April 2, 2008
The prudent will have to pay for the profligate
By Martin Wolf
You have enjoyed a debt-financed spending spree. But times are now harder: you find it impossible to roll over your debt; you have to pay much higher interest rates than before; or you find that the value of the assets you pledged as collateral is now less than your loan. What can you do? Provided enough of you are in trouble, you call for help from the fairy government-mother.
Thus, George Magnus of UBS, among the wisest analysts of this crisis, has already observed, with some approval, that the crisis “is spawning an array of well scripted but highly unconventional public policy responses” – that is to say, rescues of various kinds.*
Over-indebted individuals have just three choices: reduce spending below income, sell assets they own to somebody else or, if the worst comes to the worst, default. But one person’s debt is another person’s asset, one person’s expenditure is another person’s income; one person’s sale is another person’s purchase and one person’s default is another person’s loss.
The remainder of this column can be read here. Debate from our panel of economists appears below.
To the extent that the government is acting as a “lender of last resort against illiquid instruments and buyer of last resort of impaired ones” then so long as liquidity returns, and the price paid for impaired assets was ‘right’, is the situation as bleak, regarding socialisation of private debt, as you portray? Public debt will rise, but only temporarily.
I do not know to what extent these bailouts can be described as liquidity loans and fair-price purchases of assets. Nor to what extent the costs of all this can be borne, relatively unproblematically, in the form of reduced profits for banks etc., capital losses for certain investors.
You then talk about the housing market - again, I’m not sure here to what extent government bailouts will leave the public lumbered with debts that will not be paid off, as mortgages are repaid. But again, perhaps the bailouts need not leave the public worse off. Doesn’t the IFS (Feb 08 public finance bulletin) think that nationalisation of Northern Rock may actually benefit the public purse?
I have no academic credentials, so do not imagine this comment will be published. If it is at all possible for Martin Wolf to address these questions in this comments thread, well that would be great.
Posted by: Luis Enrique | April 2nd, 2008 at 11:44 am | Report this commentBrendan Brown: De-leverage is indeed likely to be a painful process in many cases. But there is also a less painful type of de-leverage - the issuance of equity and retiral of debt. Many presently highly levered borrowers, still solvent, are in a position to issue equity and retire debt. Over coming years we are likely to see a reversal of heavy equity retirement by the corporate sector and instead huge issuance volumes. The corollary will be a run-down of debt. Under present institutional arrangements this is not possible for the household sector, as there is no institution ready to take equity stakes in homes. But with many highly leveraged households looking at ways to reduce debt such an institution might come into existence. Financial innovation is still alive, even if discredited of late. In the private equity sector, the challenge will be for still solvent borrowers to tempt present bond holders to accept early repayment at well below par (but above present distressed prices of debt) and issue equity to fund the conversion.
Brendan Brown is head of economic research at Mitsubishi (UFJ) Securities International plc, London
Posted by: Brendan Brown | April 2nd, 2008 at 12:38 pm | Report this commentWillem Buiter: Much of what Martin says is right. He does, however, in his discussion of government purchases of impaired assets, call a child of mine ugly, and as a co-parent (with Anne Sibert) of the Market Maker of Last Resort, I feel obliged to protest.
Martin writes: “The solution they all desire is for the government to act as lender of last resort against illiquid instruments and buyer of last resort of impaired ones. While the former activity has been known since the days of Walter Bagehot’s Lombard Street, the latter is an overt bail-out.”
Not so, or at the very least, not necessarily so. When markets are disorderly and illiquid, it isn’t just the prices of good or prime assets that fall below their fundamental values. The same holds for the prices of bad, impaired and sub-prime assets. Impaired assets too will have a fair or fundamental value. That fundamental value may well be far below the face value of the security, but it may also be well above the price the impaired asset would fetch in a fire-sale in an illiquid market.
If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing.
The central bank is especially well placed to play this role because, as long as the distressed/impaired assets are denominated in domestic currency, the central bank will never become illiquid or insolvent by purchasing them.
Should, despite the fact that the impaired asset was purchased at a price below its fundamental value, the central bank eventually make a loss on the asset, recapitalisation of the central bank by the Treasury (that is, the tax payer) may well be necessary, or at least desirable, if the only alternative is self-recapitalisation by the central bank through monetary issuance.
This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.
A subsidy is present only if the expected, risk-adjusted, rate of return for the central bank on the purchase of the impaired asset is less than the central bank’s opportunity cost of funds. There is no economic subsidy if the price paid to the seller exceeds what the seller would have received from a sale in the free but illiquid market, as long as the central bank expects to earn an appropriate risk-adjusted rate of return on the purchase.
