra that all the world’s economic problems can be traced to the U.S. in general, and to big U.S. banks in particular.  “Already,” he says, “this illness has spread to the global economy.”

Already?  Industrial production in Japan began collapsing in November 2007, two months ahead of the U.S., and the Japanese industrial decline has been twice as fast.

Unlike the U.S., real GDP began falling in the second quarter of 2008 in Germany, France, Italy, Japan, Singapore and Hong Kong.  By no coincidence, that was when the price of oil rose as high as $145 a barrel.  Soaring oil prices raise the cost of production and distribution for many industries, and reduce real household incomes and therefore consumption.   Nine of the ten postwar U.S. recessions were preceded by a major spike in the price of oil.

In a piece for the Claremont Review of Books (written last November), I conclude , “This recession is not just a U.S. problem, not just about housing, and not just financial.”

Compare the decline in real GDP over the past 4 quarters (from The Economist):













Does it make sense to blame the largest declines in GDP on one country with the smallest decline?  If so, then we need some explanation of how some uniquely American “illness has spread” to so many innocent victims.

If the explanation is supposed to be falling U.S. imports, then the worst decline by far would have been in Canada and Mexico (where real GDP was rising even in the third quarter).  If the alleged causality is supposed to be because of some undefined links between financial centers, then Italy would not be among the hardest hit.

When it comes to trade, in fact, the shoe is mainly on the other foot: Collapsing foreign economies crushed U.S. exports.

In the second quarter of 2008, U.S. exports accounted for 1.54 percentage points of the 2.83% annualized rise in real GDP.  But falling exports subtracted 2.84 percentage points from fourth quarter GDP.  Falling exports, not falling consumption, were the biggest single contributor to the overall drop of 3.8%.

After looking at which economies fell first and fastest, it might be more accurate to say that some foreign  illness has spread to the U.S. economy than to assert or assume the causality ran only in the opposite direction.

Those Federal Strings that Come with Bail-Out Cash

Companies tend to like getting bailed out.  Heck, I wouldn’t mind a personal bail-out.  I mean, that nice Nigerian fellow promised me a share of the unclaimed bank account from his country’s late dictator.  It isn’t my fault the deal didn’t work out!

Government cash has led naturally to restrictions on employee compensation.  It has also encouraged people to turn to politicians to get loans from banks.  There was the notorious case in Chicago (full, it seems, of notorious cases!) where workers demanded that Bank of America bail out their failing firm because it canceled the line of credit to the firm.  After all, BoA had received federal money.  That meant it was supposed to willy-nilly give cash away, irrespective of the prospect of being repaid.  Illinois politicians piled on and naturally the bank caved.

Now people are calling their congressmen when they get rejected for a loan at banks that collected government checks.  Reports McClatchy Newspapers:

Rep. Mel Watt is used to dealing with constituents who need help with government agencies.

But once Congress passed a $700 billion bailout of the banking system, some people started turning to the Charlotte Democrat for help with the private sector. They’ve asked him to assist their appeals of rejected loan applications from banks that collected federal bailout money.

It’s an unusual type of request for Watt, who views the pleas as a sign of the times. An increasingly unsettled American public is looking for help with their own economic hardship but also asking for accountability because banks and other big businesses are getting bailed out by the government.

On the one hand, this is outrageous.  On the other hand, if the taxpayers have to support the banks, why shouldn’t the banks support the taxpayers?  The logic is obvious even if the consequences are potentially catastrophic.

It won’t be easy to roll back the federal government’s leap into socialism American-style.  But if we don’t halt the federal subsidy express, there might not be much real “free enterprise” left in America when we finish.

David Brooks — An Update

After carefully transcribing and then posting the nearly indecipherable argument forwarded yesterday on NPR’s All Things Considered by David Brooks, I thought, well, even the smartest people in the world can make a verbal hash of things when put on the spot with a live radio or television interview.  I had a nagging feeling that there must have been a well-thought-ought perspective knocking around in those words somewhere.  Was I being unfair to the man?  

And this morning — what do you know! — I open up Friday’s New York Times (I didn’t get to it yesterday) and see an op-ed length treatment of the very argument Brooks tried to make on NPR.  Alas, even when Brooks had a couple of days to think about each and every word, he still managed to be only a smidge less opaque than on NPR.

David Brooks: Thumbs Up for the Housing Bailout

On Friday’s All Things ConsideredNew York Times columnist David Brooks was dismissive of Rick Santelli’s now-celebrated rant against President Obama’s housing bailout.  Brookes conceded that there was a “fundamental unjustice [sic]” associated with the bailout, but…

We’re not just individuals; we have a system, a system we all share.  And the system right now is so unsteady that we have no individual responsibility in our own system because the economy is so unsteady.  If you deserve a job sometimes you get laid off, if you don’t deserve, sometimes you don’t get laid off.  And the government’s fundamental responsibility right now is to make sure the system is stable. And that may reward people who took unnecessary risks but we just have to live with that. The primary responsibility here is not to worry about the moral hazard; it’s to keep the stability of the system as a whole intact.  And I think that the housing plan is a pretty moderate and respectable way to go about that.

If you can figure out what the heck Brooks is saying here, my hat’s off to you.  As best as I can tell, Brooks is arguing that the economy is in free fall and the only way to arrest the collapse is to stop the foreclosures.  If that means bailing out the irresponsible, then bail them out we must.  At least, I think that’s what he’s saying.

