Deal or no deal?

Yesterday, the Dow dropped 777 points in reaction to the failure of Congress to pass the Troubled Assets Relief Program (TARP) — that is, the Bush-Paulson plan reworked by Chris Dodd and Barney Frank.  Today, the Dow recovered almost 500 points in expectation of some deal in Capitol Hill.

Of course the financial system needs to be propped up somehow, at taxpayers expense, or risk a deeper and longer recession.  If there’s no deal in Congress in the next few weeks, several financial institutions are very likely to collapse due to short term but hard to solve liquidity problems.  Interbank and all types of credit will freeze further.  The stock market could sink — Dow 5,000 anyone?  And the effects on that part of the economy that produces actual wealth (rather than financial claims over such wealth) can be huge.

Even without this financial mess, the “real” economy is already in trouble.  The statistics on output and employment are not yet terrifying, but they show clearly that the economy is sliding into a recession.  That has to do with the usual cycle, with the effect intensified by the bursting of the real estate bubble.  So, there’s a wealth effect already hitting the “real” economy.  The portion of it that comes from shrinking values of real estate assets.  As people get poorer because their real estate equity stopped functioning as — to use the expression coined by Doug Henwood — an ATM machine, they are likely to shrink their consumption spending, which is by far the largest (and typically most stable) component of the economy’s overall demand.

With the financial mess, those problems in the “real” economy compound.  We have a double whammy: 1) the credit freeze slowing down further the “real” economy and 2) the wealth effect in steroids that results from the seriously shrinking values of financial assets across the board, including corporate stocks.  The latter effect is particularly worrying because, so far, “real”-economy corporations have had, on average, rather robust balance sheets.  With 1) and 2) working in tandem, we have a whole new game.  If equity shrinks significantly, then all corporate balance sheets will suddenly appear more leveraged, right at a time when rolling over corporate debt is become more difficult.

I’m going over the risks of the no deal just to convince myself that, all said and done, the choices may not be as stark as they appear.  I mean, no deal now doesn’t have to mean no deal at all.  It is just no deal for now.  I mean, as of today, Obama is expected to win the election.  As we know, expectations can change, as they depend on the information we have now, and the information gets updated as time elapses.  But if there’s no deal, the economy is not likely to improve and probable voters are not likely to blame Obama and the Democrats for it.

So, here’s the thing: In principle, yes, it’s better to face now these risks and try to preempt a deeper and longer recession by passing the TARP deal as is, or almost as is.  However, in the long run, this “better” may turn out to be only “marginally better.”  Why?  Because it’s likely that, in November, Obama and the Democrats running for Congress will prevail, which will drastically alter the political landscape.

Come January (or even November) the Democrats will be in a completely different position, thus having more clout to shape up expectations in the economy and, more importantly, to shape the actual bank rescue deal.  It seems to me that the Democrats in power would be more willing, especially under active popular pressure, to undertake the (partial) nationalization of troubled banks, a much better approach than buying off toxic assets at some above-market arbitrary price in the hope that 1) the banks are thus re-capitalized and 2) the Treasury is at some point able to dump them in the market at a decent premium.

Krugman, DeLong, Galbraith, et alia have aptly argued in favor of the Sweedish approach to rescuing the banks and there’s no reason to belabor that point here.  I could add (a bit vaguely, I admit) that Mexico’s own experience is consistent with their argument.  In 1982, Mexico nationalized the banking system.  Then, during the Salinas administration, the banks were sold back to private capitalists.  Even though the process was corrupt to the core, it seems that Mexico’s treasury didn’t do too bad on the deal.  (I’ll sound like Palin vis Couric, but I should get back to ya on this.  Need to look for references to this, as I’m sure there are studies that show it.  My 3 readers: please help.)

Then, in 1995, as a result of the Tequila crisis, Mexico’s private banks got again in deep trouble.  This time, the government of Ernesto Zedillo used the National Fund for Savings’ Protection (FOBAPROA), an institution created by Carlos Salinos in the spirit of the FDIC, to assume the banks’ liabilities that resulted from the insolvencies and bankruptcies following the peso plunge.  Altogether, the FOBAPROA assumed about 50 billion USD of banks’ bad debt, and that debt was later (in 1998) formalized as part of Mexico’s public debt.  Aside from the outright fraud and corruption involved in FOBAPROA’s operations, duly documented by the political opposition in Mexico, the deal was not nearly as good from the viewpoint of Mexico’s treasury as the 1982 nationalization.

