Two articles in the Financial Times, one a discussion of the implications of Japan’s crash for US policy, the other the latest in a series of comments on the credit crisis by Larry Summers, take different views of the best remedies for our economic woes. Unfortunately, the Japanese prescription seems likely to be necessary, yet the Summers article (and some online commentary on it) suggests the US is a long way away from embracing realistic solutions.
Note that the analogy to Japan presupposes that our mess is of a similar magnitude to theirs. A lot of experts don’t accept that, since their asset bubbles (stock market and real estate) were on paper much greater relative to the sustainable value of the underlying assets than ours.
But I am not persuaded that anyone has done the right analysis. What matters is not so much how big the market cap of the various inflated assets got to be, but how much credit was extended against them. For instance, in Japan, corporations borrowed heavily against the value of urban land (Japanese banks would lend 100% against the nominal value), but unlike the US, homeowners did not have vehicles for extracting their inflated equity, so the residential real estate bubble did not have the same systemic impact that the commercial one did. Some very simple numbers would shed light on the debate. Moreover, we have far more levearge on leverage than Japan did (geared hedge funds and investment banks owning CDOs, which themselves were sometimes leveraged; hedge funds of fund adding another layer of borrowing on top of the borrowing at the hedge fund level). The debt to GDP ratio in the US is 270%, higher than the level before the crash of 1929, when it was 250%. What was the level in Japan in 1989?
Further, I am not certain a US GDP leverage measure tells the full tale. Per the wonders of our originate-and-distribute model, US mortgage and corporate paper is in a lot of foreign hands. Similarly, some levered players in our markets don’t necessarily borrow from US concerns (think of all those London-based hedge funds, who probably borrow at least in part from foreign entities). And we also have various derivatives exposures which are not captured in any formal computations of leverage (that’s going a bit far, but not by much, since Basel II give the banks considerable latitude in how the compute the equity that needs to be held against derivatives positions).
And to what degree do we offset Japan’s very high domestic savings at the time of the crash against its bubble? Consider: even if our credit mess is on paper less bad, we aren’t in a position to resolve it internally. Our continued and not-likely-to-reverse-anytime-soon dependence on foreign capital (we had better hope it doesn’t change in the near future; the alternative is a dollar crash, which would wreak havoc here and abroad). That is a more complicated problem to parse.
Finally, the article mentions that the US does not face the risk of deflation. We are witnessing liquidity hoarding in the interbank markets. I already have economically literate readers who tell me that they are holding large cash balances at home our of fear of a bank holiday and are trying to find a bank they deem to be safe. A couple of bank failures and we could be well on the way enough withdrawals from banks to generate a money supply contraction, no matter what the Fed does with the monetary base.
That is a long-winded way of saying that the powers that be may be deriving false confidence from looking at incomplete measures of the financial service industry’s gearing.
So back to the FT. in “Japan’s ‘lost decade’ offers dire pointers for the Fed,” Gillian Tett and Krishna Guha argue that the big lesson from Japan was in the end, the government had to recapitalize the banking system and delay only made matters worse. Yet rescuing banks was highly contentious in Japan, and keep in mind that unlike here, banks were not highly profitable pre-crash and executives were not paid princely sums. In other words, they lacked the controversy of the financial services industry lining its pockets before it went belly up.
But let’s tease out the Japan hypothesis. Let’s say that, in the end, the banks will have to get a public injection of funds. What might be some implications?
First is that all these measures to shore up markets are a very indirect, inefficient, and therefore costly was to try to finesse the real problem, that a lot of institutions are or shortly will be insolvent. That says we should quit propping up the mortgage market, particularly since letting housing and mortgages find their level will entice cash on the sidelines to come in, and deal with the damage to institutions directly, It similarly suggests that we might deal with the damage to families frontally rather than by trying to prop up home prices (for instance, Dean Baker’s own to rent, which has homeowners stay in their residence as renters, is a government-mediated version of a longstanding banking practice, deed in lieu of foreclosure, where the homeowner would hand over the deed but stay in place as long as they could pay a reasonable rent, at least until the bank found a buyer. The Baker plan would give tenants somewhat stronger rights to remain if they stayed current in their lease payments. Other measures might address job or wage losses).
Second, if these institutions are insolvent, the government has no reason to be shy about nationalizing institutions, and that means wiping out the equity holders before any funds are injected. Yet people like Summers seem remarkably loath to even voice that idea, as if it were somehow anticapitalist. Huh? What is anti-capitalist is privatizing gains and socializing losses. No more free lunches for those who get salvaged by taxpayers.
We also need more serious discussion of new regulator approaches, not charades like the Paulson plan that pretends that reorganization is tantamount to a new supervisory regime. My colleague Columbia professor Amar Bhide sent an elegant recommendation that he presented last November:
Severely circumscribed ‘regulated’ institutions