I am becoming ever more worried. I never expected much from the Europeans or the Japanese. But I did expect the US, under a popular new president, to be more decisive than it has been. Instead, the Congress is indulging in a populist frenzy; and the administration is hoping for the best.
If anybody doubts the dangers, they need only read the latest analysis from the International Monetary Fund.* It expects world output to shrink by between 0.5 per cent and 1 per cent this year and the economies of the advanced countries to shrink by between 3 and 3.5 per cent. This is unquestionably the worst global economic crisis since the 1930s.
One must judge plans for stimulating demand and rescuing banking systems against this grim background. Inevitably, the focus is on the US, epicentre of the crisis and the world’s largest economy. But here explosive hostility to the financial sector has emerged. Congress is discussing penal retrospective taxation of bonuses not just for the sinking insurance giant, AIG, but for all recipients of government money under the troubled assets relief programme (Tarp) and Andrew Cuomo, New York State attorney-general, seeks to name recipients of bonuses at assisted companies. This, of course, is an invitation to a lynching.
Yet it is clear why this is happening: the crisis has broken the American social contract: people were free to succeed and to fail, unassisted. Now, in the name of systemic risk, bail-outs have poured staggering sums into the failed institutions that brought the economy down. The congressional response is a disaster. If enacted these ideas would lead to an exodus of qualified employees from US banks, undermine willingness to expand credit, destroy confidence in deals struck with the government and threaten the rule of law. I presume legislators expect the president to save them from their folly. That such ideas can even be entertained is a clear sign of the rage that exists.
This is also the background for the “public/private partnership investment programme” announced on Monday by the US Treasury secretary, Tim Geithner. In the Treasury’s words, “using $75bn to $100bn in Tarp capital and capital from private investors, the public/private investment programme will generate $500bn in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time”. Under the scheme, the government provides virtually all the finance and bears almost all the risk, but it uses the private sector to price the assets. In return, private investors obtain rewards – perhaps generous rewards – based on their performance, via equity participation, alongside the Treasury.
I think of this as the “vulture fund relief scheme”. But will it work? That depends on what one means by “work”. This is not a true market mechanism, because the government is subsidising the risk-bearing. Prices may not prove low enough to entice buyers or high enough to satisfy sellers. Yet the scheme may improve the dire state of banks’ trading books. This cannot be a bad thing, can it? Well, yes, it can, if it gets in the way of more fundamental solutions, because almost nobody – certainly not the Treasury – thinks this scheme will end the chronic under-capitalisation of US finance. Indeed, it might make clearer how much further the assets held on longer-term banking books need to be written down.
Why might this scheme get in the way of the necessary recapitalisation? There are two reasons: first, Congress may decide this scheme makes recapitalisation less important; second and more important, this scheme is likely to make recapitalisation by government even more unpopular.
If this scheme works, a number of the fund managers are going to make vast returns. I fear this is going to convince ordinary Americans that their government is a racket run for the benefit of Wall Street. Now imagine what happens if, after “stress tests” of the country’s biggest banks are completed, the government concludes – surprise, surprise! – that it needs to provide more capital. How will it persuade Congress to pay up?
The danger is that this scheme will, at best, achieve something not particularly important – making past loans more liquid – at the cost of making harder something that is essential – recapitalising banks.
This matters because the government has ruled out the only way of restructuring the banks’ finances that would not cost any extra government money: debt for equity swaps, or a true bankruptcy. Economists I respect – Willem Buiter, for example – condemn this reluctance out of hand. There is no doubt that the decision to make whole the creditors of all systemically significant financial institutions creates concerns for the future: something will have to be done about the “too important to fail” problem this creates. Against this, the Treasury insists that a wave of bankruptcies now would undermine trust in past government promises and generate huge new uncertainties. Alas, this view is not crazy.
I fear, however, that the alternative – adequate public sector recapitalisation – is also going to prove impossible. Provision of public money to banks is unacceptable to an increasingly enraged public, while government ownership of recapitalised banks is unacceptable to the still influential bankers. This seems to be an impasse. The one way out, on which the success of Monday’s plan might be judged, is if the greater transparency offered by the new funds allowed the big banks to raise enough capital from private markets. If that were achieved on the requisite scale – and we are talking many hundreds of billions of dollars, if not trillions – the new scheme would be a huge success. But I do not believe that pricing legacy assets and loans, even if achieved, is going to be enough to secure this aim. In the context of a global slump, will investors be willing to put up the vast sums required by huge and complex financial institutions, with a proven record of mismanagement? Trust, once destroyed, cannot so swiftly return.
The conclusion, alas, is depressing. Nobody can be confident that the US yet has a workable solution to its banking disaster. On the contrary, with the public enraged, Congress on the war-path, the president timid and a policy that depends on the government’s ability to pour public money into undercapitalised institutions, the US is at an impasse.
It is up to Barack Obama to find a way through. When he meets his group of 20 counterparts in London next week, he will be unable to state he has already done so. If this is not frightening, I do not know what is.