This is a problem. As Frank Borman, the chief of Eastern Airlines, said back in the early 1980s, "Capitalism without bankruptcy is like Christianity without h.e.l.l." Unfortunately, the Fed"s interventions have kept afloat both the illiquid and the insolvent; the major banks and financial firms have undergone precious few bankruptcies. Financial inst.i.tutions that no amount of liquidity or regulatory forbearance can save remain in operation. Like the infamous zombie banks that became a symbol of j.a.pan"s Lost Decade, these firms must go bankrupt, and the sooner they do, the better.
But that will depend a great deal on another problem: how to unwind and dismantle the various special facilities that the Fed established in the midst of the crisis. As early as January 2009, Bernanke spoke confidently about the Fed"s "exit strategy," and he clearly believes that as credit conditions improve, the financial system"s dependence on easy money will subside. Perhaps. But the rescue effort that he and other central bankers oversaw is on a scale never before tried. Its extraordinarily large number of moving parts make it very difficult to know how attempts to wean one swath of the financial sector off easy money might affect other parts of the system. Bernanke has rea.s.sured anxious lawmakers that there is a plan, but we"re in uncharted waters here: this level of intervention has no precedent.
The monetary policies pioneered by Bernanke have another, less noticed aspect: many of them are, strictly speaking, no longer purely a matter of managing the money supply. The Fed has instead stepped into the financial system and effectively subsidized its operations, potentially incurring losses that could ultimately fall on the shoulders of taxpayers. Put differently, it"s engaging in monetary policies that bleed imperceptibly into the traditional domain of fiscal policy-namely, government"s power to tax and spend. Those are prerogatives of the legislative branch, but in this crisis Bernanke"s policies have blurred that line, turning the Federal Reserve"s power to lend money into a means of spending money on the financial system. It has granted many subsidies to the financial system in its time of need, and it has purchased potentially risky a.s.set-backed securities. Even its policy of purchasing long-term government debt may end up costing money: when the time comes to sell it, the Fed may well have to unload these bonds at a loss.
These encroachments on the terrain of fiscal policy, however, may have been inevitable. After all, proposals to allocate taxpayer dollars to rescue the financial system have encountered tremendous political resistance, from the first, failed attempt to secure money for the Troubled a.s.sets Relief Program to the strong resistance to the stimulus package in the spring of 2009. From the beginning of the crisis, there has been some resistance to using fiscal policy to combat the crisis.
That"s unfortunate: the government"s ability to tax and spend, while not always immediate in its effect, is one of the most powerful weapons in the a.r.s.enal of crisis economics. Still, its use carries plenty of serious risks, particularly in the recent crisis, when legislators disbursed taxpayer money not merely on the traditional objects of deficit spending but on bailouts, guarantees, and backstops of everything from banks to carmakers to the very homeowners whose troubles helped ignite the crisis in the first place.
Chapter 7.
Spend More, Tax Less?
When President Herbert Hoover gave the annual State of the Union speech in 1930, the United States was one year into what would become an enormous economic catastrophe. But on that day he emphatically declared that "economic depression can not be cured by legislative action or executive p.r.o.nouncement" and that "economic wounds must be healed by the action of the cells of the economic body-the producers and consumers themselves." Hoover counseled that "every individual should sustain faith and courage" and "each should maintain his self-reliance."
Thanks to words like these, Hoover remains the quintessential symbol of government apathy and inaction. The truth is actually much more complicated-and more interesting. In the very same speech, Hoover noted that spending on public works projects typically collapsed during economic downturns. This time, he proudly reported, national, state, and local governments had deliberately spent money on infrastructure improvements as a counterweight to the Depression. In fact, he bragged that "as a contribution to the situation the Federal Government is engaged upon the greatest program of waterway, harbor, flood control, public building, highway, and airway improvement in all our history." Under this "do-nothing" president, the federal government effectively doubled its spending on such projects.
Though Hoover supported such expenditures, he also believed in limits. "I can not emphasize too strongly the absolute necessity to defer any other plans for increase of Government expenditures," he proclaimed. Nothing less than "rigid economy" would keep the federal budget in balance. The message was clear: there would be no deficit spending on his watch.
Pity Hoover: he lived at a turning point in the history of crisis economics. His speech revealed a man trapped between two very different paradigms for handling the crisis. One, which looked to the past, prescribed patience and balanced budgets; the other, which became the wave of the future, prescribed deficit spending and ma.s.sive public works projects. Hoover could see the future, but he was tethered to the past. He wanted to reconcile contradictory aims: to cultivate self-reliance, to provide government help in a time of crisis, and to maintain fiscal discipline. This was impossible.
