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Do tax payers need to bail-out the financial system?

February 14th, 2009 · No Comments

Often, the best first approach to a difficult situation is to list as many ‘stylized facts’ as one can think off. Here is one ‘stylized fact’ to dominate all others: no economic recovery without a functioning banking system. It’s a simple truth, there will not be many people disagreeing with it (hence it is a ‘stylized fact’). Yet, politics is still pussyfooting around it. We cannot afford that..

‘Stylized facts’ are simple, rather uncontroversial statements that describe the essence of a situation and most knowledgeable people would not disagree with them.

To approach a difficult situation, it often helps to list as many stylized facts as one can think off. It is actually remarkably difficult to go completely wrong if one does that with any kind of discipline (unless one does not have the required knowledge to come up with any stylized facts, of coarse..).

We need just two to point us at the right direction to get us out of the economic mess we’re in:

  1. There will be no economic recovery without a functioning banking system
  2. No matter how much money the Fed creates, inflation will not be an immediate problem, and when it becomes a problem, the Fed can take the money away.

The second ‘stylized fact’ is actually a bit more controversial, but to our knowledge, we have not come across any argument why it wouldn’t be true. So we can cut it into two parts:

  • Inflation is not going to be a problem as long as demand is way lower than the productive capacity of the economy.
  • When demand (and the economy) recovers, the Fed just start selling the securities it has been frantically buying during the crisis to pump liquidity into the financial system.

If one combine these two simple stylized fact, then we have a solution. The Fed should become the ‘bad asset bank’. The funny thing is, we’ve not seen this solution anywhere (which might be due to the fact that we can’t read everything, but still..). Now, enter a third stylized fact:

  • The Fed is already buying up bad assets on a large scale.

So apparently, it’s not a matter of principle, but of scale. The Fed can buy a significant amount of bad assets, but apparently there is some upper limit to its capacity to do that (and the thorny issue about how much to pay for them).

The only thing we can think of is that the Fed’s balance sheet will become very ugly indeed. But it already is. And, perhaps even more important, what’s the alternative??

The most immediate alternative is that we worsen the balance sheet of the US government. Taxpayers fund a bad debt bank (and a stimulus program to boot). How is that financed? By bonds, as no politician in his right mind is going to increase taxes in the middle of a rather steep recession.

Who will buy these bonds? Well, uhh… “the markets”, or, the Chinese. Perhaps. But since interest rates are already low, and since it is an economic imperative to keep them low (to give some relief to the housing market), we’re not sure whether demand from either “the markets” or the Chinese will materialize, especially since the supply of new bonds seems, well, rather large…

They might buy, but at higher interest rates, which would run afoul of Fed monetary policy, which would respond by buying up these bonds in order to get interest rates down again. This is indirect monetary financing. It’s already happening, and we’re pretty sure that with new large bond issues, it will increase substantially.

So why all the fuss. Why not let the Fed deal with the bad assets directly, rather than via a government funded bad asset bank, which requires large issues of new bonds, which will largely end up at the Fed anyway?

The only reason we can think off is that large numbers scare the hell out of people, especially if their re-election depend on them. That’s the reason we only get a $800 billion stimulus package, while demand shortfall is almost $3 trillion.

That’s why we won’t let the Fed deal with all the toxic assets (or at least enough of them to get banks functioning again).

This same timidness in facing the true magnitude of the problems cost Japan a decade or more in wasted economic opportunities, one should read this excellent article to get a real sense of urgency.

In the meantime, create as much money as is required to solve the banking crisis. It’s the only way. All alternatives are far worse, and rememeber, when recovery is there, all that excess liquidity can be taken away.

So in the end, the choice between a state-funded bail-out and a central bank funded bail-out is not that stark.

  • The first worsens the balance sheet of the public finances
  • The second worsens the balance sheet of the central bank.

But if, as seems likely, a publicly funded rescue plan ends up issuing large amounts of government bonds that the central bank is buying anyway to keep long-interest rates from rising, we can better take the direct route.

In principle, there seem to be little reasons not to embark on that route (although we would agree that a proper plan involves more, it should get incentives right, for instance). The only thing holding us back seems to be the very large numbers involved..

Tags: Credit Crisis · Public Policy