There were three theories about what made the Great Depression great, and how it could have been avoided by better policy.
- Milton Friedman: the Depression was Great because of a lack of liquidity, and if only the Federal Reserve had kept the money stock from falling everything would have been fine.
- DeLong-Summers: the Depression was Great because expectations of continued deflation became entrenched, and when those expectations were broken--by Roosevelt's New Deal--recovery began.
- Ben Bernanke: the Depression was Great because of the collapse of the banking system, and the resulting credit channel failures that robbed businesses seeking to expand of capital.
The past fifteen months have been a big strike against Friedman: Ben Bernanke has kept the economy liquid, and yet we are in a recession which may become a deep recession. The past fifteen months have been a strike against DeLong and Summers: no expectations of deflation have emerged, and yet here we are.
Bernanke's theory of the Depression is the only one standing (which doesn't mean that it is right, only that it may be right).
So what to do? We don't want to let the banking sector collapse into bankruptcy--Lehman Brothers was bad enough, and we don't want to replicate the Great Depression. But we also don't want to repeat Japan's mistakes of the 1990s, with zombie banks neither alive nor dead failing to do their job for the economy as they focused on getting back above water to create some value for shareholders and executives.
And here is my worry about the current plan to buy preferred rather than common stock of the banks. Preferred stock runs a risk of creating zombies--if shareholders and executives conclude that the preferred has all the equity value if they continue business as usual, then they will not continue business as usual but will instead start behaving like the Japanese banks of the 1990s. And we don't want that.
By mighty spells the Head Voodoo Priest Henry Paulson has raised the corpses of America's biggest banks from the graves to which the financial crisis was consigning them, but has he restored them to life, or just to zombiehood? Will they do their job for the economy, or will they begin wreaking destruction, all the while crying out: "BBRRAAIINNS! BBRRAAIINNSS!"
If so, it will be up to Neel "The Zombie Master" Kashkari to control them...
Justin Lahart collects opinions. I tell you, I'm never going to ask Barry Eichengreen for an extension:
Barry Eichengreen, Berkeley: This is now, finally, the right move. Were it a student paper, I would give it give it an A- for quality but lower the final grade to a C for lateness. The minus on the A reflects the Treasury´s reluctance to opt for straight stock with voting rights as other governments have done. If we are going to entrust the banks with taxpayer funds as part of their equity, then the taxpayer should have a vote. This is especially a problem with the weakest institutions, where at some point management, unrestrained by representatives of the taxpayer on the board, will be gambling for survival using public money. What should be next, you ask. Let the new measures work. Apply some fiscal stimulus in the form of aid to state and local governments and targeted tax cuts. The stimulus will be needed.
Kenneth Rogoff, Harvard University: It wasn’t just the right move, it was the only move. Thanks goodness they didn’t dally for another week to finally figure it out. There are many challenges ahead. The recession is only just picking up steam, now. In the wake of the housing and credit bust, there is no way that the US is going to sustain consumption at 70% of GDP. Exports will fall as the rest of the world goes into recession. [On policy] surely the next Congress will pass a massive bailout for mortgage markets, especially if housing prices continue to fall. Last but not least, the latest Treasury plan begs the question of what a post-bubble payments system should look like, and how it should be regulated. Will future profits from retail banking all come from supplying convenience services for what essentially amount to deposits with the US government? Surely the regulations governing money market funds will have to be completely rewritten.
Doug Elmendorf, Brookings Institution: These new policies are huge steps in the right direction. However, the announcement alone will not be enough, just as other recent announcements like the TARP and the Fed’s CP facility failed to increase lending by banks. It’s crucial now that the money start to flow from the government through all of these channels.
Anil Kashyap, University of Chicago Graduate School of Business: [I] strongly think recapitalization is the deep problem. I would prefer giving the option to raise it privately first, and would like to make sure that they do not waste money on an insolvent firm (a la Japan in 1998). Guaranteeing the debt is important to buy time. Ideally the time would be used to make sure you are only helping solvent banks.... I think if they truly get the details right and succeed at recapitalizing the system, then intermediation will start returning to normal. My guess is that we still wind up with a recession but perhaps one that is much less onerous than if they not acted now.