I wish I could be more specific about the reasons why one approach worked and the other didn’t, but at some point one has to be humble and admit that ignorance is no valid argument.

Anyway, the main point I wanted to make today is this: Sometimes it’s better to have a good fight than a bad settlement.

Krugman’s column

In his latest column, Krugman reminds us of a solid reason not to vote for McCain in November: Phil Gramm might be his Treasury secretary.

López Obrador no descarta acuerdo con Calderón

Si el usurpador Felipe Calderón abandona los planes de privatizar PEMEX, López Obrador se dice dispuesto a negociar un acuerdo de unidad para abordar la crisis económica, crisis cuyo epicentro se ubica en Estados Unidos.  Esto lo declaró ayer el presidente legítimo en el Zócalo de la Ciudad de México ante una multitud congregada en asamblea informativa del Movimiento Nacional en Defensa del Petróleo, en un discurso en el que 1) resumió en forma certera los fatales defectos del régimen económico mexicano en los últimos (casi) 25 años y 2) llamó a tomar varias medidas de expansión de la demanda agregada para encarar la crisis.

Larry Summers: It may work out well

Larry Summers’ column in the Financial Times.  Now that the Paulson proposal has been amended, it may turn out to be okay — he opines.  I don’t know the details of the proposal to be submitted to the two houses in the next few days.  So, I have no opinion yet about it.

Ganó el Sí

El Ecuador tiene una nueva constitución política.  Ganó la iniciativa del presidente Correa.

What works and what doesn’t

Brad DeLong advocates a Swedish approach (taking over the banks) versus a Paulson-Dodd-Frank plan not backed up by the Republicans.  On his most recent blog entry, Krugman agrees that’d be the choice of last-resort.

To understand the case of Sweden (1992), you may want to read this article in the New York Times or, if inclined to read more technical stuff, this NBER paper by Maurice Obstfeld.

The IMF has a report (pdf) out on what works and what doesn’t in bailouts.  Thanks to Joanna Bujes for the lead.

Joseph Stiglitz: a better bailout

Chances are the 3 people following my blog have already read the latest by Joseph Stiglitz on The Nation.  If not, here it is.

Debate watch party for me, panel discussion for you

I was going to type a few thoughts in defense of the spirit of my rescue plan.  But we are having a Debate Watch Party at home tonight, and need to go shopping for munchies and beverages, and pick up my son at day care.  Since I cannot just leave like that, here’s the YouTube video of the panel discussion on the financial crisis held at Princeton on 9/23/2008 (picked up at Krugman’s blog).  Enjoy!

Crisis on Wall Street

Doug Henwood on the crisis

The new article in the Nation by the author of Wall Street.  Excellent! Since he’s got us used to excellent writing, there’s no surprise.

Today, I’m preparing classes and getting my paper on fiscal incentives, maquiladoras, and local standard of living in Mexico ready for presentation in Montreal. So I cannot yet address the objections that have been raised against my rescue plan. As soon as I can, I’ll take that task up.

James Galbraith on the bailout

Today, rushing to my next class, I’m just going to channel James K. Galbraith’s short interview with Harpers.  Enjoy and leave comments.

My rescue plan

Take a look at Krugman’s 4 step description of the crisis.  Krugman says Paulson is trying to contain the mess at step 4 (using $700 billion over 2 years), while a better approach (Krugman’s) would be to act on step 2.

I can beat them both.  I think a sensible rescue plan should work on step 1.  That will make it more effective, equitable, and inexpensive.

According to a 2007 study by the Chicago Fed authored by S. Agarwal and C.T. Ho, the estimated face value of outstanding subprime loans in 2007 was $1.5 trillion.  (I’ve seen other estimates at around $1.3 trillion, but let’s not quibble with details.)  According to some sources, recent subprime delinquency rates nationally average 24% or so.  The Mortgage Bankers Association estimates 19% subprime delinquency in its latest survey (thanks Doug Henwood and raghu for the leads) while the Chicago Fed study puts the rate at 15%, but let’s assume 25% delinquency.  The exposed portion of those outstanding subprime mortgages amounts to $375 billion.   The number of households involved is 2.5 million, under the assumption that the national average price of a subprime housing unit is $150,000.

