By Ricardo Caballero
We are running out of time. There is no end in sight unless much political capital is put at risk now. We have a superb team of economists and technicians, but their voices seem to have been lost.
I recall Lawrence Summers, chief White House economic adviser, rightly claiming that if markets over-react, the government has to over-react even more. US Treasury secretary Tim Geithner, even in his much criticised first announcement, sounded like a man of the right principles: We must stabilise the financial system, regardless of cost, was the message delivered with clenched teeth.
However, Geithner’s and Summer’s actions do not match their strong rhetoric. They seem to spend much of their energy tackling political hurdles rather than facing head-on the financial crisis.
We are dealing with a large problem of uncertainty and fear. There are important real problems to solve and they are insurmountable unless panic is put to rest.
No matter how many inefficient contortions and conversions individual financial institutions may do, until the problem of systemic panic is resolved, it is only a matter of time until the next crisis blows up in our faces. Those that think that solving the problems of one bank, by nationalising it or otherwise, will restore confidence, fall into an extreme fallacy of composition: What may be the right solution for an isolated case, is not for a systemic problem.
Last week, we saw the importance of confidence in an environment gripped by fear. As Ben Bernanke, US Federal Reserve chairman, testified at the Senate banking committee, markets began to rise. Somehow political posturing vanished as the Q&A progressed, and the exchange became focused.
But the mood changed with the conversion-deal for Citi. The key word is “deal.” The US government seems to be so terrified of a political backlash from being perceived as favouring banks over taxpayers that it approaches financial policy with a “deal” mentality rather than with a systemic and medium-run perspective. The right question is “What is the best solution that will enable us to recover as soon as possible?” Trillions of dollars of wealth and income are being sacrificed for political appearance sake.
Let me contrast this Citi deal and the financial panic it triggered with an alternative I proposed in a Washington Post article (and in a longer version in Nouriel Roubini’s RGEMonitor and in Richard Baldwin’s VOXEU).
There I argued that an effective mechanism to stop the downward spiral in equity markets would be that the government guarantees a minimum price in some of these shares a few years from now. The mechanism works by what economists call backward-induction: If we know that the price will be at least something in the future, and there is an upside potential as well, then the price must be even higher today.
I have worked out with Pablo Kurlat, an MIT Ph.D. student, a model that yields some interesting numbers. One of the conclusions is that had the government offered a minimum future share price guarantee to new equity holders of $2.7, it would have boosted share prices today to $6.8 and allow Citi to attract all the private capital that it may need for an extreme scenario.
It gets more interesting. Because investors are scared, the government can make a good business by selling insurance. Suppose that instead of the $2.7 guarantee, the government decides to offer a super-guarantee on the new equity of $5.8 per share. This guarantee would immediately boost the share prices to $8.4 (even of the old shares, which are not directly guaranteed) and allow the bank not only to raise enough private capital to fight a potential liquidity shock, but also to repay $17bn of the government’s preferred shares. This policy has an expected net gain for the government of $3.8bn and a much lower risk exposure than direct equity holding. These are rough estimates, but their qualitative features are robust. Essentially, through the insurance mechanism the government transforms heavily discounted equity into a treasury bond plus a call option on the upside of the bank. This makes it possible for banks to raise capital through equity issuance at reasonable prices, and to repay the Treasury for its insurance provision service.
I hope to convey the message that squeezing current stakeholders for political appearance is self-defeating. Conversely, doing exactly the opposite is probably the only hope we have for a (mostly) private sector solution to the problem, and hence for a real and permanent solution.
At this stage of the crisis, bad news spread quickly across the financial network. Recall that Citi’s share prices crashed by 40 per cent after last week’s conversion, but the demise didn’t stop at Citi, as Bank of America’s shares fell by more than 20 per cent, and so on. We must reverse this contagion mechanism. For example, it is not too farfetched to think that had the equity insurance policy been adopted for Citi instead of the conversion plan, the price of the other financials also would have risen sharply¯after understanding that the government is truly committed to supporting wealth enhancing private solutions; then the rest of the market would have risen, thus triggering a good feedback mechanism. Policy needs to focus on mechanisms that have the potential to spread good news throughout the system.
Throughout the world governments hope that small repairs (relative to the magnitude of the crisis) will suffice, and interactions are becoming more virulent by the day. It is time to put a stop to this madness and to match the strong rhetoric with equally strong ammunition, which requires using political capital in the short run. The return from reversing the downward spiral will be enormous. This is the North to keep in mind.
Ricardo Caballero is head of the department of economics at Massachusetts Institute of Technology
A longer version of this piece was originally published at RGE Monitor and VoxEU