It is perfectly legitimate for the central bank to take credit risk (default risk) onto its balance sheet, as long as it (and the tax payer) are properly rewarded for taking on this risk. This can be achieved by paying a price for the impaired asset that is both punitive (less than its fair or fundamental value) and better than what the seller could realise by selling in an illiquid market.
It is certainly possible that past purchases of illiquid and impaired assets have been at valuations that were excessive, and thus did indeed represent a subsidy to the seller. It is unfortunately also likely, that such buying of pig’s ear assets for silk purse prices will be repeated in the future. But it is not inherent in the performance of the market maker of last resort function. The Governor of the Bank of England is, rightly, extremely concerned with creating moral hazard - incentives for future excessive risk taking by lenders and borrowers. I would hope that the Bank of England would blaze a trail for future Market Makers of Last Resort by insisting on punitive prices for the impaired assets the Bank acquires, either as collateral or through outright purchases.
Martin should argue for appropriately punitive valuations of these official purchases of impaired assets in illiquid markets. The tools for discovering such prices exist, and don’t require the government buyer to know much or indeed anything at all about the fundamental value of what it is purchasing. Various reverse-auction mechanisms (with the central bank as the single buyer) have value-revealing properties.
The government made a mint in a regular auction as the single seller of band spectrum licenses. I am sure the auction specialists professors Paul Klemperer and Ken Binmore would be only too happy to help out with the reverse auctions. Indeed, professor Klemperer is, I believe, already advising the Bank of England on these matters.
One problem with the Market Maker of Last Resort is that there is no symmetry between illiquid and disorderly market conditions, where there is an obvious role for the buyer of last resort, and liquid and orderly market conditions. Even liquid and orderly markets can be bubble-driven rather than driven by fundamentals. We have seen a number of cases in the recent past - notably the tech bubble and the US, UK, Spanish and Irish housing bubbles.
The government (central bank) acting as seller of last resort in irrationally exuberant markets would (a) be politically unlikely and (b) be ineffective, even if the authorities were willing to engage in short selling as well as outright sales.
The Market Maker of Last Resort will indeed turn out to be only a buyer of last resort. The resulting asymmetry cannot be corrected by the use of the standard monetary policy instrument (hikes in official policy rates), except insofar as these are needed to achieve the price stability objective of the central bank.
Instead the asymmetry should be corrected by regulatory or credit controls on all highly leveraged entities, whether they call themselves banks, investment banks, hedge funds, private equity funds or whatever. Limits on leverage ratios that are varied counter-cyclically by the central bank, minimal regulatory capital requirements and minimal liquidity ratios (both also varied countercyclically by the central bank) are the natural counterpart to the buyer of last resort.
But don’t throw this beautiful baby out with the bath water.
Posted by: Willem Buiter | April 2nd, 2008 at 2:33 pm | Report this commentHow much debt is too much for US households? The amount of debt that can be supported must be a function of interest rates and disposal income, but is also a choice made by consumers. That is why there are differences in the level of debt (as % of GDP) across European countries. In addition, one has to explain why the amount of debt in almost all countries, including the US, trends up over time (as % of GDP).
I agree that the increase in debt we have seen in recent times in the US as interest rates have trended down from a peak in the early 1980s is unrepeatable and therefore growth will slow as consumer spending slows. What I don’t think is a given is that the existing stock of debt is unmanageable to a large degree, (as % of GDP). Some reduction seems likely due to cyclical factors and sub-prime, but sub-prime is small is the overall scheme of things. I find it hard to see a mass de-leveraging of the US consumer unless interest rates increase or there is a prolonged and significant increase in unemployment. That rise in unemployment would be the CAUSE of deleveraging not the EFFECT. Lower GROWTH in consumer spending due to lower growth in debt does not have to mean higher unemployment if consumer spending doesn’t actually fall.
In the early 1990s housing crash in the UK, net new mortgage borrowing dropped dramatically. However, the outstanding stock of mortgage debt never grew less than ~5% pa, (nominal).
[I’m also dubious about reading too much into savings rates from national accounts data since savings are what is left as the residual between two large numbers and also the treatment of housing I’m sceptical about - but this is not really my point]
Posted by: Jonathan Spread | April 2nd, 2008 at 2:59 pm | Report this commentMartin Wolf suggests that the destruction of the purchasing power of money, by engineering an inflation would be be at the expense of the elderly. Doesn’t that partly depend on how the inflation is engineered? Helicopters dropping printed money over retirement homes would be less painful for example.
