Ireland: Keynsianism's Worst Nightmare

Question: what keeps Paul Krugman up at night? Answer: not being able to perform fiscal stimulus because of a skittish bond market. Unfortunately for the Irish, this is the situation they now find themselves in. As Krugman explains:

to satisfy nervous lenders, Ireland is being forced to raise taxes and slash government spending in the face of an economic slump — policies that will further deepen the slump.

And it’s that closing off of policy options that I’m afraid might happen to the rest of us.

And how did the Irish get in this predicament? Again back to Krugman:

On the eve of the crisis Ireland seemed to be in good shape, fiscally speaking, with a balanced budget and a low level of public debt. But the government’s revenue — which had become strongly dependent on the housing boom — collapsed along with the bubble.

Even more important, the Irish government found itself having to take responsibility for the mistakes of private bankers. Last September Ireland moved to shore up confidence in its banks by offering a government guarantee on their liabilities — thereby putting taxpayers on the hook for potential losses of more than twice the country’s G.D.P., equivalent to $30 trillion for the United States.

The combination of deficits and exposure to bank losses raised doubts about Ireland’s long-run solvency, reflected in a rising risk premium on Irish debt and warnings about possible downgrades from ratings agencies.

Hence the harsh new policies. Earlier this month the Irish government simultaneously announced a plan to purchase many of the banks’ bad assets — putting taxpayers even further on the hook — while raising taxes and cutting spending, to reassure lenders.

Luckily for the United States, our banking sector isn't so outsized that our too-big-to-fail institutions are too-big-to-save. Small comfort. And the United States' government debt-to-GDP ratio is at a lower starting point than that of most European nations, so we have quite a bit more runway than our friends across the pond. Still, if the PPIP is as inefficient and ineffective as its critics fear, then every day could seem like St. Paddy's Day: we'll have run up too much debt to save the banks to commit to any other spending, cutting vital counter-cyclical programs at the worst moment. Again, back to Krugman:

For now, the United States isn’t confined by an Irish-type fiscal straitjacket: the financial markets still consider U.S. government debt safer than anything else.

But we can’t assume that this will always be true. Unfortunately, we didn’t save for a rainy day: thanks to tax cuts and the war in Iraq, America came out of the “Bush boom” with a higher ratio of government debt to G.D.P. than it had going in. And if we push that ratio another 30 or 40 points higher — not out of the question if economic policy is mishandled over the next few years — we might start facing our own problems with the bond market.

Not to put too fine a point on it, that’s one reason I’m so concerned about the Obama administration’s bank plan. If, as some of us fear, taxpayer funds end up providing windfalls to financial operators instead of fixing what needs to be fixed, we might not have the money to go back and do it right.

And the lesson of Ireland is that you really, really don’t want to put yourself in a position where you have to punish your economy in order to save your banks.

The brouhaha over the AIG bonuses will be remembered fondly as a time of sober judgment if we turn Irish, and bail out the bankers, while cutting services for the public at large. But even this obvious political reality seems unlikely to change policy towards the banks - after all, it's much easier to simply cross your fingers and hope the banks can earn their way out of this crisis a la 1982, than take serious steps to restructure them. Japan circa 1995, here we come!

PPIP DOA?

Is the Geithner PPIP already over? Clusterstock reports that Jamie Dimon announced that he does not foresee JP Morgan participating in the PPIP, either as a buyer or a seller. From Clusterstock:

Speaking on the company's just-concluded conference call, JP Morgan (JPM) CEO Jamie Dimon downplayed the PPIP, saying the bank had nothing to sell into it, and that it certainly had no interest in partnering with the government as a buyer.

What's more, he said, he didn't consider the PPIP to be that big of a deal, suggesting that it's just one small piece of what Treasury is doing to prop up the system.

Remember, this is coming from the bank that has 10% of all mortgages. They're saying they have nothing to sell and that toxic asset prices aren't the problem.

I guess 6X leverage isn't enough to bid up the prices of toxic assets high enough for banks to still not take enormous losses. This was fairly predictable. Now what's the plan?

