Protect Depositors First

FROM A BLOG POST OF SEPT 26, 2008:

            If there is anything that government should do, it is this bank bailout proposed by Treasury Secretary Paulson.  In America we debate whether government should be small and stay out of the way of households and businesses (the Republican view) or should help people realize their potential (the Democratic view).  This debate is reasonable and should continue.  What is not debatable is that government should step in when the market fails. 

Secretary Paulson’s rescue plan is vague, but the key elements are there — namely, we must remove the bad assets from the balance sheets of our financial institutions and help them recapitalize.  That’s it, folks.  All the rest is political posturing.

When passion, whether fear or exuberance, overwhelms rationality, which is critical to the functioning of markets, government must step in.  This calms nerves and allows us once again to determine a fair price for an asset.  So, all the talk from Republicans in Congress about the government bailout being “financial socialism” is poppycock.

 I worked for more than a decade as an emerging markets economist, during which banking crises swept the globe.  The much-maligned IMF and World Bank pressured governments in crisis to quickly clean up their banks’ balance sheets and recapitalize them, so that they could get back to providing credit for economic growth.  The U.S. has experienced exactly such a shock, not as large relative to our wealth as in these countries; but in absolute dollar terms, this is the biggest financial shock this planet has ever seen.

An IMF Working Paper, “Systemic Banking Crises: A New Database,” which came out this month (and I recommend you read), examines 42 financial crises in 37 countries from 1970-2007.  It suggests that the recapitalization of financial institutions is the surest way to minimize lost economic output from a financial crisis.  The paper notes that the average cost to the taxpayers of bank bailouts was 13.3% of GDP.  If handled correctly, the cost to the US Treasury of this crisis could remain as low as 5-7% of GDP.  Still, the dollar figures are enormous, and this is what gets headlines.  However, our economy is also enormous; and relative to the deep US tax base, the cost of this crisis should be modest.

On the other hand, if nothing is done, more financial institutions could fail, their assets could be sold in a disorderly fire sale, depressing real estate prices further, more job losses could occur, which would snowball into defaults on other consumer loans, business loans could go bad, losses in the financial system would mount, the recession would deepen, and tax revenues would drop.  The government would have to step in anyway to protect depositors, and the cost to the government of recapitalizing the banks later on could be even larger.  The hit to the American taxpayer could dwarf the costs we are facing now. 

Because of the bank failures of the Great Depression, our government insures traditional bank deposits up to $100k and last week agreed to protect money market mutual funds as well.  The government is on the hook for up to 75% of GDP or a whopping $11 trillion!  By helping banks get healthy again, the government would avoid paying out on this enormous liability.  Likewise, by holding the impaired assets and selling them gradually as the economy recovers, the government would help markets get back to doing what they do best, determining prices. 

            We have done this before.  In the eighties (during Republican administrations) when 2700 financial institutions failed, the Resolution Trust Corporation took over bad banking assets, costing the tax payer an estimated 3.7% of GDP, or over $200 billion.  And this wasn’t just on Wall Street.  The S&L crisis included lots of institutions in the Sun Belt where Republican voters live.    

How the pain of this adjustment is apportioned is important.  Affected players include bank managers and shareholders, bank creditors and borrowers, investors, depositors and taxpayers.  Critical to minimizing the damage to our economy is protecting depositors first.   Panic among depositors, a bank run, such as we saw during the Great Depression and have seen in emerging markets, would be much worse than what we are experiencing now.  Fairness in apportioning the pain is not unimportant, but getting back to growth and safeguarding the future should be our guides. 

             The government should purchase impaired assets for a price that allows banks to recapitalize, providing funds they can relend.  In exchange, the government can take stakes in some larger institutions, and attach conditions, such as firing senior managers and requiring the board to seek private sources of capital.  This would penalize current management and shareholders, sending an important message for the future, that you will pay a price if you mismanage your bank.  When we exit the crisis, the government can sell the mortgage assets and its equity stakes, lowering the ultimate cost of the bailout to the taxpayer. The fact that the assets the government is buying are secured by real estate, which has tangible economic value, means that recoveries could be sizable.