If these calculations are even roughly accurate, the Treasury could — not buy those assets from the financial firms that hold them, directly or as underlying of derivative assets, but — locate the original issuers of the mortgages (the subprime borrowers) and help them make the monthly payments for the next 10 years.  In 10 years, the borrowers will have enough equity to fend for themselves.  And if the subprime borrowers are expected to service their loans normally over the next 10 years, then the financial firms that acquired securities backed by those mortgages will have capital to function, service their own liabilities, continue to provide credit to the economy, and overall perform the wonderful things they are known to always do for our social good.

Note that the Treasury doesn’t need to come up with $375 billion cash upfront.  They just need to service a relatively small annuity with a total payment adding up to whatever is required to help those borrowers meet their payments on time over the next 10 years.  Clearly, the present value of that annuity would be much less than $375 billion.  If we say it’s $100 billion, we’d very likely be exaggerating.  But let’s exaggerate and say it’s so.

Still, should the Treasury give away $100 billion to 2.5 million poor families who dared dream own a house?  I am not going to make the “populist” argument that doing so is better than handing $700 billion to a few hundreds of shareholders and creditors of broke financial firms over 2 years (I’m sure that the $700 billion would not be the end of the Paulson plan, just like Wolfowitz’s $60 billion budget estimate wasn’t the total cost of the Iraq war).  Giving money to people in need, of course, creates horrible moral hazard, which in turn erodes the basis of our civilization.  When in distress caused by a disaster not of their making, people would grow accustomed to receiving the solidarity and support of the rest of society and, thus, would start to behave in self-destructive ways.  As we know, only the rich have the moral fortitude to properly use government subsidies: the bigger the subsidies, the more morally they behave.  So, no.  There would be a quid pro quo, an upside to taxpayers.

Clearly, our economy and fisc underproduce key public goods and — as a result — the quality of our life suffers.  Two of those goods are public education and public health.  Clearly, if more Americans are educated and healthy, the rest of us benefit greatly.  They would be more likely to be better coworkers, neighbors, citizens, etc.   It turns out that, by helping those people the government would have tremendous leverage over them.  Thus, the government could condition the financial help on their committing to sending their children to schools (all the way to college), and to schedule regular visits to the dentist and the physician.  They themselves would commit to attending vocational school, if of age.  Etc.  That would make our society much more livable at their expense.

But, how would those schools and clinics be funded?  They may not even exist.  Let’s see.  Say that the present value of locating the borrowers and managing the annuity fund to help them service their loans over the next 10 years is $20 billion.   Again, I’m exaggerating.  Now add that to the present value of the annuity, $100 billion.  That’s $120 billion altogether.  Take the first year of the Paulson plan: $350 billion.  Subtract those $120 billion from them.  You have a remainder of $180 billion.  That’d be more than enough to build and fund those schools and clinics.  How do I know?  Based on the estimated present value of my family dental and medical plan (Oxford, using a discount rate of 5% p.a. and deeming these plans perpetuities, i.e. making premium payments not only over a lifetime but forever, as any decent government would do) , I estimate that giving good dental and medical care to 2.5 million people and their families would require less than $75 billion (present value).  That’s health care.  Education could use up the rest.  Luckily, $120 billion would even leave change to cover with medical and dental services other segments of the currently uninsured population.

With about half the money Paulson wants us to give him, we can get the financial system back in shape and generate a substantial amount of public good at the expense of those reckless subprime people who started it all.

You are welcome.

Who pays for the Paulson-Bernanke Plan? It’s complicated

I just posted this long comment on Paul Krugman’s blog.  It’ll appear in a few days.  They are always lagging behind.

*  *  *

What is the effective incidence or ultimate distributional effects of the Paulson-Bernanke rescue plan?

The argument that the median household benefits from rescuing the financial institutions is not absurd.  If we don’t rescue them, they’ll drag down the whole economy.  Although a growing economy doesn’t necessarily benefit the average household (we’ve seen in the last few years, the gains from productivity going almost exclusively to the top), economic contractions have a way of being even worse for regular people.

That would be the growth/efficiency argument in favor of rescuing the financials.  But how about the (related but distinct) equity argument?  Who wins, who loses?  The devil must be in the details.

As I understand it, a public entity is being proposed to buy out the bad assets in the financials’ balance sheets.[*]   At what price?  How are they going to price them?  There’s no market for them.  The public entity (the USAFobraproa, as I call it, because it’s like Mexico’s Fobaproa after the 1994-5 Tequila crisis) will be the market maker for those assets.

For all practical purpose, the effective, current market price of those assets is next to zero.  That’s why those financials are in deep.  If the public entity paid for them their current market price, the banks would get no rescue.  So, that can only mean that taxpayers are going to pay a price above their current market price.  How much above?  Well, apparently, $700 billion for them all.  The stockholders of banks gain, we lose.

