Carlo Resta from RGE:
"In the 1960s, while the Italian economy was booming, such to talk of “The Italian Economic Miracle”, IRI - Istituto per la Ricostruzione Industriale S.p.A. - was among its most important factors[1]. The IRI, (Institute of Industrial Reconstruction) was a conglomerate owned by the Italian government and inherited by the Great Depression period. By the 1960's it was growing at rates that were more than double those of the national economy and it was once the largest non-oil producing company in the world outside the United States. It had stakes in a multitude of sectors of the Italian economy, ranging from infrastructure and manufacturing to telecommunications.
This experience of the IRI contains some valuable precedents and lessons for policy makers today in the midst of the extreme economic difficulties.
When the 1929 market crash initiated the worldwide depression of the 1930s, few countries were as adversely affected as Italy, even though this propagated with a certain delay. Italian banks had a history of purchasing substantial interests in Italian industry, and when those industries began to fail it appeared that the nation's banking system might well collapse. The Fascist government of Benito Mussolini created IRI in January 1933 to bail out Italy's three largest banks, Banco di Roma, Banca Commerciale, and Credito Italiano. As a result, wrote Stuart Holland in: The State as Entrepreneur. New Dimensions for Public Enterprise: The IRI State Shareholding Formula, “the new state holding company found itself responsible for major proportions of the main industrial and service sectors in the economy.”
During the years of its intense growth, IRI behaved unlike any corporation seen before. Because it served the interests of the state, it did not have to concern itself with short term profits. Thus IRI could sink millions of lire into enterprises, like steel and road building that private companies shied away from. The effect of such government investment was to create markets in which other companies could then compete, thereby expanding the economy as a whole. The U.S. government was using tax-breaks and incentives, but their situation was different, so Italy employed IRI. Not only did IRI create economic markets, it did so in areas thought to be most beneficial to the country as a whole or in areas of strategic importance.
It is crucial to remember that IRI avoided the pitfalls of most state-run businesses. The problem with most state-run businesses, especially in the formerly communist countries, was that there were few incentives to be productive or efficient. Thus, state-run companies often became notorious for mismanagement, creating unnecessary jobs and spending public money unwisely. IRI avoided these drawbacks by creating a level of distance between itself and its subsidiary holding companies. IRI's subsidiaries were put in a position to behave as if they were private enterprises; they were encouraged to be entrepreneurs, while the small core of IRI management acted as investors, backed by the financial might of the Italian government. While IRI was 100 percent government owned, the subholdings were not, and thus these subholdings could attract private investment as well. And so they did.
When IRI was working well, it combined the dynamism of entrepreneurial capitalism with some sort of social guardianship and long term forward looking common purpose. The success that IRI had in the 1950s and 1960s, during what was dubbed: “The Italian Economic Miracle”, made it the model for governmental involvement with industry around the world. In the 1960s, Great Britain, France, Australia, Canada, Sweden, and West Germany all initiated programs that were based at least in part on the IRI formula of mixed state/private investment formula.
Many European countries, particularly the UK, were looking at the “IRI’s formula” as a positive and effective example of a proper state participation in the economy. It was better than the straightforward “nationalization” because it allowed a direct cooperation between public and private capital. Many of the companies of IRIs’ group had mixed capital, partly from public government, partly from private investors. Many of IRI’s enterprises were listed and the bonds issued by IRI to finance its own companies were massively subscribed by savers.
Here are the main functions of the newly proposed Institutes for Economic Reconstruction:
1.Be of immediate support to companies in strategic sectors of the economy; prevent their collapse, avoiding catastrophic impacts by taking over preferred shares, (a midway instrument between shares and bonds with no voting rights), taking control only where strictly necessary.
2.Acquire stakes in small and medium size businesses (SMEs) to protect them for being indirect contagion casualties, facilitate their financing, their international development plans.
3.Acquire preferred stakes in new enterprises with strong growth prospects, to promote new technologies, new inventions, more exports to BRICs, vital sectors of the economy …
4.Act as a traditional institutional investor in search of long term returns, acquiring assets domestically but also abroad, restoring confidence and stabilizing markets in coordination with the necessary general economic reforms of each of the western countries.
