James Kwak's Blog

Big and Small

2009-03-27T15:46:28Z

Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:

Increased power and regulatory centralization to deal with the problem of systemic risk

Increased protections for consumers and investors buying financial products

Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions

International coordination among regulators

This all sounds good to me, and an improvement over where we are today. But reading Geithner's discussion of systemic risk - the topic he focused on yesterday - I kept thinking it had been too long since he read Frog and Toad to his children.

]]> The section on systemic risk reads like this (emphasis added, feel free to skim):

To ensure appropriate focus and accountability for financial stability we need to establish a single entity with responsibility for consolidated supervision of systemically important firms and for systemically important payment and settlement systems and activities.

. . . [W]e must create higher standards for all systemically important financial firms regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms, sets objectives and principles for their oversight, and assigns responsibility for regulating these firms.

In identifying systemically important firms, we believe that the characteristics to be considered should include: the financial system's interdependence with the firm, the firm's size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.

Given the existence of "systemically important firms," I agree they need careful regulation. But why does Geithner assume that they have to exist at all?

There are a few main things that made companies like AIG and Citigroup systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities.

Interconnectedness is not going to go away. Complexity may not go away completely, but increased supervision could give regulators a better grasp on complexity. For example, all firms could be required to provide detailed information about their positions to regulators, in a standardized format, so that it could be imported into aggregate computer models; data about positions would be kept only by the regulator and not made public. Complexity could also be reduced by limiting the number of businesses an institution is allowed to engage in (like under Glass-Steagall, but updated for today's world). But size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities). And if a highly interconnected, highly complex but small financial institution fails, the system as a whole would be fine.

What would such a world look like? There would be a lot of small- and medium-sized banks that collected deposits and lent money to households and businesses. There would be brokerage and asset management firms that you used to invest your savings. There would be hedge funds and private equity firms that rich people and other institutional investors used to invest their money. There would be investment banks that helped companies issue equity and debt securities. There would be boutique firms that did research and other boutiques that M&A advising. For any financial service anyone wanted, there would be a company that provided that service; it just wouldn't necessarily provide every other service, and it wouldn't have $2 trillion in assets. It would look something like the 1970s.

What's wrong with this picture? Some people would argue that it would limit financial innovation. But there is no correlation (or a negative one) between the size of a firm and its degree of innovation. Nor do you need to operate a financial supermarket to innovate: mortgage-backed securities were pioneered by Salomon Brothers, an investment bank under the old definition. Finally, perhaps we could use a little less innovation.

Some would argue that costs would be higher, because smaller firms would be less able to capture economies of scale and scope. First, casual empiricism debunks this theory immediately. When I got my mortgage on my house, I got a much lower rate at a small community bank (which holds onto its mortgages rather than reselling them) than at any national bank. National banks also typically offer the lowest rates to savings customers, except when they are about to fail and desperately need cash from depositors. Second, even if this were the case, perhaps slightly higher costs are a price worth paying for reduced systemic risk.

Basically, this is the issue that Ronald Coase discussed in "The Nature of the Firm" (Wikipedia summary; paper). A firm's optimal size is reached when the transaction costs of doing business in the market equal the administrative costs of managing the firm; the bigger the firm, the higher the administrative costs. Clearly some financial institutions reached a level of scale and complexity where they simply could not even understand what they were doing, let alone manage their risks appropriately; they were too big, looked at just from their own perspective (and excluding the implicit Too Big To Fail subsidy). To this equation, we now need to add the social costs (negative externalities) of being Too Big To Fail: moral hazard, socialized losses, and so on.

To some people, the idea of size caps will seem anti-capitalist (or even un-American). However, that viewpoint is based on a misunderstanding of what the modern large corporation actually looks like. In the United States, supposedly the most dynamic capitalist economy in the world, our corporations are run almost exclusively as giant bureaucracies with a rigidly hierarchical decision-making structure. When I was in the business world, I saw several of these entities from the inside or up close, and they are identical: there's barely a trace of the free market to be found. Even in the technology industry, the biggest companies, like Cisco and Oracle, expand by buying innovation from startup companies where the innovating actually happens. (Some large technology companies expand by copying innovations made by startup companies, but that's another subject.)

Geithner's testimony yesterday did contain at least one important insight:

In general, the design and degree of conservatism of the prudential requirements applicable to such firms should take into account the inherent inability of regulators to predict future outcomes.

