Wednesday, March 25, 2009

Price Discovery on the Big Rock Candy Mountain

Willem Buiter nails the latest Treas/Fed PPIP proposal with his usual acuity. His analysis is spot on regarding the relevance of Akerlof’s lemons, the unwholesome mixing of bad and toxic assets, the shabbiness of the measures taken to obscure the true costs to the public, and the colossal waste of the whole enterprise in light of the far superior alternative of establishing a good, new (public) bank. I would differ only with his final sentence, which calls for tax increases and spending cuts in the teeth of an effective demand crisis.

Now three additional observations:

1. The one genuinely beneficial potential of Geithner’s public-private partnership plan is that it can generate price discovery: the market process it jumpstarts will price the toxic assets that are purchased. Buiter and other critics note that this will be a biased subset of the total—this is where Akerlof comes in. I would add one more complication. The subsidy scheme Geithner is putting in place is asymmetric: capping losses on the downside but not earnings on the up. If the subjective probability functions of investors regarding the true value of these assets is normal and reasonably compact, the subsidies will result in minimal pricing distortion. I haven’t looked at Lucian Bebchuk’s analysis (he is the intellectual godfather of this price discovery scheme), so I don’t know if he took a position on subjective probability form, but the proposal makes the most sense this way. My suspicion, however, is that fundamental uncertainty clouds the perception of what complex, toxic derivatives will ultimately be worth. If so, the distribution is neither compact nor normal. With long, fat tails the asymmetry in the payoff structure becomes crucial, and exerts strong upward bias to the resulting bids. If this is true, the prices “discovered” in this arrangement will be a poor guide to what private sector buyers are willing to offer in the absence of subsidies.

2. Much of the evasiveness of the sequential bailout schemes can be traced to a simple political-economic fact: unlike European countries, such as Sweden, whose resolute responses to earlier financial crises are held up as models for the present, the US has a legislative-executive, not a parliamentary, system. Obama’s crew does not possess a guaranteed legislative majority; it has to charm or obfuscate to win support for each new measure. This alone can explain why decisive action, like nationalization, is off the table. (Even worse, of course, is the fragmented authority of the EU, which shows us what the US would be like if we had stuck with the Articles of Confederation.)

3. In the end, even the most comprehensive, expensive program of bailouts will not put the US or global economy back on its feet. We are not building a bridge back to 2006. Financial systems everywhere and households in many countries (including ours) are massively overleveraged and will be consolidating their balance sheets for years to come. There was real misinvestment on a grand scale, encompassing not only housing (and not only in the US), but also a distribution of manufacturing capacity that depended on global imbalances persisting to eternity. The process of writing all this off will be protracted and painful. Finally, a destructive feedback loop has taken hold, in which weak economic prospects dampen investment demand, and weak investment depresses incomes. Even unfrozen banks no longer stuffed with junk will lend gingerly at best.

This is why I think a rapid shift in policy toward public banking is essential. How it can be reconciled with (2) is unclear, however. How can we get from here to there?

9 comments: said...


Yes, there is a serious political problem with the second point.

I agree that what is going to happen with these price search mechanisms is not going to come out all Pareto efficient, and may come out so weirdly and badly distorted as to lead to a real mess. There is a serious possibility that this will in fact blow up and not work at all well.

However, and once again, the not-so subtle point is that this is both a trick to get the garbage off the books of the troubled banks and also a method to inject some recapitalization funds into those banks, although it will not be labeled as such, through all these subsidies. May end up a mess, but it is not designed to be all neat and efficient.

Regarding a more idealistic outcome, also not politically likely, unless things get much worse, would be to put the big banks into receivership, break them up, and then push them towards being credit unions or some sorts of cooperatives. I have long favored cooperative and worker-managed approaches to the old fashioned centralized state socialism approach, which has had an unfortunate past, even in democratic countries.

Peter Dorman said...


Like Buiter, I think it would be much easier and more efficient to get to "good banks" by creating them from scratch rather than pruning and restructuring existing ones. And as to where to look, I think we could do a lot worse than emulate the German Sparkassen. These public banks have many of the good features of public ownership without the drawbacks of old-style state socialism. They are buttressed as well by a healthy cooperative banking sector, much bigger than ours.

Eleanor said...

Credit unions sounds lovely. said...