5.Defy fears that external SWFs investment reasons are other than portfolio diversification and that by investing in other countries they could take control of crucial national interests, or could influence other sovereign states. Consider co-investments with SWFs with the aim of contributing to a globally coordinated stabilization effort.
Now, the big problem facing this depressionary period is that there is strong general reluctance to undertake any investment at all. There is widespread fear. The risks are perceived to be too high; a vicious “Trust Crunch” circle is generated, and that brings to a compression and ultimately to the freezing of any exchange in the economy. If the blood stops circulating even the healthiest individual will eventually die. The banks stop lending, even to themselves; consumer confidence plummets at its lowest, panic spreads across and creates damage to fundamentally sound businesses. The above curve gets flatter and it moves more and more to the extreme right of the graph. This deadly spiral must be “unlocked”!
The implementation of a proper “State/Private Co-Investment” formula allows reducing enterprise risks, guarantees a long term view horizon, reestablishes trust and confidence in the markets for investments to take place, gives a positive boost to all of the firm’s constituents, and thus decreases risks. The presence of such a ‘Strong hand’, enhances the value of a company for all the parties involved: employees, management, suppliers, customers, shareholders, bondholders, financing banks, insurers, regulators, local administrators. The positive impact reverberates also into other companies of the same sector, creates a compounding positive virtual circle, a psychologically positive impact into the entire system.
... The impact of the “State/Private Co-Investment Formula” is obviously of superior significance in periods of deep dislocation and depression like those we are currently going through. Historical examples show also that where there is a public presence, growth is even faster than the market average at times of expansion. Last but not least, history reminds us that the most important element will be, much further down the line, a proper ‘exit strategy’ for the public money. This is a relevant aspect but it can be addressed later on.
Furthermore, a renewed formula of the Italian I.R.I., a new breed of western Sovereign Fund which I call Institutes of Economic Reconstruction (IER), can be viewed exactly as a portfolio manager, having to allocate capital among different selection of enterprises and industrial sectors.
...The IER holding company can also be viewed as a fund manager and similarly, if successful in allocating its asset among best performers and diversifying risks accordingly, generating return higher than the market. ...The value generated by these asset allocation strategies will also improve because the allocation process itself is made easier by the presence of a “strong hand” that reduces fears and uncertainties. And we know that asset allocation is the most important factor in successful value creation and preservation. From the case study of IRI, we see that when the Italian economy was growing 8%, IRI was growing more than double that.
The stronger the depression, the higher is value of the “State/Private Co-Investment Theory”. Same was for the Great Depression and for other similar historical periods. After all the creation of “Sovereign Alpha” does not just come automatically, but it is also be the result of a selection and an enhancement process; the enterprise will have to improve its values and standards, requirements, conditions, and keep them that way.
If IRI chemistry allowed to flourish the unstoppable Italian art of making do with what available; if that formula allowed the unfolding of the fantastic creativity of the Italians and their relentless ‘trial and error’ mentality that brought to life world icons like Ferrari or Espresso, Versace and Armani,… up to the helicopters currently used by the USA President and much more, think what a similar formula could do to revamp a United America and the western economies today. Not only the historical comparables match, but the advantage of available technology and knowledge make possible a more effective and controlled use of the “State/Private Co-Investment” formula. Yet, time is of the essence.
A new breed of Sovereign Wealth Funds, the Institutes for Economic Reconstruction (IER), based on the “State/Private Co-Investment” formula with the crucial goal of reestablishing confidence in each of the national markets, and restarting the much needed economic growth, appears to be the only way forward and a viable one. Not Von Hayek but not really Keynes either. It is going to be a balanced, comprehensive approach, a real generator of modern value.
This approach not only will benefit the individual enterprises which receive the participation from the State, but it will also generate a positive crucial impulse to the global economy, increasing overall market returns and reducing risks. Last but not least, ethical and sustainable growth considerations will be able to receive a reasonable place in a much needed restructuring of the world order. Markets will come out different from this crisis but ultimately stronger.
