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Reacting to the Spending Spree
Policy Changes We Can Afford
By Terry L. Anderson, Richard Sousa
Hoover Institution PressCopyright © 2009 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
Wrong Incentives from Financial System Fixes
Stephen H. Haber and F. Scott Kieff
Few doubt the seriousness of the recent crisis afflicting the financial systems of the United States and the world. Few claim that nothing needs to be fixed. And few have missed the major debates about what types of solutions are best — often conducted at high volume, intensity, and frequency. So rather than try to add to one side or the other of the well-rehearsed arguments about each type of proposed reform, we try to refocus the analysis on some core incentives: when the basic rules of the game are changing, property rights and the rule of law are too ill-defined, creating exactly the wrong incentives for investment and economic growth. The wrong incentives created by repeated surges of bold government action pose risks that have direct, short-term impacts, which we fear have been seriously underexplored during both the end of the Bush administration and the beginning of the Obama administration. We hope that, by pointing out these risks, they can be significantly mitigated at relatively low cost.
We begin by recommending a change to the general approach: halt soon the introduction of new, bold programs. We are not saying that nothing should be done; we are saying that it is important in times like these for government to reach closure on its decisions so that it can pick one set of rules of the game and then stick to them. We then focus more narrowly on the process of structuring workouts from bad deals and recommend avoiding approaches that undermine bankruptcy. Bankruptcy allows the large group of private professionals who are experts at restructuring or winding up bad deals — consultants, financiers, lawyers, managers, and so on — to get involved. Given the magnitude of the problem of toxic assets, any solution to the current crisis will almost certainly need to involve these private actors. We then explore how particular reform proposals can be implemented without running afoul of the cautions that are the focus of our effort. In the final analysis, we applaud the Herculean efforts by so many serious thinkers in the Bush and Obama administrations and outside government who have thrown themselves into this important work in good faith and with great sacrifice. All we can hope to add to the conversation are these relatively easy-to-deploy (and important to deploy quickly) tools for mitigating some vital but underappreciated risks with proposed financial system fixes.
REVIEWING PRESENT APPROACHES
Four broad categories of approaches to solving the present crisis have been either tried or proposed by the administrations of both Bush and Obama, as well as by other countries facing similar problems today and in the past:
1. Let the markets and courts work it out, using institutions such as foreclosure and bankruptcy directly or as a backdrop.
2. Have the government take over the banks and nationalize them, taking control rights as well as cash flow rights. The government then cleans the balance sheets by selling off toxic assets, and re-privatizes the banks.
3. Have the government recapitalize the banks by injecting cash in exchange for preferred shares that have cash flow rights but not formal control rights.
4. Have the government buy up the toxic assets in a special bank or institution created for that purpose, leaving control rights and cash flow rights in the hands of shareholders.
Most government rescue programs, including the one announced in March by Treasury Secretary Geithner are hybrids of at least two of these four broad strategies. While each strategy has advantages and disadvantages, the second and fourth require the government to act directly on markets as a buyer, seller, or manager of assets or firms. Strategies two, three, and four also have an indirect effect on markets in that the government is changing the underlying rules of the game by changing various laws, regulations, or norms of practice. Which solution societies arrive at depends on their political institutions. In the U.S. case, the problem facing political decision makers is as follows:
If they let the markets and courts work it out, in time banks and other financial intermediaries will foreclose on properties and those foreclosed properties will be sold on markets. The problem is that this solution involves a lot of pain for two groups: bank shareholders (who have to write down their capital) and voters (who have to sit by while they are either forced out of their houses or watch the market value of their homes plummet). Another risk is that a change in the underlying psychology of consumers will develop a logic all its own, resulting in a long-term recession much like the one Japan suffered in the 1990s. This solution is therefore not politically acceptable — at least not to a government that wants to get elected again.
The political dangers in having the government nationalize the banks (strategy two) are several. First, the government can be accused of socialism. Second, it is not clear that the government actually has the statutory authority to nationalize banks or that it can develop enough political support to make a fundamentalchange in that statutory authority. Third, if the plan winds up costing taxpayers trillions of dollars, the government will be the only one to blame.