            In order to limit the government’s ownership stake in our financial system, the government could take equity stakes only in large, systemically-important institutions, where it would have a say in management.  This is what the government has already done with A.I.G., Fannie and Freddie.  With smaller institutions, the government could pay less for impaired assets and push them towards private sources of capital, or let them fail. 

            As for borrowers, the government should provide incentives for them to make their loan payments.  The program could lower their debt service burden, allowing many to keep their homes, on the condition they make the payments.  The risk of attaching a borrower rescue to the plan is that it sends a message that you can buy more house than you can afford because the government will bail you out.  And, to administer such a program with millions of borrowers could be difficult.

            Is it true that with Paulson’s plan the depositor is saved but the taxpayer takes a hit? Depositors, taxpayers, homeowners, and yes Barack and John, voters, are one in the same.  It is you and me.  Will everyone take the same hit?  No, but our social welfare net, perhaps buttressed by some relief to homeowners, should keep most everyone afloat.

            The United States is strong.  Our GDP represents one-quarter of global output and is more than three times the size of the next largest economy (Japan’s).  Although Bush’s tax cuts and spending increases have increased the deficit and debt, last year our government debt was below 60% of GDP, which is high, but less than that of other industrialized countries, such as Germany, Canada and Japan.  So, we have room to do this bailout, but not a lot of room. 

Longer term, America must correct the weaknesses that make our prosperity fragile.  We should take action to improve the quality of our GDP.  GDP is the measure of all purchases in the economy.  A lot of our purchases are wasteful – too many homes, cars, fuel, disposable paper-or-plastic, designer food, entertainment, etc.  By investing more in education, we can insure that we produce a higher-quality GDP, higher value-added goods, such as software, green and life-saving technologies, better and cheaper health care, knowledge-based services.  And of course, we must save more.

Horst Kohler, the president of Germany and past head of the IMF, earlier this year critiqued Anglo-Saxon capitalism, calling for a “continental European banking culture.”  It seems our heavy reliance on the market is at fault, whereas government intervention is the hallmark of continental European capitalism.  This is a legitimate debate.  Yet the higher GDP growth rates, higher labor productivity, lower unemployment rates, quicker rebounds from crises that characterize American capitalism demonstrate the benefits of the Anglo-Saxon variety.  On the other hand, the financial bubbles, crashes, skewed wealth distribution, job insecurity, and pollution and waste also characterize American capitalism. 

It is perhaps not as Kohler says that we have swung too far toward free markets, but that we have to develop better tools, better incentives to soften the excesses and clean up the messes. We will not avoid the booms and busts because government cannot possibly keep up with the innovation going on in our markets.  The role of government is to do two things: 1) set up incentives and penalties that encourage prudent behavior, and 2) do a good job cleaning up the inevitable mess.

            What are our political leaders up to?  The biggest financial crisis since the Great Depression comes in the middle of a very competitive election.  Our leaders on both sides of the aisle want to solve the crisis.  They genuinely do.  But they also want to exploit the crisis to enhance their appeal to voters.  Republicans want to appear in charge and able to make the difficult decisions to solve the crisis.  Democrats support a rescue, but only insofar as they can pin the blame for the mess on the last eight years of Republican government.  As for us — the voters, the taxpayers, the depositors — our interest is in our leaders making the right decisions, which in this case is to implement Paulson’s bailout.  We enjoy the political theater, yes, but please fix America’s problems.

Feel free to send this around…

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One Response to “Protect Depositors First”

  1. Declining powers: the US debate on health care reform « Scherblog Says:

    […] Paulson and Bernanke as well as Democrat Geithner, a year ago, lest we forget.  I wrote about that on my blog, applauding all those involved on both sides of the aisle.  Yes, Paulson was helped along by […]

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