We have the means, the expertise, and now a good impending necessity to make it happen.
“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty”. Winston Churchill
Carlo Resta is the founding Partner and President of Oraculum Advisors Limited, an investment banking boutique consultant to global financial services institutions for their business development, marketing, partnerships andalliances activities.
As a wealth manager, Carlo was the Managing Director of Global Investment advisory at Chase Manhattan Bank, for Europe, Africa and the Middle East from 1999-2001. The group was responsible for all client-directed investment business in this region within Chase’s Private Bank. As a start-up and product specialist in equities, Carlo was formerly a Director of the Client Strategies Group for the Merrill Lynch International Private Bank from 1997 to 1999. From 1995 to 1997 he was a Director, Global EquityDerivatives, at Merrill Lynch where he developed and expanded the derivatives business of Merrill Lynch in Southern Europe. He was also responsible for marketing Merrill’s entire range of financial products and services to his client-base. Carlo’s team launched the first Equity Linked Capital Protected Investment Product for the Italian,Portuguese and Spanish markets. Most recently in 2002 and 2003, Carlo worked for the Old Mutual Group on projects dealing with their expansioninto new financial products and services. Prior to joining Merrill Lynch in 1993, Carlo spent eight years at San Paolo Bank in their headquarters in Turin and in New York. Carlo holds a degree in Economics and Banking Sciences from the University of Siena, Italy, and an MBA in Finance and International Business from New York University, Leonard Stern School of Business.
sábado, 24 de enero de 2009
miércoles, 21 de enero de 2009
Culturally constructed ignorance
Clive Thompson from Wired:
"...Normally, we expect society to progress, amassing deeper scientific understanding and basic facts every year. Knowledge only increases, right?
Robert Proctor doesn't think so. A historian of science at Stanford, Proctor points out that when it comes to many contentious subjects, our usual relationship to information is reversed: Ignorance increases.
He has developed a word inspired by this trend: agnotology. Derived from the Greek root agnosis, it is "the study of culturally constructed ignorance."
As Proctor argues, when society doesn't know something, it's often because special interests work hard to create confusion. Anti-Obama groups likely spent millions insisting he's a Muslim; church groups have shelled out even more pushing creationism. The oil and auto industries carefully seed doubt about the causes of global warming. And when the dust settles, society knows less than it did before.
"People always assume that if someone doesn't know something, it's because they haven't paid attention or haven't yet figured it out," Proctor says. "But ignorance also comes from people literally suppressing truth—or drowning it out—or trying to make it so confusing that people stop caring about what's true and what's not."
... continues...
"...Normally, we expect society to progress, amassing deeper scientific understanding and basic facts every year. Knowledge only increases, right?
Robert Proctor doesn't think so. A historian of science at Stanford, Proctor points out that when it comes to many contentious subjects, our usual relationship to information is reversed: Ignorance increases.
He has developed a word inspired by this trend: agnotology. Derived from the Greek root agnosis, it is "the study of culturally constructed ignorance."
As Proctor argues, when society doesn't know something, it's often because special interests work hard to create confusion. Anti-Obama groups likely spent millions insisting he's a Muslim; church groups have shelled out even more pushing creationism. The oil and auto industries carefully seed doubt about the causes of global warming. And when the dust settles, society knows less than it did before.
"People always assume that if someone doesn't know something, it's because they haven't paid attention or haven't yet figured it out," Proctor says. "But ignorance also comes from people literally suppressing truth—or drowning it out—or trying to make it so confusing that people stop caring about what's true and what's not."
... continues...
martes, 20 de enero de 2009
Paul Krugman: The pain in Spain …
… isn’t hard to explain. Spain was basically Florida, with a housing bubble inflated by both resident and holiday purchases, and now the bubble has burst.
But Spain is in worse shape than Florida, for two reasons — reasons familiar to anyone who was involved in the great debate about whether the euro was a good idea.
First, Europe doesn’t have a central government; Spain, unlike Florida, can’t draw on Social Security and Medicare checks from Washington. So the burden of recession falls entirely on the local budget — hence the country’s declining credit rating.
