Monthly Archives: March 2009

Am I the only one to think that tax incentives for new car purchases – cash for clunkers, in the words of Alan Blinder - are a daft idea? Even Obama has succumbed to this rot, despite an encouraging toughening of his general stance on government financial support for the US car industry (workers, shareholders and even unsecured creditors of GM and Chrysler have to take a larger haircut if more federal aid is to be forthcoming.  Now let’s apply the unsecured creditors part of this logic to the banking sector also!)

Fiscal incentives to induce automobile owners to trade in their jalopies and buy new cars have been introduced in many car producing countries, including Germany, France, Italy and Spain.  A number of US states and Canadian provinces also have introduced such schemes.  The rationale is partly a general Keynesian demand stimulus, partly a sector-specific subsidy to workers, managers, share holders and creditors in the automobile industry and other industries that depend on them.  If the programme is temporary and the cash incentive substantial, such programmes are bound to work.

This artificial shortening of the economic life of a car seems nuts.  It’s worse than getting paid to dig holes and fill them again.  It’s like being paid to burn down your house to encourage the residential construction industry. 

The Group of Twenty (G20) meetings that start on April 2, ought to have started on April 1 instead.  That way, when nothing but hot air emanates from the Docklands venue, at least the organisers of the event will be able to claim it was all an April fool’s joke.

In the unlikely event that the assembled dignitaries get serious and decide to negotiate as if the well-being of mankind hung in the balance – as it does – I have a short agenda to propose.

(1) A true commitment to maintain an open global trading environment

The summit of finance ministers and central bankers from the (G20) in the English town of Horsham on 13-14 March 2009, concluded with a statement that contained the following sentence: “We commit to fight all forms of protectionism and maintain open trade and investment”. Let’s just hope they are more successful that they were for the past year and a half, or even since their mid-November 2008 meeting.

The hypocrisy and mendaciousness of the G20 when it comes to protectionism are breathtaking.  The World Bank published a Report on March 2, 2009, which shows that seventeen of the 19 developing and industrial nations (plus the EU) have introduced restrictive trade practices since pledging (again!) in mid-November to avoid protectionism.

The G20 includes the Group of Seven industrialised countries — Britain, Canada, France, Germany, Italy, Japan and the United States — and 12 developing countries and emerging markets — Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, South Africa, Saudi Arabia, South Korea and Turkey — as well as the European Union. Since the financial crisis started in August 2007, officials in the countries monitored by the World Bank (including but not restricted to the G20 members) have proposed and/or implemented roughly 78 trade measures.  Of these 66 involved trade restrictions and 12 trade liberalising measures; 47 trade-restricting measures were implemented.

The president of Brasil, Lula da Silva, at a joint press conference on the 27th of March 2009 with Gordon Brown, the UK prime minister, made the following statement: “This crisis was caused by the irrational behaviour of white people with blue eyes, who before the crisis appeared to know everything and now demonstrate that they know nothing.”

That statement is not merely ignorant and stupid.  That statement is racist.  As a white person with blue eyes, I am offended by it.  I am waiting for Mr. Lula da Silva’s apology to the entire population of white people with blue eyes.

Having a white skin and blue eyes is clearly not necessary for causing the crisis.  I am sure Citi CEO Vikram Pandit wants to claim at least some of the credit for the crisis.  His predecessor, Chuck Prince is white but does not have blue eyes.  He was named by Fortune Magazine In 2008 as one of eight economic leaders “who didn’t [see] the crisis coming”, and identified in January 2009 by Guardian City editor Julia Finch as one of twenty five people who were at the heart of the financial meltdown.  He also made the famous statement in July 2007 that : “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”.  E. Stanley O’Neal, the former chairman, president and chief executive officer of Merrill Lynch, is an African American (I don’t know his eye colour).

Having a white skin and blue eyes is clearly not sufficient for causing the crisis or contributing to it.  I will spare the readers of this blog the list of names of white people with blue eyes who did not cause this crisis.

President Lula da Silva may want to defend his racist remark by noting that white people with blue eyes were disproportionately represented among those who caused the crisis or contributed to it.  He would no doubt be right.  He also would be advised to take an introductory course on the distinction between statistical correlation/association and causation. Concepts like spurious correlation, omitted variables (wealth, class, education, gender to name but four of the most obvious ones), and common third factors driving a statistical association between two variables, would represent a welcome addition to the intellectual capital of the Brazilian president.

