Treasury’s New Program Mixes Sound Economics and Wishful Thinking

Treasury’s New Program Mixes Sound Economics and Wishful Thinking

March 25, 2009

The administration’s new program to wring the toxic assets out of the banking system is a huge bet, which, like most of the previous reforms for the current crisis, is based equally on sound economics and a good dose of wishful thinking. The truth is, it couldn’t be otherwise: We’ve never experienced this kind of crisis before, so we cannot know which reforms will actually work.

The essence of the new Treasury program is the creation of new, public-private partnerships to purchase the bad assets held by Citigroup, AIG and others. The government and private funds or other entities would each put up one-twelfth of the money to buy tranches of toxic paper, and the other five-sixths would be borrowed by the private parties with federal guarantees for their lenders. One aspect of the plan that requires a good dose of faith is that reasonable prices can be set for these assets by using auctions. This aspect assumes that a number of private parties will bid on each tranche of assets and so set a reasonable price. The hope here is that the federal guarantees for the loans to buy these assets will unlock hundreds of billions of dollars in new financing, and that could well be the case. Score one for the Treasury: They’ve found a way to create a market for these assets, something which eluded the Paulson Treasury when they proposed auctioning off assets of unknown and dubious value.

Here’s the catch: The banks now holding these assets — Citi, AIG, and so on — have already written down their value on their books. And it’s impossible to say whether these write-downs — “marking to market” in a market that hasn’t been operating — are in the neighborhood of the prices which the Treasury auctions will produce. Selling them will increase “liquidity” in the banking system, which means there will be buyers for what’s being sold. But liquidity isn’t the main problem here. The core of the financial system crisis is that many of the largest institutions look like they’re insolvent or nearly so, and so unable to use the asset side of their books to provide new flows of credit for the economy.

Here’s where the pricing of the bad assets becomes important for the rest of us. If these institutions receive roughly the same price from the auctions as they’ve already assumed in their write-downs, they’ll be as insolvent as they were before the new program. One hope underlying the program is that the assets will auction for much more than their current owners believe they’re worth, bolstering their capital. Or, alternatively, there may also be the hope that all of the financial activity involved in selling off these toxic, “legacy” assets will bolster general confidence, so that businesses will be more willing to borrow and other institutions will be more willing to lend to them. In that case, the renewed economic activity could improve conditions for the sick institutions, slowly bringing them back from the edge of bankruptcy.

Much like the Treasury’s approach to stemming foreclosures in its new housing program, this approach addresses directly the secondary problem of liquidity, in the hope that doing so will affect the essential problem, which is that these institutions are bankrupt or nearly so. The alternative which the administration so far rejects is to address the core problem directly, with transitional or brief “nationalization” — take over the sick institutions, pull out the bad assets (without having to value them), and then sell off the rest to another bank or group of investors, who would reopen it as a healthy bank that could resume lending. There are serious risks in that approach as well, both economic and political. The Republicans would surely go on a predictable tear denouncing it. More important, the market might believe that it was only the beginning of government takeovers, and pull back on a range of financial activities so far less affected by the systemic crisis. But if the current strategy doesn’t work, the only other option apart from transitional nationalization will be to ask the country to put up with an indefinite period of recession and stagnation, until the system slowly rights itself. Eighty years after the last systemic financial crisis, the option of “sit tight and wait for the markets to correct themselves”— Hooverism in a pure form — should be wholly unacceptable, both economically and politically.



Anticipating Inflation Now Can Save Taxpayers $50-$70 Billion

March 19, 2009

The Federal Reserve yesterday announced $725 billion in new purchases of Fannie Mae and Freddie Mac securities to hold up housing finance, along with plans to buy $300 billion in Treasury securities. Before this latest program, the Fed was already running the most expansionary modern monetary policy since the Weimar Republic. On top of $2 trillion in guarantees for a broad range of private securities, the Fed has been gunning the monetary base at an extraordinary rate. Consider the following: The Fed normally expands the monetary base, which forms the basis for credit and the overall money supply, by an average of 1 to 2 percent per-month. In September and October of last year, they expanded that base by 58 percent; in November and December, they increased it another 50 percent.

The Fed was right to do all this, in a deliberate if desperate attempt to push enough juice into a severely strained and strapped financial system, to enable it to get back on its feet — or at least to not slip into a coma. It hasn’t worked so well yet, because the financial system and economy are sicker than anyone thought. And now we’re caught in a vicious circle: The financial system’s woes pushed the economy off the cliff, which then took most other economies in the world with it; and now the problems of our economy and everyone else’s are intensifying the financial system’s weaknesses.

And the Treasury is out in the markets every day selling the government’s securities, even when the Fed’s not buying. And like some titans on Wall Street, they may be making a bad bet with your money. The bet here is that inflation will be nothing to worry about for another decade; and if that’s wrong, taxpayers will pay a big price. At issue here is what’s called Treasury Inflation-Protected Securities, or TIPS, securities which pay those lending to the government a set interest rate, like any other Treasury security, but one figured off a principal amount that adjusts upward every six months to take account of inflation. At the price TIPS are now fetching, the market is betting that inflation will be nothing to worry about for another decade. And the Treasury is backing up that bet by selling TIPS at very low prices.