For option three, the buying of preferred shares, there await two horns of a dilemma. On the one side lies the appearance that the government has simply given away too much money while failing to take control away from those seen as having contributed to the underlying problem. On the other sides lies the reality that the government actually is taking a great deal of control, which is one reason some banks have tried desperately to return the money they received through the TARP program created by former Treasury Secretary Paulson. Although the preferred stock may not convey control rights as a formal matter, the ability to grant or withhold future cash injections conveys a great deal of control. Control also is wielded by the ongoing threat of shut down or other unfavorable action in response to regulatory reviews like the stress tests, or by the ongoing threat that any member of a bank's leadership or rank and file can be publicly called to the carpet regarding their compensation package.
There is also a political and economic danger to solution four, the government buying the toxic assets via an institution especially created for that purpose. The basic problem is that the government will inevitably pay more for the assets than their market value, for at least two reasons. First, the owners of the assets (the banks) know the quality of the assets better than the government. Second, the government will have an incentive to pay a price as close to that demanded by the bankers because, to the degree that the government pays less than the book value, it will require the banks to write down capital, in turn leaving the banks undercapitalized when the process is done. This may mean, in turn, that the government would have to undertake yet another rescue plan: to recapitalize the banks by buying more shares.
Treasury Secretary Paulson's solution was number four, which was politically viable for only three days. Treasury Secretary Geithner's plan is a combination of solutions one and four, but the government has already deployed solution three via the TARP program. The end result is a curious hybrid. The government tries to bring private market actors into the solution by giving investors the opportunity to buy toxic assets. At the same time, most of the financing for these transactions comes from the government, via an equity match from the Treasury and via a loan from the FDIC. Private actors bear some risk because they must put up part of the capital and must service a loan from the government to cover much of the rest, but they have the option of walking away from bad assets because the loans are nonrecourse (they are collateralized only by the assets being purchased). The government has also, however, taken preferred stock ownership stakes in the banks, via the TARP program.
In short, there are a lot of moving parts to the government's approach. Not only can they work at cross purposes to one another, but the high degree of ambiguity about whether the next government action will target any particular margin creates a huge disincentive among market actors to invest in any particular direction.
A related concern with this hybrid set of strategies is that they are so inherently burdened by the huge risks of the government paying either too much or too little that they lead to the government implementing its goals through a protracted series of moves. As discussed more fully below, we think that whatever benefits may come from getting the approach exactly right through careful titration are eclipsed by the risks of multiple rounds of bold actions.
The bottom line is that at least two key unintended consequences follow when market actors come to expect that the government will continue to change the institutions in an open-ended way. The first is that the belief the government will step in again in the future encourages moral hazard: private actors may take too much risk, expecting to be bailed out in a future round of government action. The second is that the belief the government will step in later may discourage private market actors from acting now, considering it prudent to wait until the government provides an even more attractive program.
We think it can be fine for the government to focus on approaches that facilitate coordination among private actors as the direct, first-order effect, so long as it avoids approaches that will require further qualitative shifts of the type that would cause overall uncertainty about what the rules of the game will be. Although the uncertainty created by successive deployment of bold moves may technically be a second-order effect in that it is indirect, it is far too big to be ignored.
THE IMPORTANCE OF FINAL MOVES TO STIMULATING REGROWTH
Showing their determination to address the present crisis, President Obama, Treasury Secretary Geithner, and Federal Reserve Chairman Bernanke have each proclaimed on several occasions, including as recently as early March, that they will take whatever steps are needed to help resolve the economic crisis. The message is in part constructive in providing a calming effect on anxious people in their roles as both citizens and market actors. But the message also is in part destructive, especially against a backdrop of several months of bold moves, going back to Paulson's original plan of direct government purchase of toxic assets in that it strongly suggests that each round of moves is not the last.
This is a serious problem because when market actors think that further significant changes are coming, they find it difficult to engage in the commercial activity our economy needs for recovery. A great deal of wealth still exists throughout the economy, in the form of labor, money, tangible assets such as factories, equipment, inventory, and real estate, and intangible assets such as securities, commercial paper, skills, and intellectual property. Further economic activity requires that these wealth components be put to work: that they be exchanged with one another through new commercial activity. But many of those assets are waiting on the sidelines. Many others are tied down in existing transactions that are not doing well at the moment; but in order for them to be redeployed, their deals must be unwound.