Six years after Hoover stood before Congress, John Maynard Keynes articulated what would become the new orthodoxy: in future crises, the government would rely on fiscal policy to cushion the economy, to increase the demand for goods and services, and to revive the "animal spirits" necessary for capitalism"s eventual resurgence. In other words, the government would aggressively spend money and, to a lesser extent, cut taxes, financing these measures with deficit spending. The old policy of letting the economy heal itself became tantamount to letting the patient suffer. In the succeeding decades, fiscal policy became the weapon of choice when dealing with economic downturns, whether caused by crises or not.
If Hoover stood at one watershed in the history of fiscal policy, we may be living at another. Keynes"s toolkit has grown from a few trusty instruments to a bewildering array of devices that government uses to intervene in the economy. In the United States and many other countries, national governments spend money not only for public works but for other purposes, like guaranteeing bank loans, debts, and deposits. They have even used tax dollars to acquire significant ownership stakes in industrial behemoths and giant banks. Just as monetary policy has evolved in bewildering and complicated ways, fiscal policy has become a gigantic-and expensive-bag of tricks.
Contemporary policy makers now find themselves in a fix comparable to Hoover"s. They may want to hand out tax cuts and spend money to prop up the labor market and increase demand and production, but many governments are already running ma.s.sive budget deficits that are increasing public debt to unsustainable levels. They want to force Hoover"s "producers and consumers" to help themselves, but they keep bailing them out at ever-greater expense. And while they want to hold the line on moral hazard, they keep providing households, financial inst.i.tutions, and corporations with new incentives to behave in precisely the ways that contributed to this crisis in the first place.
In short, a bundle of contradictions lie at the heart of twenty-first-century fiscal policy. While our present predicament may not be as dire as it was in Hoover"s day, the old way of doing things is no longer compatible with the new realities that loom on the horizon.
Conventional Fiscal Policy.
John Maynard Keynes was the first major economist to propose that government should use its powers to tax and spend in order to ameliorate economic hardship. His a.n.a.lysis was simple and straightforward: in an economic downturn, the total demand for goods and services falls far below the supply, triggering unemployment and a drop in production. Writing in the shadow of the Great Depression, Keynes concluded that this cycle, if permitted to go unchecked, could feed on itself. If the crisis got bad enough, the "animal spirits" of the economy would perish, and fearful entrepreneurs and consumers would curtail spending more than was justified by weakened incomes and economic woes. Despite a surplus of desperate workers and idle factories, a vicious circle of ever-falling demand, employment, production, and prices would grip the economy in a deflationary spiral and result in a permanent state of stagnation.
Keynes believed that the economy would not emerge from the doldrums on its own. Only if the government stepped into the breach and directly or indirectly picked up the slack in demand relative to the glut of excess supply and idle capacity could the economy stabilize itself, let alone return to prosperity. That would require deficit spending, but it was better to spend money preventing a catastrophe from worsening, Keynes maintained; balancing the budget could wait until after the crisis pa.s.sed. In fact, Keynes believed that a premature return to fiscal discipline would likely throttle any nascent recovery.
Though Keynes first published his ideas in 1936, government policies inst.i.tuted earlier in the decade antic.i.p.ated his recommendations. Beginning with Hoover"s early experiments and culminating with Roosevelt"s New Deal, public works projects large and small put people back to work and propped up the demand for goods and services. The amount of construction undertaken then remains impressive even today. The Public Works Administration, the Works Progress Administration, and the Civilian Conservation Corps built 24,000 miles of sewer lines, 480 airports, 78,000 bridges, 780 hospitals, 572,000 miles of highways, and upwards of 15,000 schools, court-houses, and other public buildings.
The results, though hardly miraculous, were dramatic: from 1933 to 1937, unemployment fell from approximately 25 percent to a little under 15 percent. In 1937 a renewed commitment to balancing the budget triggered a yearlong relapse into a severe recession, whereupon the Roosevelt administration resumed its earlier strategy of financing the New Deal with deficit spending. The outbreak of World War II, which necessitated government spending on an even more ma.s.sive scale, helped the United States escape the lingering effects of the Great Depression and brought about a more sustained recovery of growth.
Keynes became the preeminent economist of the postwar era, and his prescriptions became the standard response not only to crises but to economic downturns large and small. Keynes eventually fell into disfavor in the 1970s. But in the early 1990s, after the collapse of the j.a.panese real estate bubble left that economy reeling, the j.a.panese government embraced his ideas once more, and in the succeeding decade, it inst.i.tuted no fewer than ten separate stimulus packages that together cost more than a trillion dollars. These efforts raised j.a.pan"s deficit to record levels and left behind a mixed legacy: plenty of welcome improvements to infrastructure but also many wasteful and pointless projects in rural areas. Economists continue to argue ad nauseam as to whether any of it was useful. Many believe the policy"s failure lay not with the idea of public works spending but with the choice of specific projects. Others maintain that the government spent too little, or pulled back too soon.