Can I suggest again that if there is to be such an inflation then the additional cash might go to everyone equally. We read constantly that the banking system is privatising gains and socialising losses and that certainly seems to be the case. But it doesn’t have to be like that. Increases in the money supply could be put into circulation in a variety of ways - the taken for granted assumption that it be though, and to the benefit of the banks, must be questioned. If we want social stability a more equitable way of engineering an inflation would put additional money out to everyone equally. That way we would all share the seignorage and would each have an equal amount of wherewithall to cope with the resulting rise in prices. Either that or the additional money would go particularly to the people most likely to be vulnerable to the rise in prices. The money system could be run on principles of social justice and will need to be if we want social peace. Why isn’t it?
As for defaulting at the expense of foreign creditors. Interesting idea. That I think is a one time only move. If I remember rightly the size of the US defence budget is about the same size as the US deficit. So if the US can’t borrow this any more and confidence in the US collapses what happens then?
Can I suggest in these circumstances we would need a new international payment regime - that the era of floating exchanges with such a huge amount of speculative cash swilling around is too destructive and that we need to go back to managed exchange rates. The liquidity for a new system will have to be created rather as Special Drawing Rights were - though this time backed at a fixed rate against a reducing number of permits to emit CO2 in an international climate regime. Instead of gold the system should be backed in the next few decades by carbon. That will shrink but, sorry, the reversal of globalisation and relocalisation is part of the way to save energy and carbon. Let’s not forget in all the fuss about the banks that we actually have an even bigger problem to solve, the climate crisis, and we need to think about how we are going to solve these problems together. We need a completely new architecture for all aspects of the money system in the post growth era.
Posted by: Brian Davey | April 2nd, 2008 at 4:33 pm | Report this commentMartin Wolf: What can I say? Willem is right. Purchases of impaired assets need not imply a subsidy. In practice, however, I strongly suspect that they will. My feeling about Willem’s baby is that it may indeed turn out to be beautiful. But I am not yet sure of it. This is a point that I hope to return to in a future column.
Posted by: Martin Wolf | April 3rd, 2008 at 12:47 am | Report this commentTim Young: I think you dismiss the idea of the US selling real estate externally too easily, Martin. The US could effectively do so by selling citizenship (subject to certain checks of course) to foreigners. The extra migration could absorb any excess of housing space built up during the housing bubble, or alternatively use an additional grant of land with planning permission. A clear advantage that the US does have over, say, China and India is a low population density for its relatively livable territory.
Posted by: Tim Young | April 3rd, 2008 at 7:36 am | Report this commentGerhard Illing: Martin summarizes the current policy dilemma very clearly. There is no pleasant escape route, so the only question is: which option minimizes long run costs for the US economy?
Posted by: Gerhard Illing | April 3rd, 2008 at 10:11 am | Report this commentIf it is correct that we are not just facing a global liquidity crisis, but instead a massive solvency crisis, central banks attempts to buy mortgage-backed securities cannot solve the underlying problem. They would simply lead to inefficient, fairly arbitrary redistribu-tion of losses from the financial sector towards the central bank. Rather than trying to prevent fire sales of toxic securities, the challenge is to prevent fire sales on the housing market in order to prevent more securities from becoming toxic. This, however, is not a task for central bankers. But all proposals to tackle the housing problem via debt-equity swaps for securitised assets are haunted by insurmountable coordination problems among numerous conflicting vested interests. Compared to that challenge, renegotia-tion of sovereign debt was child’s play. That is the reason why politicians have to come to the rescue, with serious long run risks for government debt.
The only escape route where monetary policy might contribute is to use the implicit de-fault option via inflation. During the 90’s, some of the most clever US economists ad-vised the Bank of Japan to commit for some time to a higher rate of inflation. Now, the same medicine may rescue the US economy. Why not announce a higher inflation target of, say 5 percent for the next five years, helping to get nominal income on a level with with excessive house prices? This way, the coordination problems of restructuring nu-merous debt contracts could be bypassed. There would even be no bias towards reck-less lenders: All lenders, even those who never dare to renege on paying back their debt would gain when higher inflation is eroding the real value of their debt. Naturally, prudent savers would suffer. But markets are not fair.