Second, the United States has a more or less geographically integrated labor market: workers move from distressed regions to those with better prospects. (The housing bust has, however, reduced mobility because people can’t sell their houses.) Europe does not: yes, there’s a fair bit of mobility both among the elite and among low-wage workers at the bottom, but nothing like the US level.
So what can Spain do? It needs to become more competitive — but it can’t have a devaluation, because it’s a euro country. So the only alternative is wage cuts, which are desperately hard to achieve (and create big problems for debtors.)
Contrary to what everyone seemed to be saying even a few weeks ago, being a member of the eurozone doesn’t immunize countries against crisis. In Spain’s case (and Italy’s, and Ireland’s, and Greece’s) the euro may well be making things worse.
And Britain’s plunging pound, unpopular though it is, may turn out to have been a very good thing.
On the same topic Ambrose Evans-Pritchard, although, ubi major minor cessat.
But Spain is in worse shape than Florida, for two reasons — reasons familiar to anyone who was involved in the great debate about whether the euro was a good idea.
First, Europe doesn’t have a central government; Spain, unlike Florida, can’t draw on Social Security and Medicare checks from Washington. So the burden of recession falls entirely on the local budget — hence the country’s declining credit rating.
Second, the United States has a more or less geographically integrated labor market: workers move from distressed regions to those with better prospects. (The housing bust has, however, reduced mobility because people can’t sell their houses.) Europe does not: yes, there’s a fair bit of mobility both among the elite and among low-wage workers at the bottom, but nothing like the US level.
So what can Spain do? It needs to become more competitive — but it can’t have a devaluation, because it’s a euro country. So the only alternative is wage cuts, which are desperately hard to achieve (and create big problems for debtors.)
Contrary to what everyone seemed to be saying even a few weeks ago, being a member of the eurozone doesn’t immunize countries against crisis. In Spain’s case (and Italy’s, and Ireland’s, and Greece’s) the euro may well be making things worse.
And Britain’s plunging pound, unpopular though it is, may turn out to have been a very good thing.
On the same topic Ambrose Evans-Pritchard, although, ubi major minor cessat.
domingo, 18 de enero de 2009
Can Economists Be Trusted? Are There Any Wrong Answers in Economics? - Part II
Mark Thoma:
"I wasn't completely happy with my discussion in Can Economists Be Trusted? Are There Any Wrong Answers in Economics?. I talked about cherry picking results to serve political aims, but I didn't talk about or come down hard enough on the misrepresentation of results for political purposes.
So I'm glad to see Andrew Gelman continuing the discussion:
"Can economists be trusted?," by Andrew Gelman: Mark Thoma has an interesting discussion of the challenge that the economics profession, and individual economists, have when they give policy recommendations.
Mark's basic point goes as follows. Consider the following four stages of a model:
(a) assumptions about fundamental principles of how the world works,(b) normative principles (that is, fundamental goals, views about how the world should be),(c) conclusions about the likely effects on policy,(d) recommendations about policies.
In any rigorous economic model, there should be a mapping leading from (a) to (c). Further reasoning (possibly mathematical modeling, as in cost-benefit analysis) will take you from (b) and (c) to (d).
That's all fine. But Mark's point is that the reasoning can go the other way too: start with (b) and (d), and then you can figure out what (c) needs to be, and then you can go back one more step and figure out what model (a) you need to get started! Even if economists are not doing this reasoning-from-conclusions-to-assumptions explicitly, you could well believe it's going on implicitly as well as being induced by various pressures such as the selection of what research results to report and even what problems to work on.
This is inevitable, and I discuss it in ... Bayesian Data Analysis. We call it the garbage-in-garbage-out problem: If you can come with any decision you'd like by just altering the inputs of your analysis, then what's the point of decision analysis (or, by extension to the above-linked example, economic modeling) at all?
My answer is something that I call "institutional decision analysis," which has two principles:
1. It can be a good idea to provide reasoning to justify your decisions. ...[A]n institution--whether it be a business, a government agency, a nonprofit organization, or some other grouping--often needs some path of bread crumbs connecting assumptions to recommendations. ...