But this kind of fiscal stimulus is but one of several approaches available to policy makers. Aside from direct spending to stimulate demand, fiscal policy also encompa.s.ses tax cuts and rebates, which in theory encourage consumers to spend by providing them with more income. In other words, they stimulate spending-or so the theory goes. This strategy wasn"t part of the playbook in the 1930s: Hoover raised taxes, and so did Roosevelt, even if the burden fell largely on the wealthy and the middle cla.s.s. But in the postwar era, tax cuts and credits have become an integral part of fiscal policy in times of recession and crisis. j.a.pan, for example, used tax cuts as part of its postcrisis response.
A third variant on fiscal policy is a "transfer payment," whereby the government sends money to particular cash-strapped groups (the poor, the unemployed) or to struggling state and local governments. Transfer payments have been a mainstay of fiscal policy since the 1930s, when many New Deal programs threw lifelines to these groups. Like tax cuts, they are part of the standard a.r.s.enal for dealing with economic crises and garden-variety recessions. Transfer payments can come in myriad forms, such as unemployment benefits, food stamps, and funds for job retraining.
The recent crisis saw a heavy reliance on all three conventional fiscal strategies. In January 2008 lawmakers fired the first of several shots by approving a $152 billion package of tax breaks aimed at individuals and businesses. The Economic Stimulus Act of 2008 was overshadowed by the American Recovery and Reinvestment Act of 2009. The total cost-a whopping $787 billion-aimed at every single target of fiscal policy. Government spending on goods and services got plenty, and straight-up spending on infrastructure and energy projects topped $140 billion; a miscellany of other spending projects-everything from fisheries to flood control systems-got billions more.
The legislation also dedicated plenty of money for tax credits and transfer payments. Indeed, tax credits took the lion"s share of the package, as individuals received breaks worth some $237 billion. Some applied across the board to broad swaths of the population; others, like the tax credit for first-time homeowners and the one for the purchase of new fuel-efficient cars (cash for clunkers), targeted specific segments of the economy. Finally, the bill directed billions to the unemployed, the elderly, and other vulnerable populations. It also steered billions more to state and local governments.
Countries around the world adopted comparable, if less ambitious, fiscal stimulus packages. The European Economic Recovery Plan, adopted in the fall of 2008, earmarked some 200 billion euros to a variety of projects; individual countries followed with their own smaller plans. j.a.pan initially planned a ma.s.sive stimulus package, but it ran afoul of politics, and the government ultimately inst.i.tuted a much more modest mix of tax cuts and spending measures. China"s far more ambitious plan totaled $586 billion, the bulk of which went to public works: rail lines, roads, irrigation, and airports; some of the funds went to the earthquake-stricken region of Sichuan. Smaller countries as diverse as South Korea and Australia also adopted stimulus measures.
These fiscal interventions certainly helped arrest the slide toward depression, but a few words of caution are in order. For starters, fiscal policy isn"t a free lunch: if a government increases spending and cuts taxes-and does so during a recession, when tax revenues decline-the budget deficit will soar. The government will have to issue more debt, which it will eventually have to pay. If it doesn"t pay the debt, and its deficits grow larger every year, then it will have to entice investors to buy more debt by raising interest rates. Those higher returns will then compete with interest rates on other investments-mortgages, consumer credit, corporate bonds, and auto loans-and can drive up the cost of borrowing for everyone else, thus reducing debt-financed capital spending by firms and consumption spending by households.
Soaring public debt ultimately ties the hands of the government. Interest rates may go too high as fears of a possible default intensify. At that point, the government has limited options. It can opt to "cheat" and print money to pay the deficit, as long as the public debt is issued in local currency, a tactic known as "monetizing" the deficit. The mechanism is the same as quant.i.tative easing, except that buying up debt has nothing to do with defeating deflation; it"s about making debt disappear. As money chases goods and pushes their prices higher, inflation is the inevitable result. That means even higher interest rates all around, and even more private spending diverted into propping up the public sector.
There"s some evidence that taxpayers may be mindful of the risks as well. In some countries that have implemented stimulus packages, consumers recognized that whatever the short-term benefits of such measures, the government would ultimately have to raise taxes. Knowing they had to save for that eventuality, consumers cut back on their spending in tandem with the introduction of a fiscal stimulus. They effectively antic.i.p.ated the long-term costs of short-term spending and, in the process, nullified some of its benefits.
Tax cuts, the other main tool of fiscal policy, can also run into obstacles. Rather than going out and spending the money derived from tax rebates or permanent reductions in tax rates, households may save it or use it to pay off their debts. That"s what happened in 2008 and 2009, when two rounds of income tax rebates largely went unspent-consumers parted with only 25 or 30 cents on every dollar they received from the government. The rest they plowed into improving household balance sheets. While that was all well and good, such prudence did nothing to prop up demand. It also shifted debt from one part of the economy to another: private debt went down, but public debt went up. This was less a stimulus than a sleight of hand.