Yes, the Sparkassens are not bad, although they are under pressure to be privatized. For readers who do not know what these are, they are tied to the postal system, "postal savings banks." In France, they are in the PTT, Poste-Telegraphe-Telephone, portions of which have been privatized. In Russia, basically the only semi-safe and functioning bank is the Sperbank, a leftover from the Soviet era, that is not tied to postal exchange, but is modeled on the Sparkassens. In Japan, the equivalent was/is the world's largest bank, and the privatizing of it has been one of the biggest political issues in the country over the past decade, even involving a member of parliament committing seppuku at one point because he voted against the instructions of his faction boss (a reminder of that bad old joke about the Japanese Liberal Democratic Party: that it is neither liberal, nore democratic, nor a party).

The German Sparkassens have been run pretty well. But some of these others have been subject to corruption and political interference. This has long been very dramatic in the case of the Japanese bank, with it being a principal conduit for funding pork barrel projects by established LDP leaders to their local business cronies and supporters, hence the focus on privatizing it as a symbol of efforts to clean up the corrupt and stagnant political system of Japan, but with powerful forces contending, powerful enough to lead to political suicides.

Many of these postal savings banks are also where people get their old age pension checks from, with the savings in them in some countries tied up with the equivalent of the country's social security systems. I remember well during times when I was living in France going into the nearby PTT to mail something or get some stamps and seeing the retirees lined up to get their old age pension checks.

Of course, there are some other really big differences between the German and US banking systems, not necessarily all that favorable to Germany, namely the high degree of ownership and control of German companies by their banks, although the Sparkassen tend to be less directly involved in this, with something similar in Japan with the banks that are at the core of the keiretsu, which are also not the postal savings bank.

BTW, to connect up with another post indirectly, in Vienna, the main building of the Sparkassen for Austria is very famous for its architecture as an early 20th century example of the Jugendstil.

Peter Dorman said...

Barkley, your overall knowledge of the obscure corners of the world economy is unsurpassed, but I have to correct you about the Sparkassen. (This word is already plural.)

These publicly owned banks originated out of municipal initiatives, not the Post. (The Post has its own savings bank, the aptly named Postbank.) The local Sparkassen federated and eventually gave rise to the Landesbank system (banks of the federal states).

The main claim to fame of the Sparkassen is their essential support for the Mittelstand, the medium-sized firms (some of which are socially owned) that comprise the backbone of Germany's export sector. As I learned from Sigurt Vitols, Germany is not only the sole industrialized economy to be free of dualism, its SME sector is actually the leading edge.

Yes, there have been scandals from time to time at these banks; they do not deliver utopia. Nevertheless, they have largely spared Germany from the madness of the recent housing/derivatives bubble, and they enjoy widespread support across the political spectrum. The pressure for privatization has come primarily from the EU, which as you know is trying to impose an Anglo-Saxon (financial market) model of corporate governance throughout Europe under the banner of a single capital market. This project has already done considerable damage, but my guess is that one of the consequences of the current crisis is that there will be much more resistance to such efforts in the future. said...


Your point is well taken. I was wrong on some of these details.

OTOH, regarding the bottom line, the Sparkassen (plural) as you describe them do not provide evidence for having "national banks" at the national level. These were entities that grew from the ground up, municipalized and later "statized" (lander) banks.

Peter Dorman said...

You are entirely right about this, Barkley. The history of the Sparkassen tells us something about why they avoided many of the problems that plague "political" banks. A top-down process for establishing public banking would have to be done carefully to come to similar results. I feel confident saying that, properly done, public banking would be a good thing, and very appropriate to the moment, but I don't have any particular insight into how to set it up. An interesting question: who does? If you were Obama (or the proverbial all-powerful "planner"), who would you put on a team to create a template for public banking in the US, at the scale we need? said...


This may be a problem of the US being too big and with such strong private orientation. I think the best hope would be to provide more support for cooperative and credit union sorts of things. The equivalent of the German approach would be to start with banks owned by local governments, but this is very unlikely to happen, or even worse, state-owned banks.

The development in Germany reflected its political history, that many of these predated the unification of Germany and were associated with the many small and independent statelets that covered much of pre-1870 Germany. The landerization largely came after WW II, if I am not mistaken on that one.

The lander banks would later become to the Deutsches Bundesbank what the district Fed banks are to the US Federal Reserve, except that they totally ran it with no national level board of governors appointed by the Chancellor of the FRG, or whomever.

Pat Donnelly said...

The USA will get around to using new banks as they will arise once there is capital to supply them and trust in them will be greater than in the legacy banks, aka toxic banks. Sadly the saga has only just begun.
I love the distiction about the US Congress/Presidency. The USA is run on lies! Hah! So true, but this was also said about the British Empire? But of course, neither side is fooled and the media is in on it!