2. As Mark noted, an overall decision recommendation on anything important is likely to be so dependent on assumptions to such an extent that it's probably fair to say that the analyst is reasoning from conclusions to assumptions (from (d) to (c) and then to (a), in my above notation). But, even then, formal decision analysis can be useful in making relative recommendations. This is the point that we made in our article about decision making for home radon. In the economics context, this might suggest that economists of different political persuasions could still give useful recommendations about how to spend money or cut taxes, or where in the economy such policies would make more or less sense.
There's always a temptation to act as a lawyer - to use theory and empirical evidence, your own if necessary, to make the best possible case for the policies you would like to see enacted.
Lobbyists certainly do this, consultants do this in some cases (though they ought to advise their clients of the full spectrum of evidence), politicians don't hesitate to shade things to make themselves look good, and some think tanks are also fully engaged in this type of activity (in a few cases, to the point of blatantly misrepresenting theory or evidence in order topromote their point of view ).
But lawyer like advocacy for preferred policies is not how academic economists ought to present evidence to policymakers and to the public. This does not mean economists should always end up in some wishy-washy, on the one hand, on the other hand position due to unavoidable uncertainty involved in the decision-making process, they can still come to firm policy recommendations. And in this regard point 1 above - connecting assumptions to recommendations - is helpful in explaining the basis for the decision (I'd add the connection between the empirical evidence and the recommendations as well). But I'd also like to see a bit more than that, including how robust the recommendations are to changes in the assumptions, whether there are other common assumptions that lead to different outcomes, and if so, why these assumptions were ruled out, and the strength of the empirical evidence being used to support the policy position.
"I wasn't completely happy with my discussion in Can Economists Be Trusted? Are There Any Wrong Answers in Economics?. I talked about cherry picking results to serve political aims, but I didn't talk about or come down hard enough on the misrepresentation of results for political purposes.
So I'm glad to see Andrew Gelman continuing the discussion:
"Can economists be trusted?," by Andrew Gelman: Mark Thoma has an interesting discussion of the challenge that the economics profession, and individual economists, have when they give policy recommendations.
Mark's basic point goes as follows. Consider the following four stages of a model:
(a) assumptions about fundamental principles of how the world works,(b) normative principles (that is, fundamental goals, views about how the world should be),(c) conclusions about the likely effects on policy,(d) recommendations about policies.
In any rigorous economic model, there should be a mapping leading from (a) to (c). Further reasoning (possibly mathematical modeling, as in cost-benefit analysis) will take you from (b) and (c) to (d).
That's all fine. But Mark's point is that the reasoning can go the other way too: start with (b) and (d), and then you can figure out what (c) needs to be, and then you can go back one more step and figure out what model (a) you need to get started! Even if economists are not doing this reasoning-from-conclusions-to-assumptions explicitly, you could well believe it's going on implicitly as well as being induced by various pressures such as the selection of what research results to report and even what problems to work on.
This is inevitable, and I discuss it in ... Bayesian Data Analysis. We call it the garbage-in-garbage-out problem: If you can come with any decision you'd like by just altering the inputs of your analysis, then what's the point of decision analysis (or, by extension to the above-linked example, economic modeling) at all?
My answer is something that I call "institutional decision analysis," which has two principles:
1. It can be a good idea to provide reasoning to justify your decisions. ...[A]n institution--whether it be a business, a government agency, a nonprofit organization, or some other grouping--often needs some path of bread crumbs connecting assumptions to recommendations. ...
2. As Mark noted, an overall decision recommendation on anything important is likely to be so dependent on assumptions to such an extent that it's probably fair to say that the analyst is reasoning from conclusions to assumptions (from (d) to (c) and then to (a), in my above notation). But, even then, formal decision analysis can be useful in making relative recommendations. This is the point that we made in our article about decision making for home radon. In the economics context, this might suggest that economists of different political persuasions could still give useful recommendations about how to spend money or cut taxes, or where in the economy such policies would make more or less sense.
There's always a temptation to act as a lawyer - to use theory and empirical evidence, your own if necessary, to make the best possible case for the policies you would like to see enacted.