Worse, certain kinds of fiscal measures can spur demand in the present at the cost of demand in the future. Many targeted tax cuts or subsidies that aim at enhancing specific forms of spending-automobiles, homes, capital improvements by the corporate sector-do nothing more than amplify demand beyond what"s normal, then undercut it when the subsidies expire. In other words, they steal demand from the future. This seems to have happened with the various cash for clunkers programs adopted in many countries: car sales went through the roof, then fell back to earth, depressing future demand.
The idea of a flawless fiscal stimulus is a mirage, at least in most democracies. Unlike monetary policy, which can be implemented immediately by a central bank insulated from the pressures of voters, fiscal measures take time to initiate and come laden down with useless pork barrel projects, bridges to nowhere, and other inefficient allocations of resources. A perfect stimulus package would deliver a tremendous bang for the buck, rebuilding a nation"s dilapidated infrastructure and contributing to future economic growth. But as j.a.pan"s experience and some of the more dubious projects funded by the American Recovery and Reinvestment Act suggest, that"s easier said than done. It"s perhaps instructive that China-an authoritarian state-implemented one of the more effective stimulus packages in the wake of the recent crisis. Mostly free of parochial political considerations, its government simply accelerated its existing, successful campaign to modernize its infrastructure. Even in that case, however, some of the spending may yet turn out to be wasteful and inefficient or may foster future bubbles.
In conventional fiscal policy, the government uses its powers to tax and spend in order to help the economy out of a crisis. But tax cuts and public works are just the beginning; government can deploy its fiscal powers against a financial crisis in many other ways, which are far more subtle, if expensive.
Let the Bailouts Begin.
Government can spend money, but it can also guarantee other people"s money. Because guarantees often end up costing taxpayers money, they qualify as a kind of fiscal policy. A number of guarantees old and new played an important role in quelling the recent crisis, even as they opened the door to the problem of moral hazard.
The most typical guarantee given by a government is that it will protect money that people have deposited in a bank from a run. Although the idea dates back to the nineteenth century, the United States lacked national deposit insurance until 1933. That wasn"t for lack of trying: between 1866 and 1933, Congress considered some 150 proposals for deposit insurance. Some of them would have required banks to purchase surety bonds, a kind of third-party insurance; others called for the federal government to guarantee the deposits directly. Still others called for a common insurance fund out of which depositors" claims would be paid.
In the Great Depression, the United States finally adopted deposit insurance that combined features of an insurance fund with a federal guarantee. Conceived and born in the opening weeks of the New Deal, the inst.i.tution that eventually came to be known as the Federal Deposit Insurance Corporation (FDIC) did not depend on taxpayer dollars; rather it operated by a.s.sessing fees on the commercial banks that were its members. Those a.s.sessments went into a fund that reimbursed depositors whose banks had failed. The government staffed and administered the FDIC, which also monitored the health of member banks and wound up insolvent inst.i.tutions or arranged their takeover by better-capitalized banks. A similar inst.i.tution, the Federal Savings and Loan Insurance Corporation (FSLIC), was founded in 1934 to protect deposits in savings and loans thrifts.
These two inst.i.tutions operated without mishap until the 1980s, when the failure of more than a thousand savings and loans overwhelmed the FSLIC. Insolvent, it was subsequently taken over by the FDIC and recapitalized with taxpayer money to the tune of $153 billion. As this episode amply ill.u.s.trates, a systemic crisis in the banking system can easily overwhelm funds set aside to meet the occasional failure. The federal government could have stood aside and let depositors lose their money, but it chose not to, as it had informally guaranteed the integrity of these funds and a bank run could have overwhelmed both solvent and insolvent banks.
But the episode summoned the specter of moral hazard. By bailing out the banks, the government signaled that it would likely rescue them again should the need arise. Bank managers didn"t have to worry about angry depositors, and depositors didn"t have to worry about losing their money: as long as a bank was insured by the FDIC, their money was safe. The FDIC effectively said as much, announcing that deposits under its protection were "backed by the full faith and credit of the United States Government."
That guarantee became an issue once again in 2008-9. Prior to the crisis, the FDIC insured deposits up to $100,000. Similar guarantees existed in other countries as well, though the "ceiling" varied from place to place. Unfortunately, the programs could not cover all deposits: many people"s accounts exceeded the maximum. In the United States alone, upwards of 40 percent of the deposits remained uninsured and vulnerable, a point underscored by bank runs on Countrywide, IndyMac, and Washington Mutual.