The market and the Treasury backing it up are almost certainly wrong this time. Here’s what may well be happening: When markets heat up or melt down, they have a tendency to assume that their conditions will persist for as far as they can see (or invest). That can explain what’s happening in the TIPs market: They’re selling at a rate and return which assume that today’s extraordinary deflation will just keep on going, for years into the future. That’s possible — but it’s very, very unlikely. The economy eventually will stop contracting; and when it does, prices will stop going down. In fact, through the booms and busts of the last 50 years, the U.S. inflation rate has consistently averaged about 2.5 percent per-year over any extended period.

Moreover, once the economy recovers this time, the extraordinary steps we’re taking to bring about that recovery will almost certainly produce strong inflationary pressures. First, we’re currently embracing the most expansionary, fiscal policy in our history (at least for peacetime), with multi-trillion-dollar deficits — and necessarily so for an economy contracting at a six to seven percent rate. And on top of that is the Fed’s unprecedented monetary expansion.

Whatever White House or congressional leaders say about education, climate or health care, the economy and the financial system, and only that, will remain the President’s central focus and task for the rest of this year and well into 2010.

Eventually we will succeed — and when we do, our wildly expansionary (if necessary) fiscal and monetary policies will extract a cost. One principal cost is almost certain to be higher than normal inflation — and that’s when the TIPS issue will bite us. If inflation is much higher five years from now than the TIPS market expects today — and you can bet on that — people who bought TIPS when everyone expected very low inflation will end up making a killing as the value of their securities is adjusted way upwards for the higher-than-expected inflation. We estimate that will cost taxpayers from $50-$70 billion in additional debt-service costs. Fortunately, there’s an easy answer: The Treasury can buy back the outstanding TIPS and reissue the debt in conventional securities. Current TIPS holders would get the current value of their securities, and taxpayers could save enough to finance an awful lot of college assistance, health care for children, or R&D in climate-friendly fuels and technologies.

At a time when nearly everywhere we turn, it costs us all billions or even trillions of dollars, wouldn’t it be satisfying to save some real money — and without raising anybody’s taxes or cutting anybody’s program?

For more information, see the new study, “The Benefits to U.S. Taxpayers from an Open Market Buyback of Treasury Inflation-Protected Securities,” at this site.



Why This is No Traditional Recession

March 12, 2009

The leaders of the Republican Party (and plenty of their followers) continue on their strange path of denying the most basic economic logic in the midst of economic crisis and opposing whatever the President says or does. Happily, the Obama administration knows economics, and they seem to generally know themselves. Yet, they may still overestimate the extent of their powers, especially their ability to turn around the economy anytime soon without serious, new initiatives.

For a meltdown that follows none of the regular rules or patterns of garden-variety recessions, the stimulus we’re providing for consumers and the subsidies for housing and banking may well be insufficient to drive a respectable recovery in 2010 and even 2011. Yet, the President’s budget forecasts — and depends upon — economic growth of 3.2 percent next year and 4.0 percent in 2011. This is a picture of a traditional, “V-shaped” recovery, like 1983-1984. It’s what happens when a deep recession suppresses the normal buying impulses of households and businesses until the early signs of recovery, when all of the suppressed demand comes back with a vengeance. The result is a strong bounce back, just of the sort assumed in the budget.

But this is anything but a traditional recession, and there’s little reason to expect a traditional-shaped recovery. The stimulus will help, as will another round likely to come this summer. They may well be enough to stop our decline, but alone they won’t sustain enough growth in demand to push the economy much out of the cellar. Here’s the crux of the problem facing the President’s economic team — and ultimately all of us: People are pulling back sharply on their spending not only because they’re afraid they might lose their jobs, or already have. In addition, they’re suffering the greatest wealth losses in their lifetimes, especially in the value of the homes that constitute most families’ biggest asset. That means that a real recovery may require a much more aggressive housing program to stem the decline in housing values as well move foreclosure rates back towards normal. If that’s beyond the administration’s reach, this recession could go on until the housing cycle unwinds on its own, or as long as another 18 to 24 months.

Besides consumers (and government), the only sources of demand in the economy are business investment and exports. We can forget about a revival of U.S. exports driving growth, at least for more than another year. That’s because much of the rest of the world is in worse shape than we are. Most of them are much more dependent on their own exports recovering than we are, so their recovery may depend on Americans buying their exports. On top of that, most countries still aren’t providing any large scale stimulus — we, along with China and Spain, are the exceptions. So, a revival of our exports will likely come only after our own consumer demand recovers, to help fuel demand in other countries for our exports. That, too, would put recovery as much as two years distant.

