Our Toxic Legacy

I was starting to think that the Obama administration lacked the will to impose tough solutions when they are necessary. Their recent treatment of the auto industry restored that hope. It does, however, raise the question: Why is Wall Street not being treated the same? Instead of cleaning up the banks, the administration seems intent on throwing money in their general direction until their health improves.

The latest scheme to drive up the the price of toxic legacy assets is probably the worst possible type of solution. It's less efficient than simply giving the troubled banks more money for free, but essentially amounts to the same thing otherwise. You can see recent posts by Paul Krugman, Willem Buiter, and others: Geithner Plan Arithmetic , The new toxic and bad legacy assets programs of the US Treasury: surreptitiously squeezing the tax payer and the Fed until the PPIPs squeak , etc.)). It's simply a terrible idea to reward failure in this way.

Fairness considerations aside, the consequences for rewarding spectacular failure with loads of bailout money are dire. The lesson banking executives would learn from that is that they should continue taking enormous unnecessary risks, because the downsides are born by someone else.

Luckily for us, there are alternatives. Although the economy certainly depends on the availability of credit and a healthy financial sector, there is nothing that says the individuals who failed so miserably last time are indispensable, nor does it really matter which banks survive relatively intact as long as there is enough of a financial sector left at the end. Even if we commit to saving the current banks, there is nothing that says we have to save their executives, shareholders, and unsecured creditors.

There is a myth going around that the people who failed the first time around are the most knowledgeable and able to fix the situation. Why? This assertion is usually made without any supporting evidence, let alone proof. If someone in 2005 had suggested that Michael "heckuva job" Brown was the best person to fix FEMA after its disastrous mishandling of Hurricane Katrina, they would have been laughed at. Why aren't we laughing now?

On reducing carbon emissions

With control of the White House and Congress both in the hands of Democrats, combating climate change is on the agenda. The Obama administration seems likely to attempt to set up some sort of Cap and Trade scheme for carbon emissions, but while, I fully support the goal or reducing emissions, I hope they will reconsider their approach.

Cap and trade introduces unnecessary uncertainty and government interference in reducing greenhouse emissions. Not only does it require that the government choose a suitable level of emissions for the country, it introduces the possibility of wild price fluctuations due to speculation and a lack of responsiveness of the total available quantity of emissions to external economic shocks. Businesses may suddenly face massive increases in costs, or conversely investments in emissions-reducing technologies may prove unprofitable as the price of emitting a tonne of CO2 falls. A carbon tax solves all these problems.

Ultimately the decision comes down to one thing: The government must establish either a price or quantity of emissions and let businesses respond by choosing the other. If the government sets up a cap and trade scheme, it is choosing the quantity and allowing the price to fluctuate (possibly wildly) even though the environmental damage done by a tonne of CO2 does not change regardless of whether its emitter paid $2 or $100 for the privilege. On the other hand, if scientists can get a rough estimate of the damage done, the tax can be set that lets businesses and consumers decide which activities and products are worth it and which aren't, and thus set a level of overall emissions that balances environmental protection with its economic impact. Even if the exact damage can't be quantified the tax could be gradually increased in a predictible way up to a level that does not impose undue burden on the economy.

A carbon tax best allows businesses to decide how much CO2 they should emit, by weighing the potential profits against the environmental consequences (conveyed to them in tax form). It also allows for a stable price for those emissions so that businesses can adequately make future plans and investments without facing yet another layer of uncertainty, and it is almost certainly easier to administer for all parties involved.

Hazardous Bailouts

Normally, in a capitalist society when companies make good decisions, their investors profit, and when they make bad decisions, their investors suffer. Investors have an incentive to be careful with their money and to not finance foolish or reckless ideas. In bailing out the financial industry the government is threatening to create moral hazard by reducing or eliminating the potential downsides for making poor choices. Not only is a “Heads you win, tails we lose” solution to the current crisis grossly unfair to the American taxpayer, it encourages repeat offenses.

For many economists and politicians considering various bailout plans, moral hazard has become a secondary issue. They argue we can’t worry about long-term problems when the whole system is about to implode. While I tend to subscribe to that philosophy in my own personal life, there is a very important group of people to whom the issue is an immediate concern: potential investors and creditors. As long as there is a great deal of uncertainty about what the government intends to do, potential investors and lenders are going to be wary of sinking money into the financial system. No one wants to get in if there’s a good chance the government will nationalize.

If the government intends to give existing shareholders and unsecured creditors a “haircut” or wipe them out, now’s the time to do it. If it intends to just throw money at the banks without a meaningful downside, it needs to make that clear. Also any Congressman who votes for that particular bailout might also want to take the opportunity to announce that he will not be running for re-election in 2010. Given the popular anger directed at Wall Street at the moment, a pledge not to nationalize or impose stiff restrictions may not even be credible. Ultimately, the solution doesn’t just need to be able to fix the credit crunch; it also needs to be politically viable.