The threat of more runs triggered a new round of government guarantees. In September 2008, Ireland had to increase its deposit insurance to 100,000 euros, then fully guarantee all the deposits of its six largest banks. In the United States, holding the line against moral hazard proved equally difficult. Shortly after Ireland issued its blanket a.s.surance, the FDIC raised the ceiling for insured bank deposits to $250,000. Two days later Germany guaranteed all of its private bank accounts; the next day Sweden extended insurance to all deposits to the sum of 500,000 kronas, or approximately $75,000; the day after, the United Kingdom raised its ceiling to 50,000. A week later Italy announced that none of its banks would be allowed to fail and that no depositor would suffer any loss. The next month Switzerland increased its own ceiling on deposit insurance. Other countries followed with similar guarantees.
This dynamic was comparable to an arms race: Ireland announcing a blanket guarantee forced other countries to do the same or at least raise the ceiling. The reason was simple: depositors could readily shift their money out of countries with limited guarantees and place it in safer havens. As a result, governments could not hold the line against moral hazard. It was a race to the bottom.
Other kinds of deposits came under the umbrella of government insurance programs. In the United States, the National Credit Union Administration (NCUA), a kind of FDIC for credit unions, took over two beleaguered members-U.S. Central and WesCorp-and then pledged $80 billion to cover the losses on all deposits in all credit unions throughout the country.
Insuring depositors was just the beginning. Many banks in the United States and Europe borrowed ma.s.sive amounts of money by issuing unsecured bonded debt. As this debt came to maturity at the height of the financial crisis, it became next to impossible to roll over, particularly after the collapse of Lehman Brothers. But since the inability to renew these debts would have destroyed banks as effectively as a run on their deposits, the European Union guaranteed its banks" bonded debt in October 2008. The same month the FDIC guaranteed the princ.i.p.al and the interest payments on debt issued by banks and bank holding companies up to a total of $1.5 trillion.
All of these guarantees came with a price tag. In the third quarter of 2009, the funds set aside by the FDIC dipped into negative territory. Almost inevitably taxpayers will be asked to shoulder the burden in the form of a bailout, much as they did in the wake of the savings and loan crisis. While that kind of support has plenty of precedent, a host of other measures sparked by the recent crisis also pledged unprecedented amounts of taxpayer dollars.
These outsize bailouts began with Fannie Mae and Freddie Mac. As the two mortgage giants came under government conservatorship, the Treasury Department pledged $400 billion to underwrite the takeover, though more may become necessary. In taking this fateful step, the federal government made explicit that the debt of these two enterprises was indeed guaranteed by its "full faith and credit."
Not for years will we know the full fiscal cost of the rescue of Fannie Mae and Freddie Mac. In moving them into conservatorship, the government has put itself on the line to cover some $5 trillion worth of obligations insured by the two inst.i.tutions, along with another $1.5 trillion worth of debt that they issued. Obviously, the government won"t be on the hook for anything approaching these sums. But if housing prices continue to decline and many more mortgages go into foreclosure, the government could end up sustaining considerable losses.
The same could be said of its efforts to prop up the housing market. The Housing and Economic Recovery Act, pa.s.sed in July 2008, pledged some $320 billion to help struggling homeowners refinance into mortgages that were insured by the Federal Housing Administration. Though the initial program a.s.sociated with this allocation failed, President Barack Obama tapped some of these funds when he announced his own $75 billion plan to prevent foreclosures. Needless to say, all these programs are works in progress, though one thing is certain: they will cost the taxpayers billions of dollars.
The biggest bailout of all is really a cl.u.s.ter of separate bailouts and guarantees funded by the Troubled a.s.set Relief Program (TARP). The original legislation in Congress allocated $700 billion to purchase toxic a.s.sets. Instead, the money has been used to prop up a host of alms-seekers, including the automakers General Motors and Chrysler and their financial arms, GMAC and Chrysler Financial. All told, these bailouts of the auto industry amounted to $80 billion. Some of this money was disbursed as loans; the rest of it was used by the government to purchase an ownership stake in the companies.
Unfortunately, car companies were but the beginning. A sizable portion of the TARP funds-some $340 billion-was funneled to nearly seven hundred different financial inst.i.tutions, giants like Citigroup, Bank of America, and AIG as well as a host of smaller banks. For the most part, the money spent on these ailing inst.i.tutions consisted of mysterious "capital injections," in which the government purchased preferred shares in a bank. These shares provided a potential ownership stake and a current steady dividend payment. This may seem like a straightforward expenditure of government money, but it marks a radical departure and takes fiscal policy in new and potentially disruptive directions.
A Capital Idea?
Banking is a business shrouded in mystery. Few people really understand how banks and other financial inst.i.tutions work, largely because they don"t understand how a bank"s balance sheet works. So while some attempts to sh.o.r.e up the banking system are readily comprehensible-insuring deposits or enabling banks to access a lender of last resort-other measures like capital injections remain puzzling. To understand them, it"s necessary to understand how a bank works.
