Thursday, October 9, 2008

Nobel Laureates (and other economists) on the Financial Crisis

I'm sure you've heard too much about the financial crisis these days, but here I'm posting some central paragraphs of the most recent publications of economical experts. As experts go, they are as big as you can get. (*author's title hyperlinks to the full original article)

Joseph E. Stiglitz, 2001 Nobel laureate, econ professor at Columbia University:

We could do more with less money. The holes in financial institutions’ balance sheets should be filled in a transparent way. The Scandinavian countries showed the way two decades ago. Warren Buffet showed another way, in providing equity to Goldman Sachs. By issuing preferred shares with warrants (options), one reduces the public’s downside risk and ensures that they participate in some of the upside potential.

This approach is not only proven, but it also provides both the incentives and wherewithal needed for lending to resume. It avoids the hopeless task of trying to value millions of complex mortgages and the even more complex financial products in which they are embedded, and it deals with the “lemons” problem – the government gets stuck with the worst or most overpriced assets. Finally, it can be done far more quickly.

At the same time, several steps can be taken to reduce foreclosures. First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit. The government effectively pays 50% of the mortgage interest and real estate taxes for upper-income Americans, yet does nothing for the poor. Second, bankruptcy reform is needed to allow homeowners to write down the value of their homes and stay in their houses. Third, government could assume part of a mortgage, taking advantage of its lower borrowing costs.

By contrast, US Treasury Secretary Henry Paulson’s approach is another example of the kind of shell games that got America into its mess. Investment banks and credit rating agencies believed in financial alchemy – the notion that significant value could be created by slicing and dicing securities. The new view is that real value can be created by un-slicing and un-dicing – pulling these assets out of the financial system and turning them over to the government. But turning them over to the government at market value doesn’t improve banks’ balance sheet; to do that requires overpaying for the assets, a transfer of wealth from ordinary taxpayers to the banks..

In the end, there is a high likelihood that if such a plan is ultimately adopted, American taxpayers will be left on the hook. In environmental economics, there is a basic principle, called “the polluter pays principle.” It is a matter of both equity and efficiency. Wall Street has polluted the economy with toxic mortgages. It should pay for the cleanup.

Download Stiglitz's lecture on Credit Crunch from the James Martin 21st Century School: Here

Gary S. Becker, 1992 Nobel laureate, econ professor at University of Chicago:

I believe it is unwise to give governments equity in private companies, even if the government does not have voting rights in company policies. Many examples in recent history, such as the current Alitalia fiasco, show that political interests outweigh economic ones when governments have some ownership of private companies. This is likely to happen in this bailout if some banks that are helped decide to sharply cut employment in the districts of some congressmen, or to transfer many jobs overseas.

Taxpayers may be stuck with hundreds of billions of dollars of losses from the various government insurance provisions and government purchases of assets. Although the media has made much of this possibility through headlines like "$700 Billion Bailout," such large losses are highly unlikely except in the low probability event that the economy falls into a sustained major depression. Indeed, with efficient auctions, the government may well make money on its actions, just as the Resolution Trust Corporation that took over many savings-and-loan banks during the 1980s crisis did not lose much, if any, money. By buying assets when they are depressed and waiting out the crisis, the government may have a profit on these assets when they are finally sold back to the private sector. Making money does not mean the government involvement is wise, but the likely losses to taxpayers are being greatly exaggerated.

The temporary banning of short sales is an example of a perennial approach to difficulties in financial markets and elsewhere; namely, "shoot the messenger." Short sales did not cause the crisis, but reflect beliefs about how long the slide will continue. Trying to prevent these beliefs from being expressed suppresses useful information, and also creates serious problems for many hedge funds that use short sales to hedge other risks. Their ban can also cause greater panic in other markets.

The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system. That is, insufficient appreciation of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such limitations, it is difficult to propose long-term reforms. Still, a few reforms seem reasonably likely to reduce the probability of future financial crises.

- Increase capital requirements. The capital requirements of banks relative to assets should be increased after the crisis is over in order to prevent the highly leveraged ratios of assets to capital in financial institutions during the past several years. Possibly a minimum ratio of capital to assets should be imposed by the Fed on investment banks and money funds. As much as possible, the measure of capital should not be its book value but its market value, such as the market value of publicly traded shares of banks. Book value measures, for example, apparently badly missed the plight of Japanese banks during their decade-long banking crisis of the 1990s.

- Sell Freddie and Fannie. The government should as quickly as possible sell Freddie Mac and Fannie Mae to fully private companies that receive no government insurance or other help. These two giants did not cause the housing mess, but in recent years they surely greatly contributed to it, partly through congressional pressure on them to increase their purchases of subprime loans. They have owned or guaranteed almost half of the $12 trillion in outstanding mortgages while having a small capital base. The housing market already has excessive amounts of government subsidies, such as from the tax exemption of interest on mortgages, and should not have government sponsored enterprises that insure mortgage-backed securities.

- No more bailouts. The "too big to fail" approach to banks and other companies should be abandoned as new long-term financial policies are developed. Such an approach is inconsistent with a free-market economy. It also has caused dubious company bailouts in the past, such as the large government loan years ago to Chrysler, a company that remained weak and should have been allowed to go into bankruptcy. All the American auto companies have asked for and received handouts too since they cannot compete against Japanese, Korean and German car makers, partly because these American companies have been incredibly badly managed. A "too many institutions in trouble to fail principle," as in the present financial crisis, may still be necessary on rare occasions, but failure of badly run large financial and other companies is healthy and indeed necessary for the survival of a robust free-enterprise competitive system.