Lobbyists certainly do this, consultants do this in some cases (though they ought to advise their clients of the full spectrum of evidence), politicians don't hesitate to shade things to make themselves look good, and some think tanks are also fully engaged in this type of activity (in a few cases, to the point of blatantly misrepresenting theory or evidence in order topromote their point of view ).
But lawyer like advocacy for preferred policies is not how academic economists ought to present evidence to policymakers and to the public. This does not mean economists should always end up in some wishy-washy, on the one hand, on the other hand position due to unavoidable uncertainty involved in the decision-making process, they can still come to firm policy recommendations. And in this regard point 1 above - connecting assumptions to recommendations - is helpful in explaining the basis for the decision (I'd add the connection between the empirical evidence and the recommendations as well). But I'd also like to see a bit more than that, including how robust the recommendations are to changes in the assumptions, whether there are other common assumptions that lead to different outcomes, and if so, why these assumptions were ruled out, and the strength of the empirical evidence being used to support the policy position.
Time to take the banks into full public ownership
William Buiter from Maverecon, FT:
Even if you do not share my view that all UK high street banks are dead banks walking...
these banks do act like zombie banks. They have enough capital to stay on their feet and stumble around a bit, but they are doing rather little of what banks are supposed to do: lending to the non-financial private sector - households and non-financial enterprises.
There are many factors contributing to this reluctance of the banks to engage in new lending.
Normal, sensible commercial prudence in the face of a severe cyclical downturn is one reason. In a recession, lending is riskier.
Irrational fear and near-panic, resulting in excessive caution and risk aversion is another reason for low volumes of new lending, for higher interest costs and for more stringent loan conditions. The balance of power inside banks has shifted dramatically to the risk controllers and bean counters. Loan officers are being kept on a very short leash. ‘When in doubt, don’t lend’ is the motto above the employee’s entrance at our high street banks.
Contradictory messages from the authorities are a third reason. The Treasury and the PM shout ‘lend, lend!’. They also shout ‘pass on all rate cuts fully to the borrowers’ thus ensuring that new lending won’t be profitable. The FSA admonishes: ‘reckless lending is part of what got you into trouble! De-leverage and raise your capital ratios. And if you have any money to invest, put it into Treasury Bills and Bonds, to ensure adequate liquidity in the future‘.
But I believe that costly partial state ownership and the fear of future state ownership (partial or complete) are themselves discouraging banks from lending. To minimize moral hazard, capital injections into the banks by the state and other forms of financial assistance by the state should be priced punitively and have other conditionality attached to it that is unpleasant for current shareholders and management (the dismissal of the incumbent top executives and the board; restrictions on dividend payouts and share repurchases until the state has been repaid; restrictions on executive pay and on bonuses etc.).
But if the state’s financial assistance is priced punitively or has other painful conditionality attached to it, existing shareholders and management will do everything to avoid making use of these government facilities. If a bank has no option but to take the government’s money, it will try to repay it as soon as possible - to get the government out of its hair. Such a bank will therefore be reluctant to take any risk, including the risk of lending to the non-financial private sector. Such a bank will hoard liquidity (sometimes in the form of deposits/reserves with the central bank) to regain its independence from the government. Still independent banks will hoard liquidity to stay out of the clutches of the government.
I believe that this mechanism is at work in a powerful way both in the UK, the US and in continental Europe. Hans Werner Sinn in a recent Financial Times OpED piece pointed out that the German rescue package for banks was fatally flawed for precisely this reason: the acceptance by banks of an injection of public sector capital brings with it a cap on managerial salaries.
Rather than accepting a cap on their salaries, managers would prefer to totter along with an under-capitalised bank and restrict the scope and scale of their lending operations.
...There are two ways of resolving this problem and of incentivising the capital-deficient banks to lend again.
The first is to make the capital cheap (gratis, in the limit) and to minimize the onerousness of the rest of the conditionality. This is the road taken in the US. The US Treasury injected capital into Goldman Sachs at less than half the cost to Goldman Sachs of a capital injection by Warren Buffett a few days earlier. AIG got a tough deal from the Fed and the US Treasury at first, but obtained much sweeter terms less than a month later. The latest capital injection into Citi by the US Treasury (preferred stock with a dividend yield of eight percent) is very cheap.