Let"s begin with a hypothetical bank"s balance sheet. On the right side you have liabilities, and on the left you have a.s.sets. What are a bank"s liabilities? Put very crudely, a bank acc.u.mulates liabilities when it takes money in order to do business. It gets this money in two main ways. The first way is to issue stock, which investors buy and thereby become the bank"s shareholders. The bank doesn"t "owe" the shareholders that money in return, but it does owe them a share of any profits. That"s why the shares are considered liabilities: the shareholders have an equity claim on the bank.
The second way banks acc.u.mulate liabilities is by borrowing money, most obviously from people, other banks, and other financial inst.i.tutions. For example, when you deposit money into a bank, you"re loaning it money. Your deposit is a liability for the bank: you may decide you want your money back, and the bank has to give it to you. The same goes for loans that other banks have made to the bank: they"re liabilities. The bank is merely borrowing that money. Banks borrow money in other ways too: by issuing bonds, for example. These too are liabilities, or loans to the bank. Most of these loans cost the bank: it pays interest on deposits, for example, and on bonds.
What does the bank do with all the money it has raised from shareholders and borrowed from lenders? It creates the other side of the balance sheet: its a.s.sets. For example, it loans money out to other banks, businesses, and homeowners. These loans are considered a.s.sets because they are investments that will, over the long run, give the bank a profit. That makes them worth something. The same goes for the other a.s.sets the bank acc.u.mulates. It may invest in government bonds or other securities, which are worth something. So are the remaining a.s.sets of the bank: the cash that"s sitting in the vault, the building that houses the bank, and other tangible items. But these odds and ends are just a small portion of the total a.s.sets of the bank. They"re also inert: they"re not making the bank much money.
That, in brief, is how banks work. They raise money by issuing equity shares and borrowing money from a range of lenders. Having acc.u.mulated these liabilities, the bank then loans the money, acc.u.mulating a.s.sets. It"s able to make a profit from moving all this money around because the rate at which it borrows is lower than the rate it charges when it lends. If all this sounds simple and straightforward, that"s because it isn"t rocket science, no matter what bankers might want you to think.
Now comes the important part. How much is the bank worth? That"s pretty simple: it"s the difference between the value of the a.s.sets and the value of the debt liabilities. Put differently, it"s the amount by which a bank"s a.s.sets exceed its debt liabilities. In banking parlance, that difference is the "net worth" of the bank. It"s also known as its "capital" or equity. This capital belongs to someone: the bank"s owners, or shareholders, who have a residual claim on the bank"s a.s.sets. This is only right: the bank owes its existence in no small part to these shareholders, who put up money when the bank was first formed, or bought into the bank"s equity when it issued additional shares. They get a share of whatever profits the bank makes-in the form of dividends-and they benefit when the bank"s shares go up in value.
Now let"s look at how banks can get into trouble in a financial crisis. So far we"ve focused on how things go awry with the liability side of the balance sheet, when a bank can no longer borrow money, or when the money it borrows is available only at exorbitant rates. That can happen if depositors panic and pull out their money, or if other banks refuse to renew loans, or if no one wants to buy the bank"s bonds. During the recent crisis, the Fed found many ingenious ways to allow banks to borrow money, while simultaneously a.s.suring anyone who lent to the banks that he would not lose his money. The government backstopped most components of the liability side of the balance sheet: it replenished equity claims with capital injections; it more widely guaranteed the deposit liabilities and fully guaranteed the unsecured debt of banks.
But what about the other side of the balance sheet, the a.s.sets? The Fed can do everything within its power to make it easy for the banks to borrow money, but if the bank"s a.s.sets are worth less with every pa.s.sing day, then the bank"s capital or net worth declines too. When a bank"s liabilities outstrip its a.s.sets, the bank"s net worth sinks to zero. It is insolvent, or bankrupt.
As the recent financial crisis worsened, many of the a.s.sets that banks had on their balance sheets did start to lose their value. Some of those a.s.sets were loans that went bad; others consisted of the securities derived from mortgages and other loans. As homeowners defaulted on their mortgages and these losses rippled throughout the financial food chain, the value of everything from loans to local real estate developers to collateralized debt obligations started to fall. And as the value of these a.s.sets fell, the remaining capital withered away.
Banks in the United States and Europe therefore needed to raise more money, or capital. First they went hat in hand to government-owned sovereign wealth funds, which purchased newly issued "preferred shares." Their name notwithstanding, these shares did not give the investors any voting rights; they merely gave them a certain share in the banks" current and future profits. Money flowed into the banks" coffers and temporarily restored them to some measure of health. But a.s.set values continued to decline, so banks raised more capital from private equity firms by issuing shares to them too. It wasn"t enough. In the fall of 2008 the value of bank a.s.sets continued to fall, and no one was interested in pumping any more capital into banks.