In normal times, deals are routinely made and modified to meet the changing needs of the private actors involved in them, who are remarkably adept at integrating new information and preferences into deals when they can predict what the basic rules of the game are likely to be. But bold government actions — and the expectation of more such actions in the future — are game-changing events. Some of these changes are the direct consequence of new laws and regulations; others are a bit more subtle. When the government spends vast sums of money on emergency programs, it has a huge impact in the short run on relative costs for taking particular risks and opportunities and, in the slightly longer run, on expectations about tax rates, inflation, and the scope of government in the future. The problem is that private actors have a difficult time taking the actions we need now when they think the rules of the game — the laws, regulations, and contracting environment — are likely to change in big ways. Such a paralysis affects those holding assets that are ready to be deployed as well as those who own assets tied up in bad deals.
Consider those who are holding assets that are ready to be deployed. When facing the possibility of significant changes in tax rates, enforceability of contracts, and available subsidies that the government is presently employing and considering, every market actor risks feeling like a patsy for diving into deals too soon to successfully operate under the new rules. It might seem that the government could employ the normal tools that private actors use in deals to mitigate the anxieties of those among their counterparties who are early movers, such as committing to what deal-makers call "most favored nation clauses," and the like. When a seller uses a clause like this in a contract with a first buyer, the seller is constraining herself not to contract with any other buyer at a lower price without also giving the first buyer that same low price. But the government can't make such commitments about its present emergency financial actions for at least three reasons. First, it would be difficult to figure out what commensurabilities, if any, exist across the various programs on offer, which means it would be almost impossible to determine whether everyone were being given the same or a different deal. Second, even if the exchange rates among such programs were determined, each program would then have to be as expensive as the others, making their aggregate cost enormous. Third, it is not clear that any market actor would bank heavily on a government commitment to equal treatment, especially against the backdrop of rapidly changing behavior. After witnessing Lehman Bros. not receiving the same bailout as AIG, one would expect treatment to vary, not to hold constant.
A somewhat different set of problems faces those presently in bad deals that must get unwound. Ironically, the expectation of changes to the rules of the game causes strategic paralysis in any party who thinks she or he is suffering particular economic trauma from her present deal. In normal times, those involved in bad deals have strong reasons to cut their losses and get out. But as new bailouts, tax breaks, insurance, and other tools designed to mitigate financial trauma are rolled out, those facing such trauma have large incentives to stay in, hoping that if the mere passage of time won't bring a particular fix their way, then further trauma might.
Although all of the above argue that government leaders should wrap up their actions sooner rather than later, we recognize that there are important reasons for not doing so too soon. In some cases, leaders may have wanted more internal vetting; in others they may have wanted to test the applications of their actions; and in others they may have figured that beginning with low amounts would avoid overpayments. We are not trying to fault our leaders for taking such concerns seriously.
What we are trying to emphasize here is that political leaders must not overlook, especially now, after several rounds of action, that the benefits generated from those actions must be weighed against the too often underexplored costs of having the market think our leaders are likely to act further. Our leadership must bake into their thinking the importance of credibly committing themselves to stop making further game-changing moves and then signal that to the market so as to induce private actors to move much faster in unwinding their bad deals and in forging new ones.
IMPRUDENTLY TOLLING THE DEATH OF BANKRUPTCY
The problems of bad deals are particularly acute during difficult times like these. A great number of ongoing deals have turned out badly, as they either contributed to the downturn or were a result of it. Despite ongoing debates about the direction of causation, assigning blame may be less important to the economy as a whole than the need to simply ensure that the resources tied up in these deals are quickly put to higher and better uses. In addition, the problems of bad deals will not go away. When new ventures are launched, especially in such times of uncharted conditions, a great number will fail, and the rules of the game must be structured so as not to leave those assets sidelined and unable to contribute to economic recovery.
Now, and for the foreseeable future, our society has a particularly acute need for dealing well with failure. Professionals who are highly trained, experienced, and skilled, who are particularly adept at swooping into a failing or failed enterprise to turn things around or at least wind things up most productively would do just the trick. Specialized legal rules and organizations would provide the essential frameworks. The fortunate news is that our society has done a great job in building both the professionals themselves as well as the legal system associated with bankruptcy practice. The unfortunate news is that so many of the present approaches to emergency action may be tolling their death knell.
Excerpted from Reacting to the Spending Spree by Terry L. Anderson, Richard Sousa. Copyright © 2009 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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