By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.
There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles. Managers could be incentivised by linking remuneration to multi-year profitability. The incentives for excessive liquidity accumulation and for excessively cautious lending policies that exist for partially nationalised banks and for banks fearing nationalisation would, however, be eliminated.
In addition, full public ownership of the banks would greatly facilitate the creation of a ‘bad bank’ that would hold on its balance sheet all the toxic assets (illiquid assets of highly uncertain value) currently held by the high street banks. The key problem with any bad bank proposal is the price it pays for the toxic assets it acquires from the banks. If all the banks, and the bad bank, are publicly owned, this problem goes away. The toxic assets are simply moved to the balance sheet of the bad bank. They could be valued at anything from zero to their notional value or historic cost (or even higher). It would be a redistribution of wealth from one state-owned entity to another state-owned entity.
Note that the guarantee component of the Bank of America package (like the earlier insurance of/guarantee for $300bn worth of Citigroup toxic assets provided by the US Treasury) does not avoid the problem of valuing the toxic assets. The problem of determining a price or value for the illiquid assets stopped the TARP from being used as originally intended - for buying toxic assets from banks and in the process becoming a price and value revelation mechanism for illiquid assets. There is a valuation embedded in the guarantee or insurance offered to Bank of America and Citigroup: the state will compensate the banks if the value of the securities falls below a certain level. But the valuation is rather well hidden, and may not be revealed unless the guarantee is actually invoked. Also, guarantees are off-balance sheet, and politicians, like bankers, like that.
The bad bank would hold the toxic assets and collect the cash flows associated with it until a liquid market for these assets is re-established. This may never happen, in which case the bad bank would hold the toxic assets to maturity.
The publicly-owned banks would be reprivatised when financial markets stabilise and the economy recovers. It would be good if a better regulatory and supervisory regime for banks and other highly leveraged entities were in place by that time.
Ironically, by partially nationalising some of the banks, by making this injection of public capital expensive financially and as regards other conditionality, and by holding the threat of possible future (partial) nationalisation over the remaining banks, the authorities created an incentive structure that is biased strongly against bank lending, and against bank risk taking generally.
The best escape from this unfortunate halfway house is to go to temporary full public ownership of all the banks. It would be cheap. It should not cost more than £50bn for the state to buy the rest of the UK high street banks. It could wait a while and get them even cheaper - possibly for nothing. But time is more precious than money in this case.
Even if you do not share my view that all UK high street banks are dead banks walking...
these banks do act like zombie banks. They have enough capital to stay on their feet and stumble around a bit, but they are doing rather little of what banks are supposed to do: lending to the non-financial private sector - households and non-financial enterprises.
There are many factors contributing to this reluctance of the banks to engage in new lending.
Normal, sensible commercial prudence in the face of a severe cyclical downturn is one reason. In a recession, lending is riskier.
Irrational fear and near-panic, resulting in excessive caution and risk aversion is another reason for low volumes of new lending, for higher interest costs and for more stringent loan conditions. The balance of power inside banks has shifted dramatically to the risk controllers and bean counters. Loan officers are being kept on a very short leash. ‘When in doubt, don’t lend’ is the motto above the employee’s entrance at our high street banks.
Contradictory messages from the authorities are a third reason. The Treasury and the PM shout ‘lend, lend!’. They also shout ‘pass on all rate cuts fully to the borrowers’ thus ensuring that new lending won’t be profitable. The FSA admonishes: ‘reckless lending is part of what got you into trouble! De-leverage and raise your capital ratios. And if you have any money to invest, put it into Treasury Bills and Bonds, to ensure adequate liquidity in the future‘.
But I believe that costly partial state ownership and the fear of future state ownership (partial or complete) are themselves discouraging banks from lending. To minimize moral hazard, capital injections into the banks by the state and other forms of financial assistance by the state should be priced punitively and have other conditionality attached to it that is unpleasant for current shareholders and management (the dismissal of the incumbent top executives and the board; restrictions on dividend payouts and share repurchases until the state has been repaid; restrictions on executive pay and on bonuses etc.).