When you are designing regulation, you have to bear in mind that the world will change. But this is another reason why simpler is better, and the simplest solution is simply to prevent firms from becoming Too Big To Fail in the first place. First, you have to expect that no matter how clever your regulatory scheme, some firms will be even more clever in finding ways to evade the system and blow themselves up. You are far better off if they are small when they blow up than if they are big.

Second, one of the "future outcomes" you have to protect against is that the firms being regulated will try to change the regulations. So one prerequisite to a successful regulatory structure is limiting the political power of the firms being regulated. This is, ultimately, the most important reason why smaller is better.

Update: Paul Krugman says something similar in his op-ed today:

America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. Banks attracted depositors by providing convenient branch locations and maybe a free toaster or two; they used the money thus attracted to make loans, and that was that.

And the financial system wasn't just boring. It was also, by today's standards, small. Even during the "go-go years," the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company.

It all sounds primitive by today's standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

The Tipping Point?

2009-03-18T05:44:09Z

$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another. Yet it may turn out to be the $165 million that broke the camel's back.

The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.

The bonus contracts - which have still not been released to the public - reflect the instinct of Wall Street to favor its employees over any other stakeholders. In the companies I worked at, it was common practice that all bonus plans were contingent on overall company performance: if the company had no money, you didn't get any, either. Even our commission plans for sales people included the caveat that the plan could be changed by the CEO at any time for any reason. The fact that AIG did not similarly protect itself shows the Wall Street habit of putting itself first, or a failure to recognize the possibility of a bad year, or, most likely, both.

The failure of the Treasury Department and the Federal Reserve to review and renegotiate the bonus plans as a condition of federal assistance last fall - despite the fact that the plans had been public knowledge since May - reflects the rushed, ad hoc nature of the deals that were struck. Or it reflects the understanding in Washington that the ways of Wall Street had to be respected. Or, again, both. And the failure to even say anything about the bonus plans since the initial bailout - even just to get ahead of the obvious public relations fiasco - reflects an overall strategy that amounts to hoping that problems will go away.

The seeming inability of the government to do anything but throw up its hands reflects the failed strategy of the bailouts so far: provide as much cash as needed, but do everything you can to minimize the impact on the companies being bailed out. The fact that this is happening at AIG - the one the government has owned 80% of since September - shows that any "nationalization" so far has been a red herring. In a bankruptcy, or a government conservatorship, employees and other creditors would not have a legal right to all of their money. In the current situation, by contrast, AIG management can choose whom it wants to make whole, which is what makes self-dealing and other sweetheart deals possible. In this context, $165 million in employee bonuses pales against tens of billions of dollars of collateral provided to counterparties - beginning with Goldman Sachs. Yes, this was to cover open trading positions. But if AIG had gone bankrupt or had been taken over, it's not clear that Goldman would have been first in line.

The testaments to "the best and the brightest" - here, referring to the people of AIG Financial Products - reflect, I don't know, either absolute, brazen obscenity, or a world-historical example of making the mistake of believing your own hype. The fact that people on Wall Street believe that they are the best among us is bad enough. The fact that people in Washington are willing to accept it is worse.

However, this scandal may yet serve a purpose. One characteristic of both administrations' responses to the crisis has been to devise subsidies for the financial sector that are too complicated for even conscientious readers to make out, such as the asset guarantees for Citigroup and Bank of America, or the preferred-to-common conversion for Citigroup. Employee bonuses, by contrast, are strikingly easy to understand.

The key issues throughout this crisis have been political as much as economic. In this case, the Obama administration has been taking a difficult political position - propping up financial institutions in their current form and insisting everything will be OK - when it would have been easier to play the populist card. This was by no means an inescapable choice; according to news reports in February, David Axelrod and Rahm Emmanuel were in favor of being tougher on the banks. Perhaps the AIG bonus scandal will force the administration's hand toward the decisive action that we need.

No, Wait! You Got It Backwards!

2009-02-26T16:56:02Z

There is nothing inherently wrong with convertible preferred stock. In Silicon Valley, for example, venture capitalists almost always invest by buying convertible preferred. The idea is that in the case of a bad outcome, the VCs are protected, because their shares have priority over the common shares held by the founders and employees. Say the VCs put in $10 million for 1 million shares, and the founders and employees also have 1 million shares, so the company immediately after the investment is worth $20 million. If the company liquidates for $15 million, the preferred shares have a "preference," which means they get their $10 million back (often with a mandatory cumuluative dividend as well) first, and the common shareholders take the loss. However, in a good outcome, the VCs can exchange their preferred shares one-for-one for common. So if the company gets sold for $100 million, the VCs convert, and they now own 50% of the common stock, so they get $50 million.