At this point, policy makers had a number of options. They could have let the banks (and other nonbank financial inst.i.tutions, such as bank holding companies and broker dealers) fail. Thereafter they would have been restructured in or out of court or through the FDIC receivership process. Typically, when that happens, some of a bank"s unsecured creditors-its bondholders, for example-will agree to convert some of the money that the bank owes them into shares, or equity in the bank. These "debt-for-equity swaps" are not exactly a bargain for anyone the bank owes money, but they"re better than nothing: those who have lent it money get a stake in it once it resumes operations. And it will be able to resume, because as its creditors forgive part of its debt, its liabilities decline relative to its a.s.sets. Voila! Now the bank has some capital and can resume lending.
This approach is the equivalent of letting the markets sort things out. Bad banks fail, are restructured, and are reborn. The same result can be achieved by having the federal government unilaterally declare certain banks insolvent and then take them over, placing them in the custody of government-appointed trustees who sell off the good a.s.sets, dispose of the bad ones, and relaunch the bank. This was the "nationalization" option that Sweden used in its own banking crisis in the early 1990s, and the United States effectively used when it took over Continental Illinois, a big bank that fell in advance of the savings and loan crisis.
But in the recent crisis neither of these approaches got a serious hearing, and after the failure of Lehman Brothers, the notion of making bondholders shoulder any losses lost its appeal. Instead, the Treasury opted to use some of the $700 billion acquired under the TARP legislation to buy stakes in banks and thereby "inject" capital into them. The biggest beneficiaries included behemoths like Bank of America, Citigroup, JPMorgan Chase, Goldman Sachs, and AIG, all of which were given tens of billions of dollars. Hundreds of other, smaller banks lined up for government aid as well. In the process, the government-and by extension, the American taxpayers-became effective owners of huge swaths of the financial system.
It amounted to creeping, partial nationalization of the financial system. As with all the other bailouts, its long-term cost is next to impossible to calculate. Most of the biggest banks have already paid back the TARP funds at this writing, and the government has divested itself of those inst.i.tutions. Others-including many of the smaller, regional banks-remain dependent on TARP and may never return the money, inflicting significant fiscal costs on future taxpayers.
For the banks that have yet to return the money, the core problem remains the same: troubled a.s.sets continue to lose value, casting a pall over their financial future. The government could keep enlarging its equity stake in the banks, but absent some fundamental change in the banks" a.s.set base, that could turn out to be throwing good money after bad.
Toxic Waste.
The question of what to do with the banks" bad a.s.sets has loomed over the crisis from the beginning. As long as loans continued to sour, and as long as securities derived from those loans continued to lose value, the banks would be unable or unwilling to lend. Rather than letting the banks continue to struggle with these toxic a.s.sets, policy makers floated a variety of proposals, all of which had the aim of extracting the a.s.sets and disposing of them, leaving the banks free to resume their business.
The most promising proposal called for banks to undergo radical surgery. This would entail taking a troubled bank and splitting it into two banks: a "good" bank that included all the solid a.s.sets, and a "bad" bank that contained everything else. The good bank could then go on to make loans, attract money and capital, and resume business. In exchange for ridding it of the toxic waste, the bank"s shareholders and unsecured creditors would take a loss proportionate to the a.s.sets spun off into the bad bank. In turn, the bad bank would be run by private investors who hoped to profit from the orderly liquidation of its a.s.sets.
A version of this scenario was implemented in 1988, when the venerable Mellon Bank got itself into trouble after a host of its real estate and industrial loans went bad. Using financing from an investment bank, Mellon extracted its dubious a.s.sets and deposited them into something called the Grant Street National Bank. Private investors with an appet.i.te for risk capitalized the new inst.i.tution, whose employees then went to work collecting on the remaining bad loans, liquidating the a.s.sets, and maximizing the return on these b.u.m investments. Unburdened of its bad a.s.sets, the newly reborn Mellon was back on its feet in short order; it attracted capital and began to make loans once again. Grant Street National Bank completed its work in 1995 and then shut its doors.
That"s arguably the most effective way to deal with the problem. Another, less preferable option would have been for the government to buy the banks" toxic a.s.sets as in the original TARP plan. The price it paid would be set by a "reverse auction," in which the sellers would "bid" by posting the lowest possible price they would accept in exchange for ridding themselves of a specific a.s.set. This is a bit like government contractors" bidding on completing a particular project: in theory, the compet.i.tive dynamic among bidders helps drive prices downward.
It"s an interesting idea, but it"s debatable whether this system would really price the a.s.sets fairly. The banks partic.i.p.ating in the auction would have every reason to resist seeing prices plummet too far. They might even cooperate or collude with one another to make sure that this didn"t happen. Moreover, many of these a.s.sets-particularly structured financial products-are rather unique, held by only a handful of banks. That seriously undercuts the reverse auction"s pricing power. For all these reasons, the government would likely end up overpaying for these a.s.sets and taking a significant loss on its investment. It might end up being the functional equivalent of a bank bailout, subsidizing the bad investment decisions of the banks with taxpayer money.
