Nationalisation as a solution to the banking crisis

Nationalization seems to suggest that we are abandoning the principles of markets. However, if done in an orderly fashion, we can bring the banking system back to reasonable health and restore confidence.

These are the steps that should be followed in nationalization. First, a quick review of every major and mid level bank must be made to determine the extent of their exposure to these assets. Second, the ones that are otherwise healthy must be saved, while the ones which are irredeemable must be allowed to fail. Third, the fundamentally healthy but impaired banks (those which don’t need capital can exist as it is) should be placed under a conservatorship (like Freddie and Fannie). Fourth, their entire equity must be wiped out, managements fired, and no golden parachutes must be given. This takes care of one form of moral hazard. Fifth, debt holders, other than senior most debt holders, must be forced to take a haircut, as there is no rationale for the tax payer to fund bond holders. Sixth, managers may be incentivized to lend according to long term profitability. Seventh, the bad assets are now moved to an RTC like bank where debt is paid down and the assets are gradually sold to private investors. Finally, when the books are sufficiently cleaned up and markets stabilize the banks can once more be available for public ownership.

What are the advantages of nationalization? The most obvious advantage is that uncertainty in the markets is removed once and for all. Rather than lurching from one bailout to another, and markets worrying about creeping nationalization, a bold solution like this would signal a bottom. Another advantage is that banks can begin to lend again. The problem with equity stakes without control was that managers and shareholders, worried about their future would rather use the money to pay their salaries and repair their balance sheet, resulting in a hobbling bank which does not take risk. At the same time moral hazard is vastly reduced when exiting managers are punished for reckless lending and hence future excessive risk taking is minimized. The greatest advantage though is that the problem of valuing assets is no more a necessity. Since both the “good” bank and “bad” bank are under government control, the asset valuation does not matter, as it merely involves transfer of assets from one part to another part of the same owner. This could be done at historical cost or zero value or any other value as there is essentially no difference. The “bad” bank collects all the cash flows associated with the assets and if no market develops, then it holds the assets to maturity. The “good” bank can be privatized when conditions improve. The cost of nationalization has been shown to have a lesser final fiscal cost than this stage wise bleeding. As an example of its actual implementation, we need not look further than Sweden which in 1993 did the same thing. The overall cost to the government was minimal. Finally, the reason debt holders have to pay a price is because there is no reason for risky debt investors to be rewarded while stock holders suffer. The tax payer should not subsidize them (senior debt holders may need to be accommodated for fear of greater contagion while junior debt holders’ rationale for investing itself is that they sought more risk and hence where paid a higher rate).

The arguments against nationalization exist. The major reason is the mistrust that government cannot run efficient operations and would be prone to political pressures. By appointing commercially oriented managers, this problem can be reduced. Further, it can be argued that state control may become permanent. Finally, a very credible argument exists to make a distinction between the Nordic experience in the 1990’s and the US. The US banking system is much larger than the Swedish system and both the costs and time required are higher and chances of a successful withdrawal at a later stage by the government are likely to be lower. The linkages in global finance may also cause issues on valuation of assets unlike in the 1990’s when most of the assets in Sweden where regionally owned. However, none of these reasons are sufficient to continue with status quo. The costs are too high, and a bold initiative is a must. Nationalization and nimble restructuring is the quickest and cleanest end to the mess we are in right now.