But do foreclosures equal macroeconomic collapse?  It’s not obvious that they do.  Foreclosures should only bother the unforeclosed if they reduce the value of their homes.  Do they?  Empirical investigation suggests that the impact of foreclosures on unforeclosed housing values is quite small.  It’s vacant homes that (sometimes) drive down the value of neighboring inhabited homes.  But if foreclosures are quickly followed by sales to new owners, that problem does not arise.  And even if it takes a while for the empty houses to sell, the impact on neighborhood housing value is temporary.  That is, as long as you’re not trying to sell when all the for-sale signs are littering the neighborhood, you’ll be OK.  Hence, the problem here is excess housing stock — empty houses that can’t find buyers — not foreclosures per se.

Will Obama’s plan reduce the excess housing stock?  It’s hard to see how.  Foreclosures have been most heavily concentrated in places where housing supply is elastic and prices remain well above construction costs.  As long as that is the case, new construction will go on — and has gone on — even in the teeth of the ongoing house price collapse.

But maybe Brooks isn’t really worried about foreclosures.  Maybe he’s worried about the decline in housing prices and the related collapse of securities built on existing mortgages.  Maybe he’s arguing that propping-up — or at the very least, stabilizing — housing prices is the only way to rescue the trillions of dollars worth of assets tied to the housing market and, thus, to rescue the economy as a whole.  If so, then good luck. Harvard economist Edward Glaeser makes a very strong argument that nothing the feds can do will keep housing prices at the inflated levels reached over the last decade.  And even were such a thing possible, Glaeser argues it would be economically counterproductive:  

Artificially boosting prices will distort construction decisions and redistribute wealth from buyers to sellers. Moreover, most schemes seem unlikely to significantly raise prices, especially in the elastic areas that have seen the largest reductions in prices. Against these uncertain benefits, the costs of many of the schemes seem quite large.  Using hundreds of billions of dollars to buy or refinance mortgages represents a large transfer from taxpayers to current homeowners… Moreover, a large-scale intervention that makes the government a vast lender is likely to create permanent institutions that impose large future costs on taxpayers. Recent events at Fannie Mae and Freddie Mac certainly suggest the difficulties that result when government-sponsored enterprises play mortgage lender to the nation. 

Nor is Glaeser sympathetic with the political rush to save those threatened with foreclosure:

As foreclosure becomes more difficult, the value of mortgages declines, which reduces the value of banks assets. Direct aid to distressed homeowners may be less problematic, but it isn’t clear that the government can or should be trying to keep people in homes they can’t afford at any reasonable interest rate.  In most cases, a small amount of aid to help in moving would be a more sensible, and cost effective, response to foreclosures.  We do need action to fix our banking system, but those actions should be targeted towards the banking system itself, not towards the housing market.

While public intellectuals like Brooks are — for the moment anyway — inclined to lecture the Rick Santellis of this world about the necessity of housing bailouts for the greater good, there is far less substance to that lecture than one might think.

Inflation and the Fed

In a National Review post on the recent Producer Price Index numbers, I argued that inflation worries are overwrought — for now. If inflation does become a problem, though, the Fed could have trouble controlling it. Here’s why.

According to a recent AP story, “Federal Reserve Chairman Ben Bernanke told an audience at the National Press Club on Wednesday that … once the economy begins to rebound and financial markets stabilize, the Fed will be able to quickly reverse the actions it has taken before inflation becomes a problem.”

That’s the trillion dollar question.

Federal Reserve bank credit rose from $890.4 billion on September 10 to $1.83 trillion by February 11, mainly because the Fed purchased a lot of semi-toxic securities (e.g., from Bear Stearns) and made huge loans against other dodgy assets. That allowed a similar doubling of the monetary base (bank reserves and currency). Even before that happened, the Fed was selling off Treasuries to make room for lesser investments. The Fed’s holding of government securities has fallen from $790.5 billion in September 2007 to $470.7 billion on February 11 (not counting some second-rate IOUs from Fannie Mae and Freddie Mac).

To assume, as Bernanke does, that inflation cannot possibly accelerate until “the economy begins to rebound and financial markets stabilize” is to assume stagflation is impossible, though 1973-75 and 1979-82 proved otherwise. If inflation catches the Fed by surprise, are they really “able to quickly reverse the actions,” as Bernanke says? How could they do that?

The Fed could certainly raise the interest rates on bank reserves — the fed funds and discount rate — which is how it makes money and credit tighter in normal times. But that rationing device would not prove so effective in times like these, because banks are already sitting on a mountain of untapped reserves. Besides, once expected inflation has begun to rise, the Fed has usually moved rates up in tiny 25-basis point steps — increases so small that perceived real interest rates can continue to fall even as nominal rates rise.

To literally reverse the actions that doubled its assets since last September, the Fed would have to sell nearly a trillion dollars worth of IOUs. Unfortunately, they don’t have nearly that many Treasury securities to sell. And even if the Fed were willing sell off all of its Treasury bills and bonds, the remaining backing for Federal Reserve notes would be little better than junk bonds. Meanwhile, private and agency securities acquired since last September must be very hard to sell — or else the Fed would not have felt obliged to buy them.

The Fed’s System Open Market Account at the Federal Reserve Bank of New York holds $39.4 billion in inflation-protected Treasury bonds — more than twice its $18.4 billion stash of short-term Treasury bills. Are they trying to tell us something?