When I heard that the government was going to give future capital as convertible preferred stock, and perhaps change some of the previous capital injections to convertible preferred, I thought this was a good thing. It would give the taxpayer more upside potential, and it would also give the government the option to take over the banks simply by converting its preferred stock to common whenever it wanted.

But the key in the Silicon Valley example is that the VCs have the option to convert or not. The Treasury Department's new Capital Assistance Program has this precisely backwards.

]]> Under the new Capital Assistance Program (CAP), the government will invest in banks by buying preferred shares with a 9% dividend. This is like the old Capital Purchase Program (used last fall for the first round of recapitalizations), but with one huge twist. Now the bank, AT ITS OPTION, can choose to convert the preferred shares into common, at 90% of the average closing share price during the 20 days ending on February 9 (the day before the new Financial Stability Plan was "announced").

An example would probably help here. Let's say that Bank of America (BAC) needs another $25 billion in capital. The government will give BAC $25 billion in cash, which BAC has to pay back in 7 years (that's the mandatory conversion date). In the meantime, BAC has to pay 9% interest, or $2.25 billion, per year. But, at any time, BAC can convert any amount of that to common shares, at $5.49 per share. (The average closing price over the 20 days was $6.10.) If it converted $5 billion into common, the government would get about 910 million (5 billion divided by 5.49) common shares, but now BAC only owes the government $20 billion and is paying 9% interest on only $20 billion.

In short, BAC has just sold the government 910 million shares for $5.49 each.

This is called a put option. At any time, BAC can sell ("put") shares to the government for $5.49, but it never has to. (The convertible shares the Silicon Valley VCs get are like call options; at any time, they can buy common shares by trading in preferred shares, but they never have to.) Having an option is always good.

What will BAC do with this option? If its stock price is above $5.49, it can either do nothing, or it can issue new common shares and sell them to private investors, say at $8. Then it can use that $8 to buy back preferred shares from the government, or just hold onto it. If its stock price falls below $5.49, things get interesting. Then BAC can buy up its shares on the market for, say, $3, and then immediately sell them to the government for $5.49. It won't get $5.49 in new cash, but it will reduce its debt to the government - because preferred shares that have to be bought back and pay interest are basically debt - by $5.49, which is almost as good.

(This would have the side effect of supporting BAC's stock price, because it means there is a buyer (BAC) who is theoretically always willing to pay $5.48 for the stock. Ricardo Caballero must be smiling)

In practice, it's not quite this simple, because the bank will require Treasury's permission to buy back common shares from other investors. But even if BAC doesn't buy back any shares, it still has the option - whenever its stock price is below $5.49 - of reducing its debt to the government by $5.49 simply by giving the government a share worth less than $5.49.

What's wrong with this? Well, nothing, if your goal is to give banks money. What you've just done is stick the government with the downside risk - we could get paid back in worthless stock - while the bank shareholders get all the upside potential. You've done this by giving the bank, for free, an option that has value. Back of the envelope, Peter thinks this option is worth about 65 cents per dollar of money invested. (It's worth so much because bank stocks are so volatile these days.) Put another way, for every $10 billion of capital we invest this way, we are giving away another $6.5 billion. I think it's probably a little less, because the option is not as flexible as the holder would like it to be, but you get the point.

As I've said many times before, if you think the banks need money, and you want to give it to them (instead of, say, nationalizing them), just give it to them already. Don't come up with these ridiculously fancy schemes to hide it. Yesterday Krugman gave Simon and me credit for writing this sentence:

This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders - shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.

But to tell you the truth, at the time we wrote that I didn't realize just how much brainpower went into this one.

There are some other worrying things in the term sheet I'll just touch on here:

Any qualifying financial institution can get anywhere from 1 to 2% of the value of its assets under this program, simply by asking - even if it doesn't need it. I guess if you're going to be giving gifts (free put options) to the banks that need to be saved, you need to be fair and give the same gifts to banks that don't need to be saved. Banks will need regulatory permission to get more than 2% - a clear sign that getting money under this program is a good thing for banks.

On top of that 2%, any qualifying financial institution can get additional money under this program in order to retire the preferred stock it sold last fall under the Capital Purchase Program. This means they can take back non-convertible preferred stock and give the government convertible preferred stock instead, with no cash changing hands.The dividend rate on the new stuff is higher (9% vs. 5%), so a bank wouldn't necessarily do this. But if its stock price is lower than its conversion price (the average price on the 20 days ending on February 9), then it should do the swap, and then immediately convert the preferred into common (so the dividend goes away). That way, instead of owing the government, say, $10 billion and paying interest on it, it can give the government $5 billion worth of common stock instead. (For those asking the obvious question: Citigroup's conversion price is $3.46. Yesterday it closed at $2.52. You might call this one the "Citigroup clause," not to be confused with Santa Claus.)