President Lula da Silva’s statement is an example of inappropriate racial profiling.  Wikipedia defines racial profiling as “the inclusion of racial or ethnic characteristics in determining whether a person is considered likely to commit a particular type of crime or an illegal act or to behave in a “predictable” manner.”

For the would-be defenders of president Lula da Silva, let me be clear about what I mean by racism.  I again use a definition drawn from Wikipedia: Racism, by its simplest definition is the belief that race is the primary determinant of human traits and capacities and that racial differences produce an inherent superiority of a particular race. People with racist beliefs exhibit stereotype-based prejudices towards individuals and groups of people according to their race.”

Note that I am condemning the sin, not the sinner.  I am not saying the president Lula da Silva is a racist.  All I am asserting is that the statement he made – that white people with blue eyes are responsible for the crisis – is a racist  statement.

To those who believe that a statement that is racist according to the definition quoted from Wikipedia is not really racist unless it is directed at a racial or ethnic group that is weak, oppressed or at the bottom of the social totem pole, I recommend a regular washing of the mind with soap and water.

The weak and the poor, and billions of others who are quite innocent of the mistakes, excesses and crimes that brought us the crisis are not helped by facile racist remarks attributing blame for the crisis coming from the leader of one of the key emerging markets.  Racial divisions and stigmatization according to eye colour will not help humanity crawl out of the hole it is in.  We have to pull together.  President Lula da Silva’s statement threatens to pull us apart.

I have always been a believer in the screw-up theory of history (and particularly of disasters) rather than of the conspiracy theory of history (disasters).  The financial crisis that has engulfed the world certainly offers massive evidence for the importance of screw-ups – errors, mistakes, misunderstandings, singular stupidity verging on idiocy, misjudgements and missed opportunities.  I am, however, as more detailed evidence accumulates about the genesis of the financial collapse, becoming more and more impressed with the importance of misfeasance and malfeasance – of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours.

The US authorities have no money to fulfil their ambition of stopping large US banks from failing without taking them into public ownership.  The $300 bn left in the TARP kitty is all that is available for recapitalising banks, purchasing toxic assets and providing other financial support.  Congress has thrown its toys out of the pram and is unwilling to appropriate more funds for the rescue of the banking sector.

As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies.  Perhaps you can only get indignant about what you can comprehend… .

The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed.  The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.

Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future.  The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.

I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC,  quite possibly illegal.

Ecce! The Public Private Partnership Investment Program (or should that be the Public-Private Investment Program?) is here, albeit not yet with quite enough information on some of the key practical details to make a full assessment.

A picture is worth a thousand words, so here is my transcription of a picture from the US Treasury’s own website:

Investment Programmes
  • $75 to 100 billion of TARP&FSP capital
  • with financing from the FDIC and the Federal Reserve
    leverage $500 billion with potential to expand it to $1 trillion of
    purchasing power
Legacy Loans
Legacy securities
Capital Financing Capital Financing
Public-Private Investment Funds Funds will raise FDIC-Guaranteed Debt Public-Private Investment Funds
  • Combines USG and private guarantees
  • FDIC will guarantee debt
  • Combines private financing with USG
    capital and potential USG leverage
  • Leverage from Federal Reserve
  • Leverage up to 6 : 1
  • Builds on existing TALF framwork

There is very little Treasury money in it.

The first thing that struck me is how little money the Treasury appears to be putting in.  On reflection, this is not surprising. The government simply has no money in the kitty to recapitalise banks or purchase toxic or bad assets on any scale.  Of the $700bn TARP money, no more than $300 bn is left.  The Congress is in one of its more infantilist phases and will not, unless and until the threat of utter financial collapse becomes even more apparent, appropriate new money for saving US banking.

If future recapitalisations of US banks (and other systemically important institutions), the cleaning of the balance sheets of legacy toxic assets and guarantees or subsidies for new lending and borrowing are constrained to cost no more than $300 bn, God help us all.  If we have to wait too long for reality to dawn on the dunderheads in Congress, the decimal point on the $300.00 bn will surely have to be shifted one place to the right.

Introduction: central banks need fiscal back-up

Even operationally independent central banks are agents of the state.  And like every natural or legal entity operating in a market economy, the central bank is subject to a(nintertemporal ) budget constraint.  Some central banks are owned by the ministry of finance.  The Bank of England, for instance, is owned 100 percent by the UK Treasury. The ECB is owned by the national central banks (NCBs) of the 27 EU member states. These 27 NCBs have a range of different ownership structures.