Since a substantial part of the debt is held abroad, inflating it away seems to be a ra-tional strategy for the US. So why has this route not yet been discussed in public? It might trigger a further flight out of the dollar. But a falling dollar would help the adjust-ment towards export sectors. Such a policy would even help to raise wealth for the US: With debt mainly in form of low-yielding dollar-denominated bonds, the real value erodes with a falling dollar. At the same time, real investment income abroad, paid in foreign currency, would gain in value. Of course, the exorbitant privilege will be gone – but that price has to be paid anyway.
Given these unpleasant options, the real puzzle (a Bernanke conundrum) is why yields on long term US treasury bonds have gone down so much during the last months. Bond holders may soon demand excessive risk premia, ending the flight into supposedly safe havens, as is already happening in the mortgage market. Rather than leaving financial markets in doubt about the future course of monetary policy, a transparent, credible commitment towards a temporary and strictly limited increase in inflation target may be the superior route, limiting the damage. A skilled Fed chairman would just need to follow the script for a fool-proof strategy designed at Princeton University.
Martin Wolf: In response to Tim Young, all I can say is that the increase in immigration would have to be very large: many many millions. Would the people with money he envisages really wish to buy sub-prime property in the mid-West? Somehow I doubt it. But I agree a big increase in population would do the trick.
In response to Gerhard, I regard this as the nuclear option. A deliberate policy of destroying the value of the world’s principal reserve currency is enormously dangerous. I would prefer a law that forced a write down of loans or a debt-equity swap. But I agree that if there is a large solvency problem, all options look scary. Inflation may not be the right choice. It could still emerge as the easiest of the options.
Posted by: Martin Wolf | April 3rd, 2008 at 5:16 pm | Report this commentMr Illing writes:
“Naturally, prudent savers would suffer. But markets are not fair”.
Silly me - I thought that economic theory was constructed in order to demonstrate that the invisible hand of markets, if not interfered with, created optimal welfare outcomes and that this was as fair as we can possibly get.
In any case, we are not talking about markets in this discussion we are talking about policies and their outcomes - consciously chosen policies not made by invisible hands but by people who are, or who should be, accountable to citizens.
So what does Mr Illing mean with the words “markets are not fair”? It makes me think that this choice of words might be demonstrating what psychotherapists call an mental process that they term “avoidance”. What is being avoided is thinking and articulating the clearer and more explicit proposition which seems to me to be implied in his statement but which he might not have wished to say quite so explicitly. This deeper proposition is “In my opinion social justice or fairness in the operation of markets should not be considered worthy of consideration. I don’t care if people are made to suffer who have done nothing to earn that suffering”.
Am I right Mr Illing?
Posted by: Brian Davey | April 4th, 2008 at 10:58 am | Report this commentI would add:
As we keep hearing the credit crisis is a crisis of trust - that makes it an ethical crisis before something to be solved by clever techniques. Clever techniques were used to hive off the toxic assets into special companies so that they did not appear in the books of the banks themselves. Analogous psychological mechanisms are used when people want to distance themselves from the consequences of their preferred public policy options. To say “naturally prudent people will suffer but, hey, the market is unfair” is to hive off a personal ethical judgement and make it the fault of the market not something that one endorses oneself. No progress will be made in the ethical debate, restoring trust in financial markets until participants in this debate own their own opinions, take their own ethical views back onto their own books.
As it happens I am a 59 year old with very small savings - if there policy discussion in which I see the ground being prepared to be robbed of my meagre purchasing power to pay for other people’s mistakes them I am going to defend my purchasing power in that debate.
Posted by: Brian Davey | April 4th, 2008 at 12:45 pm | Report this commentAdrian Ash: Game for a laugh? Read the following quotes, but imagine the words “tax-payers’ cash” wherever you see the words “government” or “central bank”. Better still, imagine they spell out the words “your savings” instead:
“We need concerted action by governments, central banks and market participants to help stop this wave [of liquidations]…”
- Josef Ackerman, head of Deutsche Bank, speaking in Frankfurt on 17th March
“The government is prepared to do what it takes to maintain the stability of our financial system…”
- US Treasury Secretary Hank Paulson to Fox News, March 16th
“In every country in 2008, every government has one aim – to maintain stability through the world economic slowdown. Britain with its central role in the world’s financial system is no exception…”
- UK Chancellor Alistair Darling, in his Budget speech of 12th March
Not quite with it yet? Try these completed examples:
“The US taxpayer last week agreed to help J.P. Morgan acquire Bear Stearns after a run on Bear, once the second-biggest underwriter of US mortgage bonds. In an effort to shore up Wall Street’s other firms, your savings also agreed to become lender of last resort to all 20 primary dealers in Treasury notes…” (Bloomberg)
“US leveraged institutions, which include banks, brokers-dealers, hedge funds and tax-sponsored enterprises, will suffer roughly $460 billion in credit losses after loan loss provisions, Goldman Sachs economists wrote in a research note released late on Monday…” (Reuters)
“The [investment] banking system is facing the 21st-century equivalent of the wave of bank runs that swept America in the early 1930s. And your money is rushing in to help, with hundreds of billions from the tax payer, and hundreds of billions more from tax-sponsored institutions like Fannie Mae, Freddie Mac and the Federal Home Loan Banks…” (Paul Krugman in the NY Times)
With it now? Just cut to the chase about bail-outs and “liquidity injections” by remembering what the state’s big generous hand-outs are made from – tax payments, both current and future, plus the spending power of private savings, ripe for inflating away when asset prices threaten to drop.