The convertible preferred stock will have no voting rights. This is hardly surprising, given that the whole point of the exercise is to avoid government control. But it's by no means necessary. For example, VC firms always get voting rights for their convertible preferred shares.

There are some very clever people in Treasury these days.

Kidnapping Chrysler

2009-02-18T16:47:05Z

In this brief interval before the new housing plan is announced, I'll try to sneak in a comment on the auto bailout, and the plans submitted by GM and Chrysler yesterday. This may be an obvious question that many people have thought about, and got some discussion in December, but: Why does Cerberus (the private equity firm that owns Chrysler) need money from the government?

Let's take this step by step. Assume GM has a viable restructing plan, but it needs $30 billion to execute the plan, after which it will be a viable standalone business. Even on that assumption, given market conditions, they would be unlikely to be able to sell $30 billion in newly-issued stock or raise $30 billion through bonds or loans, because of information asymmetry: put simply, no one would believe them. Therefore, they can only get the money from the government, because the government is the one institution that will provide a below-market loan because of the public interest (saving the auto industry and either hundreds of thousands or millions of jobs, depending on whom you believe).

Now, with Chrysler, which is asking for $5.3 billion in new loans (on top of the $4.3 billion already committed, and in addition to another $6.0 billion from the Department of Energy's alternative energy funding program - see page 16), there is a difference: The people writing the plan and the people who could provide the money are the same people, since Chrysler is majority-owned by Cerberus, so there is no information asymmetry.

]]> Let's provide a comparison. If Chrysler were a Silicon Valley, venture capital-funded startup that needed cash, and had a viable plan, the VCs would simply invest more money, effectively diluting themselves (and the founders). If the Cerberus overlords really believe the plan that their underlings mailed in yesterday, why not put in the money themselves? And even if they don't want to put in additional equity like a VC would, why not loan the money to Chrysler and keep the interest payments themselves instead of sending them to Washington - and avoid the oversight that comes with government money? (In the proposal, Cerberus does offer to exchange their $2 billion loan to Chrysler for equity; but this just shows that they don't expect to get the full $2 billion back. More tellingly, they are not offering to send good money after bad; they are not even offering to contribute some new cash, leveraged with a loan, which is the classical private equity model.)

Cerberus's stated reason in December for not putting in more money was that this would violate their fiduciary duty to their limited partners. This looks to me like an admission that putting more money into Chrysler is a bad investment, but if someone knows more about this argument, let me know.

There are two other plausible reasons why Cerberus would prefer to go to the government. The first is if they can get cheaper capital (a lower-interest loan) from the government than from their limited partners or from the capital markets. But then the question becomes why the government should be in the business of giving cheap capital to a private equity firm that has other sources of capital.

The other possibility is that Cerberus/Chrysler doesn't actually believe the plan, and that's why Cerberus doesn't want to put in the money. The plan is a Hail Mary strategy that might work, but the chances of it working aren't good enough to put in their own money; but if they can get free money from the government (free in the sense that if Chrysler collapses, Cerberus won't have to repay the government), they might as well give it a shot. This is the implication of page 13 of the Chrysler proposal:

If Chrysler is unable to restructure its liabilities and if further government funding is not forthcoming, the "Orderly Wind Down" alternative would be pursued, however it may have severe social and economic consequences for both Chrysler and the broader U.S. economy

This sounds like an admission that they are willing to attempt the plan with government money, but not their own money.

However, we can't reliably infer what Cerberus really believes from their behavior, because even if they were willing to put in their own money, they wouldn't say so until after the government turned them down. You've probably heard this bank bailout analogy: The banker walks into the Oval Office, puts a gun to his head, and threatens to blow his brains out unless he gets a bailout; the government bails him out because they don't want to have to clean the carpet. The difference here is that no one cares about Cerberus (the three-headed dog that guards the entrance to the underworld), so instead he dragged a hostage named Chrysler into the Oval Office and put the gun to her head. In the end, this feels like a kidnapping, where Cerberus is betting that the Obama Administration won't be willing to take any risks with the hostage's life.