Not unlikely, but not necessarily either.  Because there’s this self-fulling prophecy thing.  If, indeed, the financials collapse and they drag down the entire economy, then indeed those assets (say, mortgages) are garbage, because the economy will not help people service them.  On the other hand, if the financials are rescued (regulated and monitored in their future dealings), then the economy may improve and help people service their obligations, thus making those assets more valuable than currently deemed, which may even turn out a profit to taxpayers.

Can somebody please measure all this stuff and straighten things out for me?  Thanks.

[*] Paulson said yesterday that, aside from those toxic assets, “our” (speak for yourself, man) financial firms are otherwise “financially sound.”  How do we assess the financial soundness of a firm but by looking at the predominant assets in their balance sheets?  That’s like saying that, aside from a person being lazy, duplicitous, and cowardly, his character is otherwise sound.  But I digress.

How to prevent what just happened

Here’s an article that Joseph Stiglitz published on CNN online before the Paulson-Bernanke plan was announced.  So, it’s a bit outdated, although not really.

Fobaproa al estilo estadounidense

Para los mexicanos con memoria e interesados en entender, el plan de rescate diseñado por Paulson y Bernanke es un Fobaproa al estilo estadounidense.  Es decir, en primer lugar, muchísimo más grande.  Otra diferencia importante es que el balance de Fobaproa lo han tenido que pagar (y lo van a tener que seguir pagando) los mexicanos, y prácticamente sólo ellos.  En cambio, los pasivos de este plan de rescate van a recaér no sólo en nosotros aquí, sino también en ustedes allá.  A menos que el resto del mundo organice una muy necesaria rebelión monetaria y financiera global.  Aquí hay algunas ideas sensatas sobre lo que el resto del mundo podría hacer.  Y aquí pueden ver básicamente el mismo argumento en láminas tipo PowerPoint (en realidad pdf).  Suerte.

All in this together? On decoupling

In this article, FT’s journalists Guha, Giles, Atkins, and Pillin write:

“Yet some experts still doubt the ability of the big emerging economies to substitute domestic demand for exports.

““We just don’t know how easy it will be for them to pull this off,” says one former policymaker. He worries that China and its peers may either slow more sharply than anticipated or reaccelerate too quickly, igniting inflation at home and in commodity prices, before they are forced to slam on the brakes again, with potentially global consequences.”

At this time, nobody knows for sure whether the rest of the world will follow the U.S. in a painful (and long lasting) recession.   It depends on how the rest of the world plays its hand.  However, as far as China is concerned, the worries of that mysterious ‘policymaker’ may be largely unfounded.  As far as the eye of a Western economist can see, China’s government is not very likely to allow for a substantial deceleration.  My friend Oscar Galindo (and my own reading of China’s experience of the last five years) has persuaded me that the Chinese have problems, but also an ample (political) degrees of freedom to keep growing.  That’s for the time being.  Moreover, the Chinese are all Keynesians nowadays.  Decades of rapid growth (with a host of dislocations, no doubt) have given the government some political capital.  So, I expect them to switch their emphasis from exports to trade diversification, domestic investment, local development, greater social equity, and the environment.

A propos of trade diversification, if Russia, India, and Latin America continue to expand their economic ties, the “decoupling” story that the FT reporters pooh pooh in this article as “naive” may turn out to be spot on.  Journalists present a strawman version of the “decoupling” argument.  On this very idea, I posted a comment on Paul Krugman’s blog:

In case you can’t find my comment, here it is [slightly ammended]:

# 6. August 24th, 2008 12:10 am

Originally, if my memory helps, decoupling didn’t mean that poorer countries (say China or Brazil) would [be] escaping the U.S.’s altogether. It just meant hedging or insuring. This was, I believe, the idea in Ricardo Caballero’s paper at the 2002 AEA meeting in Washington, DC, where he introduced the idea normatively.

So, if I remember correctly, it only meant that the ups and downs of the cycle in the rich countries wouldn’t hurt poorer countries, except to the extent the ups and downs are *systemic*. Obviously, the U.S. is a huge part of “the system.” In that sense, exposure to systemic risk is necessarily exposure to the U.S. There’s no way around that. All those countries could do is lower their betas.

But if the premise is that decoupling requires poorer countries shedding all risk (including systemic risk), then the argument is silly. It’s impossible. Decoupling is refuted by assumption.