Still another option would be for the government to form a kind of insurance partnership with the ailing banks. Let"s say a bank has toxic a.s.sets originally worth some $50 billion. In effect, the bank would agree to pay a deductible-for example, it would take the first $3 billion in losses-and the government would cover most of any additional losses on the remaining $47 billion. In exchange for getting a guarantee that it would take a hit "up front" of only $3 billion, the bank would pay the government an insurance premium. Alternatively, the government could receive an equity stake in the bank equivalent to any losses above and beyond that first $3 billion.
A version of this approach has been widely adopted in the United Kingdom, and the U.S. government guaranteed several hundred billion dollars" worth of impaired a.s.sets held by Bank of America and Citigroup. Here"s how it works in practice. In Bank of America"s case, the pool of troubled a.s.sets totaled $118 billion, with a "deductible" of $10 billion. After taking that first hit, Bank of America was off the hook, though it had to pay "coinsurance" covering 10 percent of any additional losses; the government would cover the remaining 90 percent. In return, the government received a hefty amount of stock, giving it a significant equity stake in the bank.
While preferable to a reverse auction, this approach still runs the risk of making the government subsidize the losses incurred by private banks. In the Bank of America case, the government has a.s.sumed that it won"t have to "insure" much of the losses above and beyond what Bank of America is going to pay. But if the cost of insuring those losses outstrips whatever revenue the government gains from entering into the deal, the end result will be the same as having the government overpay for some dud a.s.sets: the government will lose money on the deal and subsidize the bad decisions of private bankers. Taxpayers will foot the bill.
For now, the problem of dealing with bad a.s.sets seems to lie with another approach. The basic idea is to have the government subsidize the private investors who agree to purchase the toxic a.s.sets and thus remove them from troubled banks. This is the idea behind the Public-Private Investment Program (PPIP, better known as "Pee-Pip"), which went into operation in 2009. It"s arguably one of the weakest ideas of the bunch. The trillion-dollar program gives low-interest loans to private investors who want to bid at auctions in which banks sell their toxic a.s.sets. The government sweetened the deal even more by offering to inject capital into inst.i.tutions that take part in this process.
Unfortunately, these low-interest government loans are nonrecourse loans, meaning that in the event that things go badly, investors can walk away from them without penalty. In practice investors have every incentive to overbid; after all, the government is subsidizing the purchase of the a.s.sets. The government is also the one stuck with the a.s.set if it turns out to be a b.u.m investment. In effect, the private sector gets all the glory and the profits when things go well, while the government-or more accurately, the taxpayer-shoulders the fiscal burden when things go awry.
So far PPIP hasn"t attracted many investors, largely because the government has effectively subsidized the banks in another way: by sanctioning the removal of regulations that would have forced them to value their toxic a.s.sets at something approaching real-world market value. Thanks to this intervention, banks have been able to pretend that their c.r.a.ppy a.s.sets are worth far more than any sane a.s.sessment would suggest. It"s like putting lipstick on a pig, but as long as the a.s.sets can be overvalued for accounting purposes, banks have little interest in unloading them.
None of these approaches are perfect, but some are better than others, particularly the idea of splitting off dud a.s.sets into a "bad bank." This approach minimizes the cost to the government by leaving the problem in private hands. It also holds the line on moral hazard and gives reborn banks every incentive to lend again. But it requires that investors take a loss, with the pain felt now rather than later. At the present time, there"s an unwillingness on the part of policy makers and politicians to deal with things up front. That"s unfortunate: kicking the can down the road runs the risk of letting banks slowly sink into a financial coma, becoming zombies dependent on public credit.
In retrospect, that dependency reached astonishing levels. In the course of the crisis, governments threw lifeline after lifeline. They injected capital into banks and other financial firms and broadened the scope of deposit insurance. They even insured the debt of banks, preventing market forces from wreaking havoc on their creditors. These measures went hand in hand with central banks" stunning offer to buy up banks" illiquid a.s.sets for cash, or alternatively, to exchange them for safe government bonds. In the United States, the government went so far as to guarantee the toxic a.s.sets of some financial inst.i.tutions and eventually implemented programs to directly or indirectly purchase those a.s.sets. All this amounted to a staggering, unprecedented intervention in the financial system. Unfortunately, for all the obstacles that policy makers encountered, rescuing the financial system may prove easier than fostering a genuine recovery.
The Aftermath.
In the early 1930s a financial crisis sp.a.w.ned a relentless cycle of deflation and depression. Thousands of banks in the United States went under; three quarters of households with mortgages defaulted; unemployment soared. The help that arrived with FDR"s New Deal was belated, and the economy stagnated. Many other countries followed a similar trajectory, limping through the rest of the 1930s until war ushered in recovery for some and destruction for others.