(Of course, American oligarchs don't use guns; they use lobbying. Which is why John Snow is still chairman of Cerberus despite overseeing this catastrophic bet on the auto industry.)

So Now We Know . . .

2009-02-10T14:45:31Z

Counting down to the announcement of the Geithner plan, the New York Times has this account of how it came into being (and why it should be called the "Geithner plan," although maybe Larry Summers is hiding behind him):

In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.

Mr. Geithner, who will announce the broad outlines of the plan on Tuesday morning, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.

I'm not a huge fan of executive compensation caps, as I think they are something of a sideshow. But I think the general approach of playing nice with banks and their shareholders is a mistake, because it leads to intransparent subsidies like the privately-financed bad bank is sure to be. (If the government is guaranteeing assets bought by private investors, as is widely rumored, it's still a subsidy; it's just not as obvious as writing a check.)

]]> The most important thing in the bank rescue plan should be cleaning up their balance sheets to the point where even in a worst-case scenario we don't need to worry about bank solvency (at least for those banks that are left standing by the rescue). If the government announced, "we will buy any assets you want to sell, at their current book values," this would be a massive subsidy worth hundreds of billions of dollars (and requiring trillions of dollars in initial outlays), but it would at least restore confidence in the banks. If the government announced, "we are taking over Citigroup, Bank of America, and JPMorgan because they are insolvent, and we will write down their questionable assets to nothing, recapitalize them, and later reprivatize them," this would also restore confidence, although it would unleash a flood of litigation and political attacks against the government for engaging in "socialism." But if instead you try to split the difference, avoid too much government involvement, and pretend you are not subsidizing the banks, you end up coming up with these too-clever-by-half subsidies that you are trying to hide from Congress and the public, and no one can be confident that they will work.

It's possible that the "uniform stress test" will be rigorous enough to weed out and either close or recapitalize all those banks that may become insolvent in a severe recession. And it's possible that the government guarantees will be generous enough to bring in enough private capital to buy up enough toxic assets to make bank balance sheets trustworthy enough. So it will take a few months to learn if the plan will work.

Searching for a Free Lunch

2009-02-04T14:08:55Z

I don't envy President Obama's economic team. When it comes to fixing our banking system, there is no easy solution.

I've been sick the past few days, but someone pointed out this article in The New York Times a few days ago that has a concrete illustration of the problem: a bond that an unnamed bank is holding on its books at 97 cents, but that S&P thinks is worth 87 cents (based on current loan-default assumptions), and could fall to 53 cents under a more negative scenario . . . and that is currently trading at 38 cents. Assume for the sake of argument that all of our major banks are insolvent if they have to mark these assets down to market value. The crux of the issue is that any scheme in which the banks receive more than market value is a gift from taxpayers to bank shareholders, and any scheme in which they are forced to take market value is one that the banks will not participate in. Let's look at a few possibilities:

]]>

The government forces banks to write down their assets to reflect worst-case scenarios (unless they do this, no one will have confidence that the asset values won't fall further), and then recapitalizes them to make them solvent. This is a desirable outcome, but bank shareholders won't go for it because they will be mostly wiped out. This is roughly what Sweden did with two banks, but Sweden nationalized them first, so the shareholders didn't matter.

The government creates an aggregator bank to buy up toxic assets. If the aggregator pays market value, no bank will sell; if it pays above market value, it's a gift. The current idea I've heard is that the aggregator will only buy assets that have already been significantly marked down, but that doesn't really help the banks any.

Another idea is having the government guarantee toxic assets, as it did for Citigroup and Bank of America so far. But this doesn't solve the problem. There is already a market to insure toxic assets - it's called the credit default swap market. If the government provides insurance at existing market prices, no bank will buy it, because the cost of the insurance would make it insolvent. If the government provides cut-rate insurance, as it almost certainly did for Citi and B of A, then it is a gift. The only "benefits" of an insurance arrangement are: (a) it's much less obvious that the government is giving bank shareholders a gift; and (b) the way Citi and B of A were structured, it wouldn't require a lot of cash from Treasury (and hence from Congress), because most of the guarantee was provided by the Fed.

Meredith Whitney thinks that the banks should sell their "crown jewel" assets - presumably, businesses they have that are still in good shape - to private equity firms, and use the cash to repair their balance sheets. This would be a nice solution, but I don't foresee it happening. Given the choice between selling the good operations and being left with barely-solvent portfolios of runoff businesses, or holding onto the good operations and hoping for a government bailout, I think all the Wall Street CEOs are betting on the latter.