That leaves business investment to fuel a recovery in time to help support the President’s plans in education, health care, climate, and most other things. But what businesses are prepared to invest when consumers here and abroad are buying so much less of whatever those businesses produce? That’s particularly so when it’s as hard as it is today for most companies to borrow funds to invest. This brings us back to something else we already know: A real recovery will also require a much more aggressive banking strategy from the administration and Congress, to force the bad debts and bad banks out of the way so that normal lending can start again. Because so many of those bad debts involve housing, a revival of business investment will likely have to follow the stabilizing of housing values. Here, again, there’s little reason to expect this will happen in time to help fund the administration’s budget proposals.

We all have to begin to think about what the policy and political landscape will be, if we don’t put in place more effective housing and banking programs than we now have, so we’re still mired in serious recession a good year from now. One change seems certain: Much of the political energy now fueling initiatives in health care, energy and climate would seep away. After another year of hard times with no relief in sight, the other thing that will matter to most voters and politicians will be the economic crisis that President Obama was elected to end.

The President knows full well — or should — that containing health care and energy costs, especially those borne by businesses, will be critical to breaking the mold of the last expansion, when most people’s wages and incomes stagnated, or worse, even as productivity, growth and profits rose handsomely. The saddest implication of our present predicament is that another 18 to 24 months of serious recession could leave untouched the deep, underlying economic problem that the President and his Party were really elected to solve.



The Denial and Anger Inside GOP Economic Policy

March 4, 2009

The leaders of the Republican Party, reeling from their painful string of defeats, seem stuck in two of the classic stages of grief, denial and anger. This week, Rush Limbaugh replaced Bobby Jindal as the leading and most colorful example. Limbaugh may seem like too easy a target, since talk radio always tends towards hyperbole. Nonetheless, the essence of the message from the presumptively addled Mr. Limbaugh is that Americans would be better off if the President’s economy program failed. Even if their homes slip into foreclosure and their kids have to drop out of college, American families would at least escape the degradations of “socialism” or, as another popular conservative pundit put it, “left fascism” (that’s from the hard-right blogger and historian, Ron Radosh).

The rhetorical excesses of talk radio and the web would hardly be noteworthy, if the same strain of non-thinking didn’t also dominate the Republican Party’s current economic positions. Let’s set the stage: Of the three natural sources of demand in a market economy, consumers have stopped spending, businesses have stopped investing, and exports have fallen off the proverbial cliff. That leaves government stimulus as the only possible source of new demand to at least slow the accelerating downward momentum of the economy and most of the people in it. Perhaps the best explanation, then, for why every Republican in the House and all but three GOP senators voted “no!” on the President’s stimulus is, well, denial and anger.

To be sure, economic ideology almost certainly plays a role here, too, on top of their denial (about the consequences) and anger (about no longer calling the shots). This came through vividly at a conference I attended earlier this week for the National Chamber Foundation. My panel was asked to talk about whether the administration’s plans foreshadowed a permanent change in the relationship between the public and private sectors. Set aside the fact that the leaders of the central private institutions in this drama, big finance, have begged Washington to amend that relationship long enough to preserve their jobs and the assets of their bond holders.

At the panel, a well-turned-out executive from a major private equity company (and former Bush Treasury official) laid out what once could have been the reasonable conservative position — stimulus weighted to tax cuts, a banking rescue that avoids taking over anybody (or dictating anybody’s compensation), and tax-based measures to reduce foreclosures. As a matter of economics, he got his targets right, even if his approaches are weaker than those favored by the administration. But at least his response suggested that he wants the economy to recover, regardless of who gets the credit.

Not so from the other member of the panel, Brian Westbury, who on top of being an economist with a Midwestern financial advisory is also the economics editor of the American Spectator and a frequent writer for the Wall Street Journal. He provided an economic-cum-ideological gloss for the denial and anger expressed by the flamboyantly-frustrated Mr. Limbaugh. Westbury’s prescription was no stimulus, no banking rescue and no program for foreclosures. The only constructive government action he could imagine was to jettison current “mark-to-market” rules. Those rules say that the balance sheets of banks and public companies have to reflect the actual market value of their assets and liabilities. So, for example, when a mortgage-backed security goes bust, you have to write down its value while preserving the liability of the money borrowed to purchase it and still owed.

In this view, none of what seems so important to the rest of us — collapsing demand, investment and trade, huge job losses, rising bankruptcies — matters for government policy. The only thing Washington should do here is to change how the financial losses from these events are reported. This isn’t economics; it’s a prescription that follows from a hard-edged ideological view that government can do nothing of value for an economy, regardless of conditions.

Unhappily, this cramped understanding isn’t limited to the pages of the American Spectator and the Wall Street Journal op-ed page. Bobby Jindal put the Republican Party on record for much the same view in his awkward response to the President’s address to Congress. He even cited the colossal inadequacies of the Bush administration’s response to Katrina as proof that the private sector is always the best answer to any problem or catastrophe — even if it’s under water at the time.

I honestly can’t believe that they’re really so dull-witted. A better explanation for Jindal and Limbaugh, along with commentators like Westbury and Radosh, is that they’re still grappling with the grief of losing the support of the American people — and the power that came with it. They’re stuck in denial and anger. And that’s a very bad position from which to consider the best policies for a nation and world economy in crisis.