Hyun Song Shin, Princeton University: It’s the right move in principle. The case for an equity injection is compelling. Think of it like this. If you buy bank assets with 700 billion dollars, you add this much balance sheet capacity to the banking system. On a leverage of 10 to 1, this is like injecting equity of 70 billion. But, if you inject 700 billion of equity, then on a leverage of 10 to 1, this is adding additional balance sheet capacity of 7 trillion. So, dollar for dollar, you get much more bang for the buck in adding further lending capacity to the banking system. Will the plan work? It depends how the equity is injected. The plan now is to buy preferred stock. This is a buffer against loss for the senior creditors, but it doesn’t add anything to the common stock. Preferred stock is a claim without control, which just drains cash from the bank (think of Warren Buffett’s 10% coupon on his preferred stock from Goldman). Preferred stock will make banks lend if the problem previously was risk of loss for the creditors. But if the problem is that the controlling shareholders (the common stockholders) are being cautious, then preferred stock will just make things worse in terms of willingness to lend. Injection of common stock will free up lending more effectively, but this is bad in terms of taxpayers getting their money back. That’s the dilemma. Do you want to protect the taxpayers’ stake, or to you want to free up lending?
Ricardo Reis, Columbia University: I think it is the right move. Not an action without problems, nor one that is desirable in general, but one to swallow given the circumstances. The root of the problems is lack of capital in the banks. If private capital doesn’t seem to be stepping in, so let it be public capital. That is, as long as it is for a good price and as long as it does the best job possible of giving the right incentives by: not rewarding current shareholders (pay little to nothing for their equity), not rewarding current management (fire them or cut their compensation drastically), and not rewarding the reckless creditors who financed them (using warrants and preferred stock that gives priority on the government being paid). What comes next depends on how markets behave in the next few days. Forecasting is usually tricky, but with the current market volatility any predictions for what will happen next are very hard.
Raghuram Rajan, University of Chicago Graduate School of Business: It has many of the elements we have been advocating. So I like it a lot better than the Treasury plan. I would worry about some details. First, while I have been in favor of recapitalizing the stronger banks so that they can lift the system, I would have preferred giving them the choice of getting government capital or raising private capital. I guess the benefit of the force feeding by the government is that the ones who do take it do not send a bad signal about their options. I am unclear how the amounts were determined. Second, a temporary guarantee of debts — e.g., for 3 to 6 months (is it for all banks) would have been preferable to a three year guarantee. Not sure how you restrict it to new debt only — I can just repay old debt and raise new debt. Third, you have to be careful that entities outside the well-protected system (e.g., small banks and insurance companies) do not face runs. It may be that the guarantee will have to be extended to more entities (not clear if FDIC will guarantee debt of all banks). Presumably, the regulators will also audit banks over the next few months to identify and resolve the weak ones. It would not be clever to offer a blanket guarantee for an indefinite period to weak banks. In this regard, supervisors will have to monitor the asset growth of guaranteed banks so as to make sure they are not gambling with taxpayer money. Presumably, also, there will be some scheme to recapitalize small and medium sized banks that are worth saving. Would like to see more private participation in those.
Markus Brunnermeier, Princeton: Overall, I like the move. It’s way better than starting a complicated reverse auction for a very heterogeneous set of troubled assets. Why? a) It recapitalizes banks directly, i.e. has a bigger bang for the buck (i.e. if you buy troubled assets standing in the books for $400bn at a inflated price of $700bn, you recapitalize banks only by $300 bn. If you inject new equity, you recapitalize the banks by the whole $ 700 bn. That makes a big difference.) b) it’s faster (since it is less complicated)! c) gives the taxpayer an upside potential as well. An alternative approach (with even more horsepower) would have been to force all banks to do a rights issue that is underwritten by the government. (Forcing all of them to do it, gets around the stigma of issuing stocks and associated stock price decline.) I am not sure whether there is still enough time left, though. There will be a wave of new regulation coming, especially from Europe. The US seems to have lost its moral authority (in terms of “how to regulate markets”). Let’s not pretend: The balance of power has shifted. Hence, it is important to think clearly and carefully how the new financial architecture should look like. I have some thoughts/outlines on my website (e.g. risk measures like Value at Risk that focus only at the risk of an individual bank have to replaced with CoVaR that measures domino effects etc..). We can talk more about if you want.