I think there are two possible outcomes to all of this: (1) the government makes a gift to bank shareholders and justifies it on the grounds that there was no other choice; or (2) the government forces the banks to sell assets at market value and accept a government recapitalization program - either by exercising its regulatory authority (similar to an FDIC takeover) or by just buying out all the common shareholders at their current low prices (either one of which would lead to a flood of litigation). In option (2), the government would then re-privatize the banks at some point. But there's no easy solution.

Long-Term Returns to Stimulus: Education

2009-01-29T13:50:55Z

The fiscal stimulus debate is currently hampered by confusion over its objectives. On the one hand, one purpose of the stimulus is to generate economic activity quickly in order to boost aggregate demand and break the recessionary spiral we seem to be in. On the other hand, people rightly worry about the capacity of the government to spend large amounts of money quickly without wasting it, and argue that the money should be put to productive use, rather than paying people to dig holes and then fill them in again. (This is why you see (at least) two versions of criticism of the stimulus plan: on the one hand, the criticism is that the government is incapable of putting money to productive use; on the other hand, the criticism is that money for things like electronic health records will not be spent in time to have a short-term effect.)

My opinion is that both are valid purposes. There probably is a limit to the number of tens of billions of dollars the government can spend next month without wasting some of it. But given the projected duration of the output gap (the difference between potential and actual GDP, meaning that the economy is performing below its full-employment capacity), I think there is also value in programs that take several quarters to disburse their money - as long as those programs are also good investments.

]]> One major area of spending is education, where the plan includes more than $150 billion in new spending over two years. While politicians (and economists) reflexively cite education as an area where investments can have positive long-term returns (through increases in productivity which increase GDP and our average standard of living), I wanted to see what empirical research there has been on this topic. There has been a lot of research on the impact on individuals' earnings of additional education (this is a common example used in first-year statistics classes), but somewhat less on the impact on national economic growth.

Two leading researchers in the economics of education are Claudia Goldin and Lawrence Katz. I looked through their papers, and the simplest one I found that covers this topic directly is "The Legacy of U.S. Educational Leadership: Notes on Distribution and Economic Growth in the Twentieth Century." This paper discusses the United States' educational lead over other countries in the 20th century and the impact it had on the U.S. economic growth. The main difference between the U.S. and Europe was not elite education, but the development of mass secondary education between World Wars I and II: as the economy became more technologically sophisticated, there was greater need for an educated workforce, including in production jobs.

Many studies have found that countries with more educated labor forces experience higher rates of economic growth. More difficult to determine is the extent to which the positive relationship between education and growth results from the causal impact of education on growth and not from reverse causation or from confounding factors correlated with both education and growth. Educational advance can contribute directly to economic growth by increasing the human capital and thus the productivity of the work force, and indirectly by increasing the rate of innovation and adoption of new technologies.

They addressed only the first effect: the impact of higher productivity. The results:

The direct impact on economic growth of the expanding education of the work force was about 0.37 percent per year . . . since 1915, and the educational factor accounts for 23 percent of the 1.62 percent per year increase in U.S. labor productivity (non-farm, non-housing business GDP per worker for 1913 to 1996 . . .).

In other words, 23% of productivity growth in the last century was due to increased education. In other studies, they discuss the decline in the rate of educational growth (the average educational level of the workforce) that has set in since 1980. If increased spending on education can reverse that decline (a big if, I know), then it could have a significant impact on productivity for decades to come.

I know this is a very controversial topic. For an opposing viewpoint, Arnold Kling says (referring to Goldin and Kaz's new book) that what's really at work there is that the average educational level can't keep growing at its earlier pace, since the current level is higher than the former level, and it just isn't possible to dramatically increase college attendance and graduation rates."

If readers know of other more recent, or contradictory, studies on the relationship between education and economic growth, please share.

The Speech I Want to Hear

2009-01-19T03:52:53Z

Many people have many expectations for Barack Obama. Although I generally write about economics, the issue I am most interested in hearing about from the new president is torture. And this is the speech that I want to hear him give:

Our nation today faces the most serious set of challenges it has faced in several decades. We are in the midst of a financial and economic crisis that has already cost millions of people their jobs and threatens the livelihoods of tens of millions more. We are fighting two wars thousands of miles away, with a military that is strained from over seven years of heroic efforts. We still face the constant threat of attack from terrorists who want to destroy our society and our way of life every bit as much as they did in September 2001. And on top of this, we face the long-term threats of global warming and maintaining the promise of financial security for an ever-growing population of retirees.]]> My most important job, and the most important job of everyone in my administration, is to overcome these challenges: to restore our economy to continued and sustainable prosperity, to bring the wars in Iraq and Afghanistan to a successful conclusion, and to protect our country from the threat of attack. This will require a tremendous amount of work, focus, and dedication from my administration and from the Congress.