Side-splitting stuff, isn’t it? With career academics both running monetary policy (at the Fed, BoE) and also supporting the “nuclear option” of rampant inflation (pace Gerhard Illing above), prudent savers will certainly need to keep their sense of humor.
“Markets are not fair” - boom! boom!
The writer is formerly head of editorial at Fleet Street Publications, UK’s largest publisher of financial advice for private investors
Posted by: Adrian Ash | April 7th, 2008 at 5:44 pm | Report this commentStephen Grenville: Willem’s comments (”The central bank is especially well placed to play this role because? (it) will never become illiquid or insolvent by purchasing them”) may exaggerate the capacity of central banks to fix the problem. The traditional open-market operation adds base money in exchange for a top-quality liquid asset. So it doesn’t do much to help good balance sheets (swapping one good asset for another), and isn’t available for illiquid balance sheets, as they have no suitable assets to offer. The big change comes when the central bank is prepared to take the normal stock-in-trade of the financial sector’s balance sheets - mortgage-baked securities and so on. The ECB showed the way, and other central banks have followed.
Now illiquid financial institutions can improve their balance sheets in a substantive way. But there is still a problem here. The base money which the central banks are adding to the system is not what people want to hold. Most base money is held by the public in the form of currency, and there is no reason why the public wants to hold more currency. In these uncertain times, financial institutions might want to hold a bit more base money in the form of deposits at the central bank, but this is low-earning asset, so there is a limit on how much they will want to hold in this form. The financial sector will want to give the excess back to the central bank in exchange for government bonds. Base money is demand-determined, so the central bank always stands ready to do this. The net effect is that the central bank swaps its good government bonds for illiquid MBS. That helps the financial system, but eventually the central bank runs out of bonds. It could, in principle, issue its own securities and go on swapping its high-quality paper for low-quality MBS. Of course this would help the illiquid market, but it takes central banks into territory they shouldn?t be in and don?t know much about - evaluating idiosyncratic credit risk. If any government institution gets into this game, it should be a Fannie Mae/Freddie Mac type institution, with some expertise in this field.
Posted by: Stephen Grenville | April 8th, 2008 at 2:19 am | Report this commentAn oven-ready solution to our turkey of a liquidity crisis is instantly available and, relatively-speaking, entirely painless. It also has a certain symmetry that would have appealed to Keynes. What we face is a large class of debt instruments that are effectively non-marketable, untradable. Sitting in Governments’ paper coffers are large amounts of non-marketable debt (fully part of National Debts) that are debts owed by one part of government to other parts e.g. US Federal Social Security funds worth $4trillion face value (low interest bearing) on paper. OECD governments have non-marketable bonds sitting around worth between typically 20% and 50% of GDP. It adds nothing to National Debts to make some of these marketable and release them (in secondary bond markets) in exchange for mortgage backed, and other financial asset-backed, securitised bonds that are currently illiquid but varifiably of genuine fundamental value, and indeed the public purse should make a profit (as Prof. Buiter and others believe) once we have blown through this downturn in the credit and economic cycle.
Government Debt, which is supremely liquid, may be exchanged at a premium for discounted illiquid bonds that should generate enough income to retire the issued treasuries over a conveniently long period. There are no adverse implications for money supply, national debt to GDP ratio, crowding in or crowding out theories, and banks and financial investment funds will still experience write-down losses, but these should not be abnormally high, just about what should be expected in a short-lived recession.
Posted by: Robert McDowell, Edinburgh | April 8th, 2008 at 7:45 pm | Report this commentMartin Wolf: Robert McDowell and Mervyn King seem to have been thinking on the same lines: hence the government’s special liquidity scheme.
Posted by: Martin Wolf | May 15th, 2008 at 4:05 pm | Report this comment