But if the state’s financial assistance is priced punitively or has other painful conditionality attached to it, existing shareholders and management will do everything to avoid making use of these government facilities. If a bank has no option but to take the government’s money, it will try to repay it as soon as possible - to get the government out of its hair. Such a bank will therefore be reluctant to take any risk, including the risk of lending to the non-financial private sector. Such a bank will hoard liquidity (sometimes in the form of deposits/reserves with the central bank) to regain its independence from the government. Still independent banks will hoard liquidity to stay out of the clutches of the government.
I believe that this mechanism is at work in a powerful way both in the UK, the US and in continental Europe. Hans Werner Sinn in a recent Financial Times OpED piece pointed out that the German rescue package for banks was fatally flawed for precisely this reason: the acceptance by banks of an injection of public sector capital brings with it a cap on managerial salaries.
Rather than accepting a cap on their salaries, managers would prefer to totter along with an under-capitalised bank and restrict the scope and scale of their lending operations.
...There are two ways of resolving this problem and of incentivising the capital-deficient banks to lend again.
The first is to make the capital cheap (gratis, in the limit) and to minimize the onerousness of the rest of the conditionality. This is the road taken in the US. The US Treasury injected capital into Goldman Sachs at less than half the cost to Goldman Sachs of a capital injection by Warren Buffett a few days earlier. AIG got a tough deal from the Fed and the US Treasury at first, but obtained much sweeter terms less than a month later. The latest capital injection into Citi by the US Treasury (preferred stock with a dividend yield of eight percent) is very cheap.
By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.
There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles. Managers could be incentivised by linking remuneration to multi-year profitability. The incentives for excessive liquidity accumulation and for excessively cautious lending policies that exist for partially nationalised banks and for banks fearing nationalisation would, however, be eliminated.
In addition, full public ownership of the banks would greatly facilitate the creation of a ‘bad bank’ that would hold on its balance sheet all the toxic assets (illiquid assets of highly uncertain value) currently held by the high street banks. The key problem with any bad bank proposal is the price it pays for the toxic assets it acquires from the banks. If all the banks, and the bad bank, are publicly owned, this problem goes away. The toxic assets are simply moved to the balance sheet of the bad bank. They could be valued at anything from zero to their notional value or historic cost (or even higher). It would be a redistribution of wealth from one state-owned entity to another state-owned entity.
Note that the guarantee component of the Bank of America package (like the earlier insurance of/guarantee for $300bn worth of Citigroup toxic assets provided by the US Treasury) does not avoid the problem of valuing the toxic assets. The problem of determining a price or value for the illiquid assets stopped the TARP from being used as originally intended - for buying toxic assets from banks and in the process becoming a price and value revelation mechanism for illiquid assets. There is a valuation embedded in the guarantee or insurance offered to Bank of America and Citigroup: the state will compensate the banks if the value of the securities falls below a certain level. But the valuation is rather well hidden, and may not be revealed unless the guarantee is actually invoked. Also, guarantees are off-balance sheet, and politicians, like bankers, like that.
The bad bank would hold the toxic assets and collect the cash flows associated with it until a liquid market for these assets is re-established. This may never happen, in which case the bad bank would hold the toxic assets to maturity.
The publicly-owned banks would be reprivatised when financial markets stabilise and the economy recovers. It would be good if a better regulatory and supervisory regime for banks and other highly leveraged entities were in place by that time.
Ironically, by partially nationalising some of the banks, by making this injection of public capital expensive financially and as regards other conditionality, and by holding the threat of possible future (partial) nationalisation over the remaining banks, the authorities created an incentive structure that is biased strongly against bank lending, and against bank risk taking generally.
The best escape from this unfortunate halfway house is to go to temporary full public ownership of all the banks. It would be cheap. It should not cost more than £50bn for the state to buy the rest of the UK high street banks. It could wait a while and get them even cheaper - possibly for nothing. But time is more precious than money in this case.
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