In this time of pressing national emergency, some have argued that we cannot afford to look backward, to investigate every allegation that has been raised about the previous eight years in Washington. And I agree that not every subject of political controversy should be made into a special investigation, especially at this time when we need unity of purpose more than ever. As a result, there may be some questions to which we will not find the answers, or that must be left to historians.

However, there is one question that I do believe it is my moral duty, my constitutional duty, and my duty as the Commander in Chief of the armed forces to ask: How did the United States come to be a country that tortures people?

It is clear to me that we have committed torture. Waterboarding, a practice that we have admitted performing on people in our power, is torture. And we cannot say that torture was committed by "a few rotten apples." It was committed on the orders of the United States government, and in the name of the American people. There is abundant evidence - including admissions by many of the people involved - that policies authorizing torture were formulated by senior government officials and given legal cover by opinions written in the Department of Justice.

Torture is a clear violation of United States law. Torture by the United States provides cover and justification to other regimes who torture their internal enemies. It reduces our moral standing in the world and weakens our ability to encourage other countries to act in our interests. And it places our own military personnel in jeopardy of themselves being tortured by our enemies abroad.

It is not enough to merely assert that "the United States does not torture people." And it is not enough for me to say, as I say now, that we will not torture people so long as I am president. We have tortured people, and to deny it would be to compound our past contempt for the law with contempt for the truth. Instead, we owe it to our victims, to our allies, and to ourselves to identify and explain how we became a nation that tortures people, both so we can hold ourselves accountable, and also so we can hope to avoid torturing people in the future.

Therefore, I will be appointing a bipartisan panel of civilian and military officials to open an investigation into the origins and development of our policies that resulted in torture. I am not interested in which CIA agents or military interrogators may have tortured individual suspects, but in how a set of governmental policies that authorized such practices came into being. I look forward to working with Congress to determine the makeup of this panel and the structure of the investigation. This will not initially be a criminal investigation, and any decision on whether to press criminal charges will be made only after the facts have fully come to light.

The United States claims before all else to be a country governed by the rule of law. In order to be a country governed by the rule of law, we must hold ourselves accountable when we fail to obey the rule of law. It is my hope that this investigation will be the first step toward once again living up to that ideal, and becoming an example for all people anywhere in the world.

More TARP Programs, More Policy by Deal

2009-01-12T19:59:54Z

Back on January 2, the Treasury Department announced something called the Targeted Investment Program. I missed this at the time, along with (according to a quick search - thank you Google Reader!) all of the economics blogs that I read. The press release admitted that this was a program announced after the fact to cover the second Citigroup bailout (the first was under the Capital Purchase Program, the main bank recapitalization plan). In essence, the program says that if Treasury thinks a financial institution is at risk of a loss of confidence, Treasury can invest in it under any terms they want. This is very similar to the Systemically Significant Failing Institutions Program, also announced after the fact (in November) to cover the second AIG bailout, which reads almost identically, except instead of talking about a "loss of confidence" it takes about the "disorderly failure" of a systemically important institution.

This isn't a power grab by Treasury - they already had this power under the EESA (the main bailout bill passed in October, commonly known as TARP). And I happen to agree that if a systemically significant institution - the kind that whose failure would have a major impact on countless other institutions - is going to fail, it should be bailed out. However, I think these programs have two major failings.

]]> First, they do only the vaguest job of specifying what types of institutions will be bailed out, making it difficult to predict when the government will step in. Shouldn't the government be able to figure out at this point which institutions are systemically significant, and say what they are instead of periodically relaxing the criteria to let in, say, GMAC? Second, and more importantly, they are completely vague on the terms of such a bailout (as opposed to the Capital Purchase Program, which has predefined terms that happen to be quite generous to participants). This is a problem because of the incentives it creates. If you are a shareholder in a bank that may be in trouble, you cannot be sure whether or not it will qualify for a bailout. And if you happen to run a bank that may be in trouble, you know that if push comes to shove, you can negotiate a deal with Treasury at the last minute by threatening to blow your brains out on their nice carpet.