Willem Buiter offers an interesting “Good Bank” solution that includes a certain degree of nationalization. The government (possibly together with some private capital) would set up a “good bank” for every insolvent bank. It would transfer the bulk of the employees to the “good bank,” purchase all the assets that can be priced in the market on its behalf, then withdraw the banking license of the old bank. This would leave the old bank, with its old shareholders and creditors and bad assets, while the new bank is healthy and ready to operate like a normal bank. If the toxic assets of the bad bank turn out to be worth something in a few years when the economy has sorted itself out, the old bank’s creditors and shareholders regain some of their money, if not, that means the bank was worthless anyway; meanwhile, the new bank, unfettered by unnecessary restrictions or bad debts goes about its business, and is eventually privatized, helping taxpayers recoup their investment. This gets credit flowing immediately and leaves the messy attempts to price illiquid assets for later when there is no time pressure.

Stimulating Thoughts

With all the unhappiness about the size and content of the stimulus, how is it that centrists have managed to force changes that address none of the complaints, valid or not, about the stimulus?

First a quick recap of the types of complaints:

Paul Krugman’s complaints are twofold. First, he thinks the stimulus bill is too small. This complaint is driven by a belief that the economy is going to face a $2.9 trillion output gap. Even if  all $800 billion or so were immediate spending, it wouldn’t be large enough to plug that gap.

Secondly, he rightly points out that large parts of the “stimulus” will not lead to immediate spending. Particularly, tax cuts are currently ineffective since consumers will probably just pocket most of the money and not spend it right now. Other critics singled out parts of the spending provisions, which they thought were not effective at stimulating the economy. The CBO estimates that only $525 billion in tax cuts and spending would happen over the next two years, with the rest falling later in the coming decade.

The Republicans complained initially that the plan was too large and could not be afforded, before going on to propose their own $3 trillion plan composed entirely of tax cuts.

With the massive current demand for US Treasury bills, thanks to the perception that they are the safest investment available, it seems difficult to claim we can’t afford stimulus of this magnitude; however, Willem Buiter offers a reasonable argument. The problem, in his view is not that the proposed deficit could not be financed, but that Congress cannot credibly claim that the increase in spending is temporary or that it will raise taxes to compensate. This will erode confidence in US ability to repay its debts, and without that confidence, the two factors that make such a deficit relatively painless to finance at the present time: the status of the US dollar as a reserve currency and the ability of the US government to borrow abroad in its own currency would disappear.

Now, with the aforementioned complaints in mind, would you:

a)      Throw in more spending to make the bill bigger

b)      Cut down the cost of the bill

c)      Make sure that the money is spent quickly and creates as many jobs as possible 

d)     Some mix of the first three

e)     Cut out the most stimulating parts like help to states, unemployment benefits, etc. and offer relatively rich people tax credits for flipping houses

Now, if you’re wondering why option e) is there and what it has to do with any of the aforementioned problems with the stimulus bill, it’s there because that’s what the Senate moderates actually opted to do.

Getting it right and getting it right now

The proposed stimulus bill passed in the House with absolutely no Republican votes, despite tax cuts and other concessions inserted to entice conservative lawmakers to support the bill. Now the bill has moved to the Senate, where Republicans could theoretically filibuster it to death. This has led to attempts by both sides to make changes to the bill in order to ensure its passage; however, most of the cuts seem to be largely symbolic in nature, rather than significant reductions in the overall cost (see NY Times article).

The Republicans’ main complaints are that the proposed stimulus is nothing but a long-standing Democratic wish list, it’s too expensive, and it does not stimulate the economy quickly enough. No amount of cosmetic changes will negate these complaints. Indeed the real problem is that the sense of urgency, in part fueled by long inactivity during the final months of the Bush presidency, has caused Democrats to throw caution to the wind. The stimulus bill seems to be the result of a quick brain-storming session where lawmakers thought of every possible way to spend money then slapped it all together into one giant bill in the name of expediency.

In my opinion, the best way forward would be to cut the bill in two. Separate out the funding that can immediately stimulate the economy: the help to states, payroll tax holiday, funding for “shovel-ready” projects, etc. and pass that part immediately. Then carefully debate the non-immediate spending and long-term reforms, which somehow ended up in a stimulus bill. Whereas stimulus is needed in the short- and medium-term so badly at this point that anything which creates jobs is useful, only some of the non-stimulus spending is clearly justifiable on its own merits; it would be nice if it were not all rammed through without some debate.

Critics of the stimulus claim that only 37% of the electorate supports the bill (see a recent Gallup poll). While technically true, the part they like to leave out is that an additional 38% of the electorate would support the bill with some sort of changes. President Obama has indicated that he would like to pass a bill enjoying broad support (hence the concessions to Republicans even though their votes aren’t strictly necessary), but he also worries that the longer Congress takes to put it on his desk for signature, the more jobs will be lost (see his Op-Ed piece in the Washington Post). Splitting the bill in two would allow quick passage of a much cheaper measure that would pack almost the same punch in the short-term, while buying time to get the long-term part right.