In my post of April 3, 2009 “How the FASB aids and abets obfuscation by wonky zombie banks”, I dumped on both the Financial Accounting Standards Board and on the International Accounting Standards Board for a second relaxation of mark-to-market valuation and accounting rules since the start of the crisis. I was wrong in including the IASB in the second installment of this roll call of members of the IAHS (the International Accounting Hall of Shame). The IASB did, in a statement on October 2, 2008, follow the lead of the FASB by allowing banks greater freedom to reclassify financial securities between the three categories of “held for trading”, ”available for sale” and “held to maturity”. However, it did not follow the FASB in the second surrender to the lobbyists of the zombie banks.
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 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.
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.
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.
Nobody home in Washington DC
Since the Obama administration took over on January 20, the US Treasury has effectively been out to lunch. As widely reported (see e.g. this account in the Financial Times), Sir Gus O’Donnell (as cabinet secretary the top UK civil servant) has attacked the “absolute madness’ of the US spoils system, where a new Federal administration replaces the entire top stratum of the civil service with new officials possessing the right political connections and leanings. Quite a few of these top officials need to be confirmed before they can start working. This can take months. Many of the new officials have no political, government or administrative experience and spend most of their first months in office trying to figure out where the washroom is instead of designing and implementing policy.
It is a system designed to produce protracted policy paralysis. Often this does not matter much. It may even be helpful to the greater good at times – “That government is best which governs least.” – but in times of war and deep economic crisis, when the world we thought we knew may be falling apart, it is not a bad idea to have a government that can both think and act. The current US administration neither thinks nor acts much, judging from the results.
The discussions around the family dinner table in the Buiter-Sibert household are about to become even more fascinating for the adults and even more mind-numbingly tedious for the children. My wife, Anne Sibert, has just been appointed an external member of the provisional Monetary Policy Committee of the Central Bank of Iceland (CBI). The five-member provisional MPC has three executive or internal members: CBI Governor Svein Harald Øygard, Deputy Governor Arnór Sighvatsson and Þórarinn G. Pétursson, the CBI´s Chief Economist, and two external experts, Anne Sibert and Gylfi Zoëga. This Monetary Policy Committee will operate on a provisional basis, with formal appointments for the next five years likely to be made following national elections in Iceland in April.
Iceland’s largest three internationally active banks collapsed during the autumn of 2008; its currency collapsed and tight capital and foreign exchange controls are now in place. That this was the likely outcome of Iceland’s unsustainable credit boom and banking sector over-expansion had been predicted in a paper by Anne Sibert and myself, written in April 2008 (for fruit flies, a shorter version can be found here).
The country now faces an extremely difficult and painful restoration of internal and external balance, with high and rising unemployment, declining activity and falling living standards. Even the best-designed and competently-implemented monetary and exchange rate policies cannot alter that sombre reality. But competence and courage can help avoid unnecessary, avoidable economic distress and dislocation, thus minimizing the economic cost and human suffering that are bound to follow what may well have been (relative to size of the underlying economy and population) the biggest banking boom and bust in history.
The UK government has offered, under its asset protection scheme (APS), to guarantee (or insure) up to £600 bn worth of toxic assets held by British banks- up to £300 bn for RBS and up to £250 -£300 bn for the Lloyds Banking Group. Barclays may be waiting in the wings. The APS insures the banks (that is, their CEOs, shareholders, junior and senior unsecured creditors other than retail depositors – already covered by deposit guarantees up to £50.000 – and staff) against losses on these toxic assets over and above a certain deductible or ‘first loss’ for the bank.
There is ample precedent for this kind of guarantee scheme. In the US, the Fed, the FDIC and the US Treasury have guaranteed a large chunk ($300 bn) of toxic assets of CItigroup. In the Netherlands, the Dutch state insured a portfolio of $39 bn (face value) worth of securitised US Alt-A mortgages held by ING.
Like its American and Dutch counterparts, this toxic asset insurance scheme is without redeeming social value: it is inefficient, unfair and expensive to the tax payer. Apart from that it is great. There also are superior alternatives available: full nationalisation and, best of breed, the ‘good bank’ solution.
This post contains the comments I made at the 6th Annual Conference: Emerging from the Financial Crisis, held at the Center on Capitalism and Society at Columbia University, on February 20. It contains 22 points, two for each of the 12 disciples, minus Judas Iskariot, who is otherwise engaged, buying silver futures.
1. It is necessary, for political economy reasons, to rush new comprehensive regulation of the financial sector. While it would be better, holding constant the likelihood of the measures being adopted and implemented, not to act in haste, there is now a unique window of opportunity – a period of extraordinary politics, in the words of Balcerowicz – to actually get the thorough regulatory reform we need. The reason is that the private financial sector is on its uppers – down and out – and will not be able to put together much of a fight, let alone its usual boom-time massive lobbying effort to veto radical measures. It is better to over-regulate now and subsequently to correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments and institutions.
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.
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