Defending Gaming the Geithner Plan

The inevitable gaming-the-PPIP-backlash backlash is on. After Joseph Stiglitz and Jeffrey Sachs lambasted Geithner's plan as a taxpayer rip-off, Noam Scheiber has taken to TNR with his oh-so-contrarian take that the PPIP being a scam isn't necessarily a bad thing. From TNR:

But is this really such a bad thing [if banks game the PPIP]? It sounds a lot like a good bank/bad bank model, in which we recapitalize Citibank to the tune of $925,000 and take the toxic asset off its books and stick it in another entity--a "bad bank"--created for that purpose. As I've said before, there may be moral objections to such an arrangement. (It is offensive that taxpayers have to bail Citibank out.) And the Geithner plan may not have enough money to recapitalize all the banks this way. But that's different from arguing that it can't work....

The only real difference, so far as I can tell, is who pays. Under Sachs's preferred approach, the bondholders and stockholders take most of the hit, while under his hypothetical gaming approach, the taxpayers do. Again, that's not fair. But being unfair doesn't doom something to fail. And I'd take an unfair success over a fair failure. (Though successful and fair would be ideal, and Sachs's proposal may get us close.)

What's a few trillion dollars between friends? But Scheiber ignores the very real possibility that the PPIP will not be enough - that bank losses will go well beyond the funding Geithner can manufacture with the FDIC and the Fed, and that the administration will have to go back to Congress. In that case, if the entire bailout process is perceived as an indefensible giveaway to Wall Street, then there is little hope of convincing Congress to pony up for more. If that happens we could be back where we were last September - financial panic as too-big-to-fail institutions fail.

Therefore, there is a premium on finding a policy that not only will work, but the public will see as being fair. Geithner seems to understand this, which is likely why he has resurrected the Paulson cash-for-trash plan with a few bells and whistles to distract the public (like any good magician, Geithner knows misdirection is key). But rather than trying to trick the public, wouldn't a much simpler plan that put insolvent banks into some form of receivership-on-steroids and restructured them make more sense? This would not only be good policy, but good politics as well; Axelrod and Emmanuel certainly understand that getting tough on Wall Street would be a popular position.

These are issues that Scheiber completely ignores. He seems to have completely bought the administration/banks' line that we must save the bankers to save the economy. But saving the banks does not mean saving the bankers who got us in this mess. Oops - I guess that makes me a radical populist.

Sachs: PPIP Is A Scam

Columbia professor Jeffrey Sachs has joined the chorus of those proclaiming Geithner's PPIP a swindle. In the wake of the FT reporting that banks are considering bidding on each others assets, Sachs explains that while most commentators have worried about outsiders profiting at taxpayer expense, the potential for insiders gaming the system is even worse. From Sachs:

Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset. All of the previous articles consider the case of true outside bidders.

Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.

Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank's net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K. Since the total of toxic assets in the banking system exceeds $1 trillion, and perhaps reaches $2-3 trillion, the amount of potential rip-off in the Geithner-Summers plan is unconscionably large.

The earlier criticisms of the Geithner-Summers plan showed that even outside bidders generally have the incentive to bid far too much for the toxic assets, since they too get a free ride from the government loans. But once we acknowledge the insider-bidding route, the potential to game the plan at the cost of the taxpayers becomes extraordinary. And the gaming of the system doesn't have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi's assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same.

Are there any assurances that something like this would not happen? And is there anyone outside the administration willing to defend this plan?

Warren Drops A Bomb on Geithner

While she speaks in a mild-mannered tone, make no mistake: Elizabeth Warren TKOs Tim Geithner. In a measured tone, she lays out the three approaches to dealing with financial crises:

1. Liquidation, i.e. Chapter 11
2. Receivership. FDIC seizes the insolvent banks, separates the good and bad assets, recapitalizes the banks/gets bondholders to perform debt-for-equity swaps, and sell back the good bank to private investors
3. Subsidies. These can either be direct, in the form of capital infusions, or indirect, such as buying toxic assets at inflated prices.