The Federal Reserve System is not owned by anyone (conspiracy freaks need not bother writing comments to deny this and to attribute ownership of the Fed to the Queen of England, the Vatican, the Rockefeller family or the Elders of Zion). Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company.  Ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, fixed at 6 percent per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks).

Even though central banks can ‘print money’ or create money electronically by fiat, they are constrained in their financial operations by two factors.

Why are the unsecured creditors of banks and quasi-banks like AIG deemed too precious to take a hit or a haircut since Lehman Brothers went down?  From the point of view of fairness they ought to have their heads on the block.  It was they who funded the excessive leverage and risk-taking of banks and shadow banks.  From the point of view of minimizing moral hazard – incentives for future excessive risk taking – it is essential that they pay the price for their past bad lending and investment decisions.  We are playing a repeated game.  Reputation matters.

Three arguments for saving the unworthy hides of the unsecured creditors are commonly presented:

    • Unless the unsecured creditors are made whole, there will be a systemic financial collapse, with dramatic adverse consequences for the real economy.
      • If the unsecured creditors are forced to take a hit, no-one will ever lend to banks again or buy their debt.
        • The ultimate ‘beneficial owners’ of these securities – notably pensioners drawing their pensions from pension funds heavily invested in unsecured bank debt and owners of insurance policies with insurance companies holding unsecured bank debt – would suffer a large decline in financial wealth and disposable income that would cause them to cut back sharply on consumption.  The resulting decline in aggregate demand would deepen and prolong the recession.

          I believe all three arguments to be hogwash.

          Insurable risk

          When insurance began to develop as an industry, it was soon felt necessary by those trying to enhance the reputation and respectability of the industry to distinguish it from gambling. The outcome of this process is that today, for a financial activity to classify as insurance and to be regulated as insurance, it has to offer products or contracts that protect against loss; gambling seeks or creates opportunities for speculative gain.  More precisely, insurance hedges an open position in order to reduce exposure to risk; gambling creates or increases open positions to boost exposure to risk.  There are a host of deep issues here, such as ‘what is the right metric for risk’ or  ‘the risk to what: financial wealth, consumption, utility’?  I will acknowledge these deep issues, ignore them and proceed.

          For the insurance industry, the insurance vs gambling distinction was operationalised using the concept of insurable interest.  An insurable interest is what economists would call an open position that is reduced in size by the insurance contract.  In life insurance, this means that a person or a legal entity can insure the life of a third party only if the value of the life to the party wishing to purchase the insurance is greater than the value of the payout under the life insurance policy.

          In property insurance, people have an insurable interest in property they own up to the value of the property, but not beyond that.

          Good Bank vs Bad Bank

          The Good Bank solution differs significantly from the Bad Bank solution as regards its distributional implications, its medium-term and long-term incentive effects and its immediate financial stability impact.

          Under the Bad Bank approach, the authorities either purchase toxic assets from the banks that made the toxic investments/loans, or they guarantee (insure) these toxic assets.  Toxic assets are assets whose fair value cannot be determined with any degree of accuracy.  Clean assets are assets whose fair value can easily be determined.  Clean assets can be good assets (assets whose fair value equals their notional or face value) or bad assets (assets whose fair value is below their notional or face value).   When the authorities acquire the toxic assets outright, they establish a legal entity to manage these assets – the Bad Bank.  The publicly-owned Bad Bank either sells these toxic assets as and when they cease to be toxic and a liquid market for them re-emerges, or holds them to maturity.

          Under the Bad Bank approach, the legacy banks, either sans the toxic assets or with the toxic assets guaranteed by the state, live to fight another day.  The presumption is that the state overpays for the toxic assets.  The price it pays is certainly greater than the immediate liquidation value of the assets by their owners.  It is also likely to exceed the present discounted value of the future cash flows of the assets, or their hold-to-maturity value.  Similarly, the cost of any guarantees provided by the state in the case where the toxic assets continue to be held by the banks, is likely to be less than the fair value of these guarantees.

          The rationalisation for the creation of  Bad Banks and for toxic asset purchases by the state that was part of the original TARP proposal - it would serve as a price discovery mechanism for potentially socially useful financial instruments that had temporarily become illiquid – is no longer credible.  Most of the toxic assets ought never to have been created and, with a bit of luck, will never be seen again.  So the fundamental rationale for the creation of Bad Banks and for toxic asset purchases by the state is the provision of a subsidy to the banks that made the toxic loans and investments.  These beneficiaries include the top management and board of these banks, the shareholders and the unsecured and non-guaranteed creditors.

          Maverecon: Willem Buiter

          Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

          Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

          Willem Buiter's website