March 20, 2008
Barack and the Banks
Obama’s attempt to avoid a depression is the defining venture of his administration. If he succeeds, he will be re-elected in 2012 with ease. If he fails, the Republicans will enjoy a political comeback.
There are three main challenges that Obama needs to address to avoid a depression. First, he needs to enact a large enough government stimulus to make a real difference in the larger economy. Second, he needs to take effective action to mitigate the damage that the wave of foreclosures is doing to families and to the economy. Finally, he needs to restore the soundness of the banking system. He has met the first challenge well, and is working on the second, but the third is the hardest of all to get right.
The stimulus package of 750 billion dollars seems huge in dollar terms, but as a percent of the economy it is roughly 6% of GDP over two years, which is actually rather moderate. The noted economist Paul Krugman wants an even larger stimulus. But given the politics of it all, this was about as large a stimulus as Obama could reasonably expect. For homeowners, Obama has put together a 75 billion dollar package to allow homeowners who are still somewhat capable of making payments get modified terms that will allow them to stay in their homes and avoid foreclosure.
The banks though are another problem altogether. The banks are in deep trouble because so many of their assets have lost value, mostly foreclosed properties and the mortgage backed securities that were issued based on the pooled mortgages of those property loans. This makes many of the banks in fact insolvent. By this it is meant that they owe more to their depositors than they can reasonably expect to get back from the combined sale of the distressed assets and the loans that are still current and being paid. This gap, between what the banks have in assets, and what they owe to their depositors, has grown to garguantuan proportions. Banks that are insolvent are in no position to lend normally, and so are basically “zombie banks”. Normally, when banks become insolvent, the FDIC takes them over, sells their assets and covers the depositors out of the FDIC insurance fund. But if the FDIC did that now, it might have to take over several of the largest banks in the country, including Citigroup and Bank of America, and it doesn’t have anywhere near enough money to make the depositors whole in its insurance fund.
Bush tried to fix this problem back in September by creating the TARP ( Troubled Asset Relief Program), which was originally supposed to buy distressed assets such as foreclosed homes from the banks, thereby restoring the banks to health. After a few weeks, Bush decided not to use the funds that way, but instead to give money directly to the banks to rebuild their own capital base. After spending 350 billion dollars, it was clear that the problem still remained and was barely dented.
Obviously, if we gave the banks enough money, they would eventually overcome the dead weight of the bad assets. But why should taxpayers do that, when the beneficiaries will be the owners (stockholders) of the banks and those who bought bank debt (bondholders)? The other option is for the government to declare the banks insolvent, take them over, leave the stockholders with nothing, and demand the bondholders accept some fraction of the full value of their bonds as payment. After a takeover, the government would strip out all the bad assets and put them in a special corporation to be sold for the highest value possible, while a new healthy version of the bank is returned to the private sector through an IPO, or perhaps even direct transfer of shares to each and every taxpayer. The financial hit to do this is hard to calculate. The difference between the asset base of the insolvent banks, and what the depositors would be entitled to in a takeover, may be 1-2 trillion dollars. The government would have to borrow that money, adding 10-15% of GDP to the national debt burden.
There are some who think that the banks are not in that bad a shape. That slowly, and with time, the banks can heal, with only a few hundred billion more in bailout money coming their way. This seems to be what the Obama administration is saying at present. They have repeatedly denied that they are looking to takeover the insolvent banks as the definitive solution to the banking crisis. But if they were planning to do that, they would not breathe a word about it until they were ready to act. Last week, the FDIC got borrowing authority for 500 billion dollars. The only reason it would need that size of a credit line is if it were planning a takeover of Citibank or B of A. Otherwise it has enough of its own funds to do its current task. Combined Citibank and Bank of America have 25% of the deposits of the entire American banking sector. Already the government owns 40% of Citibank. I think that Obama is positioning for a possible takeover, but until everything is ready, he has to pretend that it is business as usual. As such, he has to tell the nation that the banks canheal ontheir own, with perhaps a bit more bailout money. But if the banks don’t heal, this economy will not return to normal. Japan faced the exactly same situation in the 1990’s, and chose to allow their zombie banks to muddle along. That choice left Japan with ten long years of a flat economy, not an outcome that Americans will find acceptable. The course of the financial sector and the economy over the next 90-120 days will be critical. If the biggest banks are starting to turn things around, then Obama will be able to avoid the hefty costs of a takeover, but if they continue to spiral down, then he will have to take these extreme measures to save the economy in the long run.
One criticism of this approach, especially given the large stimulus package, is that all this deficit spending will drive up inflation. This year the deficit is supposed to come in at 13% or so of GDP. The biggest deficit of the last 50 years by comparison was about 6% in 1983, and on average they run about 3% of GDP. Add another 10-15% of GDP to fix the banks, and the total increase in debt will be massive. But it is not clear that by itself will lead to inflation. Interest rates are very low, so the government gets to borrow the money at very low interest rates. Also, we cannot have inflation when the economy is flat on its back and millions are unemployed and factories are idle. If inflation is to come back it will be after the economy recovers. But when that happens, hard policy choices will need to be made.
The Federal Reserve will need to raise interest rates rapidly and appropriately to prevent inflation. And Obama will need to throttle back sharply on deficit spending to more sustainable and normal levels. If these steps are done correctly, inflation in 2011 or 2012 will remain moderate.
Overall, the debt to GDP ratio is going to a very high level over the next 2 years, but will remain below 85%, which will not be crippling, but will mean that the government will have to work to whittle that back down to a more desirable 50% or less over the next 10-20 years.