Brad DeLong, Berkeley: Yes, it is the right move–but nonvoting preferred stock scares me as giving too great incentives to gamble for resurrection; I would prefer voting common; it’s the devil, but a lesser one. What comes next? Big fiscal stimulus, I think. All those banks need expanding manufacturing businesses to lend to.
John Cochrane, University of Chicago Graduate School of Business: …grumble grumble, yes there are all sorts of warts on it, but at least this one will probably work, in the narrow sense that it can end the “crisis” or “credit crunch.” Most of all, I think it will “work” well enough to put a stop to the escalating political panic and the contagion of bailouts. My biggest fears, and those of the markets I think, have been that some new “plan” comes along every two days which can wreck everything.... If I were in charge I would announce loudly “and we’re going to sit on our hands for a whole week no matter what happens to daily stock prices.” But there are lots and lots of problems with it. Most obviously, now the government has stock in banks. Ok it’s preferred and nonvoting, but still, it is stock. And the government doesn’t need to vote its shares in order to profoundly influence how banks are run! There are lots of good practical reasons to fear government-run banking systems; governments inevitably use control over the banking system for political ends. Already ours has shown a wonderful track record in pushing Fannie Freddie and banks to make and hold bad subprime loans.... Of course, I would much rather do the same thing by marrying bank operations to new private capital rather than a government investment, and I see no reason what that is infeasible. There is lots of private capital sitting around. Pretty much by definition if the government is buying equity and private investors are not, it means the government is getting a bad deal, buying the assets at too high a price and thereby bailing out the existing share and debt holders.... So, the real questions arise going forward. What happens if the assets become worth even less? What happens if we discover that the bank really is insolvent, meaning the assets (mortgages) are worth less than the liabilities (debt)? A bank like that needs to fail, meaning the stock gets wiped out, the debt gets written down, and the operations married to new equity. Issuing a new class of stock now doesn’t help, it gets in the way. The point of equity is to be a “cushion” that can absorb losses if things get worse — which, for some banks, they surely will. Bottom line, this needs to be a very temporary plan, with a much clearer path for how banks are going to be allowed to fail, to reorganize, to marry with private equity. Otherwise, this has become “no bank may ever fail again”, and part of a government-run banking system. That will quickly become sclerotic.
Charles Calomiris, Columbia Business School: Yes, these parts are the right move, and as you know, many economists including myself have been calling for them for weeks. But the other aspects of TARP will likely be a mess to implement, especially asset purchases and asset work outs, and I predict that we will regret the stubborn insistence of the Treasury to waste resources on these plans that could be so much better put to use as capital injections.
Jeremy Stein, Harvard University: I think the plan is a strong step in the right direction. However, one item that was not addressed, and should be, is the continuation of dividend payments by the banks. Simply put, the government should force the banks to suspend all dividend payments. It makes absolutely no sense for the government to put money into the banks, only to see a significant fraction of it flow out again as dividends to shareholders, and in many cases, bank executives with large equity stakes. There is an obvious conflict of interest here: the value of the enterprises themselves, as well as social interest, are better served by the money being retained inside the banks, and being used to rebuild capital. But junior claimants who want to siphon off value from more senior creditors clearly want to move as much cash out the door to themselves as possible. Again, this should be stopped immediately. Bank CEOs may claim that cutting dividends will send a negative signal to the market, making future private issues more difficult. But of course, if the government simply compels them to cut dividends, there is no signal sent at all.