Then Warren examines Treasury's policy of subsidization to date, before concluding

Treasury's overall approach seems based on the premise that the banking problem is temporary - and look, we all hope that's the case. If it is, more aggressive steps may never be needed. It is possible, however, that Treasury's approach fails to acknowledge the depth of the current crisis. The economy may not come roaring back. And the big profits that propped up the banks during the housing boom may not return. For some, that means it is necessary to consider alternate approaches.

Translation: this is not a liquidity crisis, and we're going to have to put insolvent banks into receivership. Hopefully Congress is paying attention.

Half of US Banks Bust?

Count Andy Beal among those skeptical about Geithner's PPIP. According to Beal

He says Treasury Secretary Timothy Geithner's new plan to guarantee loans to buyers of toxic assets won't lead to many sales because the problem isn't liquidity but price. They are not low enough. Half the country's banks--4,000 in all--would be bust, he says, if they marked their loans to what the loans would fetch in an auction. He says banks are fooling themselves by refusing to mark busted assets down.

"Banks are on a prayer mission that somehow prices will come back and they won't have to face reality," Beal says. And that reality, according to Beal, is going to get a lot worse. "Unemployment is going over 10%, commercial real estate hasn't even begun collapsing and corporate credit defaults are just getting started," he says. His prediction: depression, without bread lines this time, thanks to the government safety net, but with equal cost to society.

Whose judgment do you trust on whether this is a crisis of solvency or liquidity: a banker who noticed all the bad loans being made as this crisis developed, or a regulator who failed to diagnose the problem?

PPIP Gaming

It's official: banks will use the non-recourse loans from the PPIP to bid up each others toxic assets. From the FT:

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.

The plans proved controversial, with critics charging that the government’s public-private partnership - which provide generous loans to investors - are intended to help banks sell, rather than acquire, troubled securities and loans....

But public opinion may not tolerate the idea of banks selling each other their bad assets. Critics say that would leave the same amount of toxic assets in the system as before, but with the government now liable for most of the losses through its provision of non-recourse loans.

This is even worse than the abortive Paulson cash-for-trash scheme. At least under the original version of the TARP, some toxic assets would actually be removed from banks' balance sheets. In trying to resurrect this rejected idea by dressing it up with a bit of financial prestidigitation, Geithner has created a perverse situation where banks have incentives to acquire more toxic assets, gambling that some of this trash will be worth something. Of course, taxpayers are on the hook if the assets are indeed worth as little as current prices imply. Somehow providing huge subsidies to banks for them to buy up worthless pieces of paper from each other does not seem like a fix to the problems plaguing the financial sector. The amount of bad debts the banks hold on their balance sheets is simply too large for the government to buy or subsidize. Debts need to be restructured; insolvent banks need to be put through orderly bankruptcies. Subsidizing failure will only guarantee the existence of zombie banks. Failed banks will eventually be put into receivership anyway - why not do it now when it will cost less?

Stiglitz: Wall Street Wins, Taxpayers Lose

This is now two Nobel prize-winning liberal economists vociferously opposed to Geithner's PPIP. A week after Paul Krugman announced that the leaked reports of Geithner's plan "fills me with a sense of despair," Columbia professor Joseph Stiglitz takes to the New York Tims to voice his own displeasure over the huge taxpayer giveaway the Geithner plan represents for banks and private investors. From the New York Times:

In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Stiglitz goes on to attack the claim that the current crisis is simply the result of a lack of liquidity - i.e. panic is driving down asset prices beyond the fundamentals. Again from the New York Times:

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time....

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.

Has the Obama economic team rebutted these arguments, aside from saying calls for putting insolvent banks into receivership are "deeply impractical"? If Obama is seen as in Wall Street's pocket, there will be no political will for further bailouts, which will inevitably be necessary. Putting off the day of reckoning, and playing nice with the bakers is a very, very dangerous course.