Tuesday, March 24, 2009

What Would Occam Do?

If the Tick were asked to comment on the toxic asset repurchase, he would probably say something like this, "For those of you who aren't paying attention, we residents and citizens of the U.S. are about to make a big doo-doo in our diaper of finance."

I understand why injecting liquidity via "toxic asset" purchase may be beneficial. However I anticipate a very large cost of administration and foresee great waste and large missteps in execution.

I believe that there is a much more elegant solution to the banking liquidity crisis. We should temporarily reduce the required reserve ratio, and allow it to slowly climb back over a 3-5 year period.

I believe that India took similar steps last year, to positive effect. This solution immediately adds liquidity. It would cost nothing to taxpayers. It would aid all banks in a fair way, and would not require politicians or bureaucrats to make high-stakes decisions that they did not understand.

For those of you who don't know me, here is a quick background. I am an Economist by education and have worked in this capacity for the IRS, focusing on the analysis of large foreign owned corporations. I have also worked as a tax accountant, and in corporate finance. While this should not make me more qualified to have an opinion than all the "experts", apparently it does.

I would tremendously appreciate responses.


Greg said...

Your assumption seems to be that freeing up credit is the solution we should be seeking. Yes, a reduction in required reserves should immediately translate into more available money for banks, and the assumption is that this money will be lent.

But this is also assuming the bank is operating in the black. For any entity, a fiscal threshold exists for which any new cash will be absorbed by debt. So even if you reduce reserve requirements from the current 10 percent to zero percent, I doubt this will be enough to bring these banks out of the red. Forget about lending.

In general, I'm not a fan of the government changing the rules. This includes a proposed reserve requirement change (which we've never done to the best of my knowledge), and also changing interest rates. Politics is (supposed to be) about creating consistency, and while tempting, the government should set up the baseline numbers and not mess with them.

What is also ignored here is the fact that not all banks are in trouble. It is mostly just the large ones. The insanely large ones. Smaller banks and especially credit unions are doing fine (or at least relatively fine considering the nature of our economy).

The other problem is that even if we eliminate all problem bank obligations, we still face a consumer market that is over-extended. Let's suppose we effectively cancel these problem banks' debt, what then? Yes, jobs will probably start being created, but our economy has changed and people are making less than they previously did and will continue to do so.

So we will have a nation of service class workers trying to pay down a debt generated by production class workers. Even with all the new job creation, this will take a while and will have a similar macro-economic effect of people putting their money in savings but without any of the benefits. So this initial job creation will result in the long run in, once again, job loss.

We'll see a period of inflation (which we are starting to see now), followed by a sharp price collapse. Overall the economy will stabilize in a new less productive service based economy, and we'll spend the next few years rebuilding.

So changing reserve requirements would be a bit like digging a hole in concrete with a spoon. Yet I'm not in favor of buying toxic assets either. I've stated from the beginning that we need to allow people and corporations to fail as much as we allow them to succeed.

No matter how Democrats or Republicans try to mask their version of "the plan," there really is only one plan, and that is to clear these banks' balances sheets. The only issue of debate in D.C. currently is how to launder the money into the banks hands with the least public outrage.

The correct answer that nobody likes is that when you find yourself in a hole, you have to take as long as it takes to climb out of it. This means a long process of rebuilding. In our "we want it yesterday" society, this just doesn't fly, so we'll continue to make the same mistakes with the same people and create new economic bubbles.

The very least thing that I would like now would be for the government to make public the list of all people and/or entities who invested in AIG’s hedge fund scheme, and a list of whose toxic assets the government is buying. I have a feeling that more people or groups than simply banks are going to be benefiting at taxpayer expense.

Old-Things said...

Credit and liquidity are related, but quite different. An increase in liquidity does not equal, and does not need to result in short term credit easing, depending on other policies that are concurrently put in place.

What it will do is to remove the forced selling of underperforming and high risk assets at values below what they are worth. New lending is one thing...the level of commercial demand for existing loans is another. It is largely this lethargy in the secondary market that is slowing a recovery.

I have no hope that we will have rational policy here. The situation is highly political, and too complex for 99.9% of people to even begin to understand, yet everyone has a strong opinion.

This whole mess is a beautiful illustration of diseconomies of scale. Our big bulky sociopolitical system is fantastic at reacting reflexively, but incapable of making good policy decisions. We need to move toward aligning the game theoretic situation that individual decision makers face with that of our citizens.

Greg said...

You may have suggested another problem by pointing out a difference between liquidity and credit. Yes there is a difference, but for a commercial "lending" bank, that difference is fairly moot as lending is the central business. But for an investment bank, the difference is relevant. Our problem here is that deregulation has destroyed the forced separation between commercial and investment banks. So this makes it more difficult to speculate about what a given bank will do given any kind of stimulus.

And even if reducing reserve rates did have the results you predict, banks will still not want to hold on to depreciated assets that have no prospect of regaining even their initial value. What will happen as I stated elsewhere is that the government will end up buying these toxic assets at inflated prices and then turn around and auction them off at prices below their actual value. More than likely the same banks will buy them back. At this point these toxic assets turn to gold and their value will go up again because of the new demand for them. And so we are back where we started pre-AIG collapse.