Edmunds S. Phelps, 2006 Nobel laureate, Director of the Center on Capitalism and Society at Columbia University

House Republicans and some economists object, saying that the government could attain its goal with a bigger or surer profit by selling the banks "default insurance" on their distressed assets: the premiums paid are hoped to far exceed the default costs. To me, government entry into the default insurance business is little different from government purchasing the assets. It is not clear to me that selling default insurance would be more profitable.

House Democrats want a parallel program that would help defaulting mortgage borrowers to avoid foreclosure -- to help them "stay in their homes." Such a step might set an undesirable precedent in economic policy. If, after investing in my vocational training, I cannot make it in the line of work I chose -- not at the real wage that the market has since established, at any rate -- will I be entitled to help from the government to "stay in my work"? Furthermore, many defaulters are housing speculators not families caught up in an adjustable rate mortgage they did not understand. Finally, the overinvestment in houses does not present the systemic risk of economic breakdown that the overextension of credit does.

However, the program to revive the operation of the banks through purchase of the toxic assets faces a sticky wicket. If the government sets the prices too low, the banks will supply little of their assets; they will prefer to hold them to maturity in order to get the price appreciation for themselves. The Treasury will then need to raise the terms. But that may cause the banks to hold off longer, speculating on still better terms ahead.

If, instead, the Treasury sets its prices too high, its funds will go far enough to buy only a portion of the toxic assets offered in response. Thus, it is not certain that such a program would work to clean out the toxic assets at all quickly. Subnormal operation of the banking industry might drag on for a few years.

A program of asset purchases, however needed, is limited in scope. It cannot be counted on to increase the equity capital of the banks -- to shore up their solvency. Underpaying for the toxic assets would actually inflict a further loss of capital. Overpaying the banks for their toxic assets could contribute capital, but that may not be politically feasible or attractive.

So it is clear that the main prong of any "rescue" plan must serve to advance the recapitalization of the banks. Cash transfusions in return for warrants are a good way to do it, as it lets taxpayers share in the upside. The rescue of Chrysler used warrants. This past Monday the FDIC got $12 billion in preferred stock and warrants in the deal that saw Citigroup buy Wachovia. The question is which banks are to be thrown a lifeline, which will have to sink or swim. This one-time dose of corporatism is unpleasant, though the banking industry is to blame for its necessity.

But these steps toward making the system operational again will leave it dysfunctional. We don't want to restore the system as it was. And the risk that the industry would cause another round of wreckage is not the only reason.

What has occurred is not just an old-fashioned banking crisis but also a banking scandal. Most of the big banks were shot through with short-termism, deceptive practices and self-dealing. We must institute basic changes in corporate governance and in management practice to restore responsibility and honesty for the sake of the economy and for the self-respect of the country.

We also need to return investment banking to its roots. There is more to the influence of the financial sector than merely its effects when it goes off the rails. The financial system is not a sort of circulatory system that passively carries fresh saving to the places in the economic body that demand the greatest investing -- as if guided by some "invisible hand." Judgment and vision -- of bankers, fund managers, angel investors and the rest -- matter hugely. So do the distortions, the limits and the license created by the regulatory system and the moral climate. To prosper and advance, the American business sector is going to need a financial system oriented toward business, not "home ownership."

Kenneth Rogoff, econ professor at Harvard University, former chief economist at the IMF
Does such nitpicking fail to recognize the urgency of fixing the financial system? Isn’t any plan better than none?

I, for one, am not convinced. Efficient financial systems are supposed to promote growth in the real economy, not impose a huge tax burden. And the US financial sector, in greasing the wheels of the real economy, has been soaking up an astounding 30% of corporate profits and 10% of wages. Thus, unlike in the 1930’s, the US faces a hypertrophied financial system. Isn’t it possible, then, that rather than causing a Great Depression, significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?

I am not suggesting that the government should sit on its hands. It needs to provide an expanded form of deposit insurance during this time of turmoil, so that there are no more Northern Rock-style bank runs. That was a big lesson of the 1930’s. The government may also need to consider injecting funds more directly into the mortgage sector while the private sector reconstitutes itself.

Certainly, the government must also find better ways to help homeowners and their lenders work out efficient bankruptcy proceedings. It makes no sense for banks to foreclose on homes when there are workout options whereby people could stay in their homes and banks could recover far more money.

UCLA econo professor Lee Ohanian:

I am particularly concerned about bad policies because significantly higher taxes have been proposed by Barack Obama. His plan would raise the marginal tax rate on the most productive workers more than 10 percentage points -- an increase that would bring us near Western European levels. His plan would also raise capital income taxes, taxing capital gains and dividends at 20%, compared to a 15% rate under Sen. John McCain's plan. A five percentage-point difference might strike you as small, but it is not. I have calculated that a five percentage-point difference in overall capital income taxation over the long haul is equal to a difference in the nation's capital stock of about 18%. This means a 6% difference in GDP and a 6% difference in the average wage rate. This means that real GDP and the average wage would fall, gradually but persistently declining about 6% after 25 years. That's not quite a Great Depression, but a significant step towards one.

What should be done? We should encourage the immigration of prime-age individuals. Beginning in 2007, net immigration fell to half of its level over the previous five years. Increasing immigration would increase the demand for housing and raise home prices. And note that the benefit would be immediate. Home prices -- and the value of subprime obligations -- would rise in anticipation of a higher population base. The U.S. particularly needs highly skilled workers. These workers not only would purchase homes, but would generate higher living standards for all Americans.

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