This is a case where it would be good for Treasury to tie its hands in advance by predefining the terms of a rescue operation (say, type of asset invested in, warrant amount, strike price, governance, executive compensation restrictions, etc.). First of all, it would enable public debate over the terms, instead of the usual second-guessing on Monday morning when Treasury announces the deal it struck on Sunday evening "before the Asian markets open." Second, it allows Treasury to say, "This is the only deal on the table. Take it or leave it." It is a commonplace in negotiations that you are better off if you can credibly claim that your hands are tied, because this gives you a valid reason why you simply cannot concede to your counterparty's requests.

The counterargument will be that each failing institution is different and the rescue has to be tailored to its situation. But I don't really buy this. The predefined plan could be, to take a simple example, that Treasury will buy as much common stock as is needed to inject the required capital, at a 10% discount to the price on at the previous market close. No matter how much capital a bank needs in a pinch, it can get it under those terms - but the more capital, the more the existing shareholders get diluted, which is exactly as it should be. This plan should have relatively harsh terms; the Capital Purchase Program is the one with easy terms that banks turn to first. Even these terms are better for shareholders than bankruptcy, which means that the bank's board of directors has a fiduciary obligation to take them if they can't find private capital and the only alternative is bankruptcy. This is obviously just a simplistic example (maybe convertible preferred stock would be better than common), but I don't see why certain ground rules like this can't be defined in advance.

Paulson v. Buffett

2009-01-09T05:37:14Z

Bloomberg has a new story out comparing the investment terms achieved by TARP with those achieved by Warren Buffett when he invested $5 billion in Goldman back in September. The results aren't pretty for the U.S. taxpayer: the government received warrants worth $13.8 billion in connection with its 25 largest equity injections; under the terms Buffett got from Goldman, those warrants would be worth $130.8 billion. (The calculations were done using the Black-Scholes option pricing formula, which has its critics, but which I think is still a good way of estimating the relative difference between similar options.) That's on top of the fact that TARP is getting a lower interest rate (5%) on its preferred stock investments than is Buffett (10%), which costs taxpayers $48 billion in aggregate over 5 years, according to Bloomberg. The difference in the value of the warrants themselves is due to two factors: (1) Treasury got warrants for a much smaller percentage of the initial investment amount; and (2) those warrants are at a higher strike price - the average price over the 20 days prior to investment, while Buffett got a discount to market price on the date of investment.

The comparison isn't a new one - we recommended that TARP emulate Buffett back in October - but Bloomberg's analysis has put the performance gap in striking perspective. Simon has a quote in the article, using the word "egregious," but the really harsh words came from Nobel prize-winner economist Joseph Stiglitz, who said, "Paulson said he had to make it attractive to banks, which is code for 'I'm going to give money away,'" and "If Paulson was still an employee of Goldman Sachs and he'd done this deal, he would have been fired."

]]> Now, to be fair, there are some plausible defenses of TARP. One is that on that fateful October day when Henry Paulson summoned the CEOs of nine major banks to Washington, he needed all of them to accept the deal on the spot, so the terms could not be too punitive. While that may be the case, it doesn't explain why bailouts since then have to be equally generous (since the program is optional, after all) - culminating in the GMAC bailout, where the "warrant" is just the option for the government to lend $250 million more at a slightly higher interest rate. Another defense I have heard is that the plan needed to leave the banks in a situation where they could attract private capital. I have only limited sympathy for this defense, because it's not as if private equity funds are lining up to invest in Citigroup (or any other major bank), even after two rounds of generous bailouts. Finally, there is the oft-repeated mantra that the country doesn't want the government to nationalize banks, and larger warrants would lead to effective government ownership. Here, I think that the clever minds in Washington could come up with a trust-like structure to shield day-to-day operations from too much government meddling (some oversight is arguably a good thing anyway), and a concrete plan for divesting those ownership stakes would go a long way to defusing any worries about creeping socialism.

On balance, I think it's hard to argue that TARP needed to be as generous to banks and their shareholders as it has been. Broadly speaking, TARP recipients have fallen into two categories: those who didn't need the capital but took it because the terms were good, and those who really needed it (like GMAC). If the terms were tougher, the former might not have taken them, but that would be fine; the latter still would have taken the money, because the government was the only place they could get it.

So the question remains: why did Henry Paulson, former CEO of the most respected investment bank on the planet, strike such bad deals for the American taxpayer? I don't know the man, but I strongly doubt that it was because of any conscious desire to enrich his colleagues. More likely, I suspect it was an unconcious product of the conventional wisdom, so strongly rooted these last twenty years, that government involvement is bad and should be minimized at all costs - even to the point of avoiding any possibility that the taxpayer might make money in dealings with private-company shareholders.