Cool heads needed

In a recent piece in the Dominion Post Roger Kerr makes the point that Cool Heads Needed in Economic Turmoil. Kerr writes that there are some things that are clear about the current crisis,

First, it will pass. Defensive actions by governments and market adjustments will pave the way for recovery, probably within a year or two. A repeat of the 1930s Great Depression is highly unlikely.

Second, market-based economic systems will not be abandoned. They involve risk and can be volatile, but their wealth-creating abilities are unsurpassed.

Third, just as in the 1930s depression, the stagflation of the 1970s and the Asian economic crises of the 1990s, many of the current problems are government-made. Governments and businesses need to learn from their mistakes.

He goes on the explain that many acts of folly precipitated the meltdown in the US financial sector,

Prime exhibits include the easy money policies of the Federal Reserve after the dotcom crash, which helped fuel the house price boom; the government sponsorship of Freddie Mac and Fannie Mac, the giant mortgage underwriters that failed; the legislation and political pressure that encouraged banks to lend to unqualified borrowers in the name of ‘affordable housing’; land supply restrictions; mark-to-market accounting rules; non-recourse lending regulations; and more.

Later he notes that

Once the default avalanche was triggered, authorities in the United States, Europe and elsewhere had little option other than to act to protect their financial systems, [...]

This is not so clear to me. As Jeff Miron has recently put it

It is time for the government to do the one thing it does well: nothing at all.

Or as Miron entitled a previous column on the US financial problems, Bankruptcy, not bailout, is the right answer.

When looking at the US governments approach to protect their financial system Miron argues that the government bailouts of banks will hide problems and spread inefficiency. He writes

If banks were fundamentally sound but temporarily in need of cash, they could sell stock on their own to private investors. Few investors now want bank stock, however, because they cannot tell which banks are merely illiquid -- short of cash for new loans because their assets are temporarily sellable only at fire-sale prices -- and which are fundamentally insolvent -- short of cash and holding assets whose fundamental values are less than the bank's liabilities.

This lack of transparency is a crucial impediment to new investment, and therefore to new lending.

Government injection of cash, however, does little to improve transparency. A bank with complicated, depreciated assets is in much the same position after the government gives it cash as it was before, since outside investors will still have limited information about the solvency of any individual bank.

Perhaps the new cash will spur the sale of bad assets, or nudge banks to reveal their balance sheets, but that is far from obvious. Banks, moreover, might remain cautious even with this increased liquidity simply because of uncertainty about the economy. Thus it is hard to know whether cash injections will actually spur bank lending.

The great Anna Schwartz also sees the problem as one of lack of transparency. This from a recent report of an interview with Schwartz by Brian M. Carney in the Wall Street Journal,

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

Miron goes on to say

In any event, government ownership of banks has frightening long-term implications, whether or not it alleviates the credit crunch.

Government ownership means that political forces will determine who wins and who loses in the banking sector. The government, for example, will push banks to aid borrowers with poor credit histories, to subsidize politically connected industries, and to lend in the districts of powerful members of Congress. All of this is horrible for economic efficiency.

Government pressure will be difficult for banks to resist, since the government can both threaten to withdraw its ownership stake or promise further injections whenever it wants to modify bank behavior. Banks will respond by accommodating government objectives in exchange for continued financial support. This is crony capitalism, pure and simple.

Government ownership of banks will not be a temporary expedient. Politicians can swear they will unwind the government's position once "economic conditions improve," but no one can enforce this promise. The temptation to use banks as a political tool will be permanent, not temporary, so government ownership will continue for decades, or forever.

Worse yet, government ownership of banks sets a precedent for ownership in every industry that suffers economic hardship. Some might argue that banking is "essential," but many industries -- autos, steel, computers or agriculture -- will make similar claims when it is their turn to demand a bailout. Thus banking will be only the first victim in an enormous expansion of the government's role. This again will have disastrous consequences for economic efficiency.

But in Miron's view this is not the worst of it,

The injection means that banks get cash, and they get it now. This benefits current stockholders and bondholders, which is why stocks have jumped on news of the injections.

The government, however, gets stock that might end up being worthless, since some banks will fail anyway. The government gets stock that may never trade in a market or have its value determined by fundamentals. The government gets stock that it cannot sell for years, if ever, without generating turbulence in asset markets as investors interpret the government's decisions or position themselves to profit from them.

Government purchase of bank stock, therefore, is a transfer from taxpayers to people who took huge risks and lost. The United States, and the world, got into the current mess by trying to insure away risk, which everyone should have known was a fool's errand. Thus bailing out risk-taking -- or providing new guarantees for loans and deposits -- will generate even greater problems down the line.

Thus the US efforts to protect their financial system may well not work and similar efforts in many other countries share at least some of the problems of the US approach. But more importantly, doing nothing at all, as Miron puts it, was an option and if the actions countries have taken don't work hindsight may make it seem the optimal action (or inaction!).

Should this surprise us? I would argue no. As I tried to argue here and here the history of the Great Depression tells us that government efforts to deal with a crisis do, by and large, little good and in fact can make matters worse.

So Roger Kerr is correct to say cool heads are need right now, but I would argue that such heads may be saying, do nothing.