GDP-US and China

My excuses for no posts for nearly a month: too much work, poor internet speeds and really sheer indolence!!! So, fourth quarter GDP figures for the US was “better” than expected: -3.8% vs -5% consensus. So started cheering yet? Maybe AK and other Dr Doom’s are wrong and the doomsayers must be dismissed right? Unfortunately, the devil is in the details. Consumer spending fell 3.5%, non-residential investment 19.1%, residential fell 23.6%. All this means that real final sales, the barometer I really watch, fell 4.9%. If that doesn’t shock you, it should. I certainly was, and it was worse than most expected. Final retail sales are important because they are the final measures of domestic demand. Such nos. portend a lot more pain ahead. Indeed, back when Q1 GDP nos. for 2008 came in, people were celebrating. When I told my professor that it was poor since retail sales fell for the first time, I was pooh-poohed (unfortunately didn’t blog at the time). People at the company I interned in where sure that a soft landing was the base case. I insisted a severe recession would follow and we were already in it then. The first tax rebates skewed Q2, and Q3 showed people the real damage. Then, Lehman (which also I consistently predicted) collapsed and the rest is history.
So, predictions for Q1 2009? Before this no. I thought 3.5%. Now maybe 4-4.5%. Why? Because, all this abnormality was due to build up of inventory which added 1.6% to GDP. To cleanse this inventory we will see Q1 see a sharp drop and hence the further decline.
A note is in order here. These are QoQ figures annualized. Hence a small error in QoQ can translated into a factor of 4 in error. Thus, if the nos. turn out to be 3.8 vs 4.2% an error of 0.1% is the real error in prediction which really is not bad. The one no. truly puzzling is the trade data which added 0.1%.
Finally, GDP in china at 6.8% is YoY figure. There are two issues in interpretation here. First, one doesn’t know the true data given China’s propensity to massage the nos. It could be to portray a rebound, or on the contrary it may be a way to prepare for future shocking nos. I believe it’s the latter. Which brings me to the second issue: YoY is misleading. QoQ figures based on the above nos. would indicate negative quarter growth!!!! If that didn’t shock you, it should. I believe that QoQ in Q1 2009 will indicate a second contraction, and viewed in this light, we can call China to be in a recession.

Stimulus-Part II

In the last post, I had berated that tax cuts are ineffective. However, tax cuts are also a virtue in some cases as I shall shortly put forward. Reagan's supply side economics had its time but tax cut seekers should realize the limits when demand slumps.
When are tax cuts most effective? Any conservative would argue that it creates incentive to work and hence improves long run productivity. They also argue that tax dollars are best spent by society individually rather than government deciding how to use it. Both these have their merits. But neither is a reasonable stimulus. Also government has to step in to make good for the collapse in private demand, to prevent a deflationary spiral.
Even for a stimulus however, there is a need for tax cuts to boost consumption. First, there may not be enough "shovel-ready" projects for government to spend on. Second, if tax cuts are properly directed properly then people may actually spend it. In that way, targeting lower income people is a good start for stimulus tax cuts. That is one place that Obama has actually correctly identified.
On the politics now- why is PEBO doing this? Does he really think that Senators like Shelby, DeMint, Coburn and other southern GOP senators are really going support this stimulus? Well, they would want the whole package to be only tax cuts rather than the present 40%. Next they will argue that we need cuts in business, capital gains and wealthy people's taxes. Then they will call cuts for non income tax payers as socialism. So, the whole thing seems such a waste. Of course, none of these tax cuts would be sufficient stimulus in the short term. And the poor would suffer inordinately.
However, the tactic may be that by agreeing to look at GOP proposals and proposing tax cuts he can call the GOP's bluff and make this into a wall street vs main street fight. That is a sure fire winning argument for Barack. But this approach carries too many risks. Most importantly, politics could threaten the entire economy. In my opinion, and in the next post I intend to quantify this, the size of stimulus, and its composition is not enough. We MUST err on the side of more rather than less stimulus.

Stimulus- Part I

The president elect is just revealing his plans for his first important legislation: the stimulus. And I am afraid it is poorly designed, at least at first glance.
Lets start with the tax cuts: 40% of the package to draw "considerable" GOP support. For starters, despite all the ramblings of conservative intellectuals on the vices of government spending and the virtues of tax cuts, it is indisputable that the multiplier effect on the economy by spending is greater. A conservative (no pun intended!!) value of the multiplier would be 1.2. This is assuming that most spending is pork, useless etc.
For tax cuts, the best case is a multiplier of 1. Why? For one, when people get tax cuts, they dont spend in times of crisis. They use it to draw down debt (pay it off), and spend on essential commodities. Not blaming the consumer, for whom it makes perfect sense, but a poor stimulus. If you wanted further proof, just look at the stimulus passed in 2008. The economy recovered for one quarter and then anemically shut down. Now, this was at a time when people where still optimistic. Anyone bets that times are better now???
Business tax breaks, as suggested add little as incentive. By allowing losses offset with past taxes, you are merely transferring wealth. What stimulus is that?
This is not to suggest that all tax breaks are bad, or that the stimulus should avoid them. Indeed this much better than Bush's tax cuts for those who dint need them and were not even asking for one. I will address this issue and the politics behind it in detail in the next post.