In a season of low value-add arguments, the man who dished worthless advice four-and-a-half months ago is being fêted across the globe today.
The financial system has a new icon, the US Treasury Secretary (USTS, to add to the alphabet soup); he is already on the cover of Newsweek and has been anointed the most powerful person in the US. Here is a sample of what he said in early May (four-and-a-half months back), according to agency reports:
About the only gauge that may have allowed him, I presume, to say the above was the movement of equity markets between March and May. Most indicators of core economic health pointed to serious macroeconomic challenges.
Fast forward to this week’s testimony on Capitol Hill where the USTS put down a marker that if a $700 billion “troubled asset relief programme” — christened Toxic Asset Dump (TAD) by Willem Buiter — is not approved within days, he foresaw calamitous economic outcomes; in other words, the same imaginative chaps who got us in this mess (while important economic arms of the US government were dozing) now have to be revived so that they can continue to play their rightful role in saving jobs and kickstarting a stalled US economy (akin to allowing serial drunks to drive again). The USTS said words to this effect to almost every query raised by US legislators; he also said that this was the only plan on the table when asked about alternatives that may be considered. Finally, the $700 billion buy-back should not be open to legal review. A day later, the USTS’s boss, the US President, warned Americans of a long and painful recession. The familiar stuff of heroes!
If the proposed relief facility is for buttressing the global financial architecture, then the money is unlikely to be enough. Nouriel Roubini, who has been prescient time and again as the sector unravelled, suggests that much more may be needed to buy all the dodgy debt out there ($2 trillion of it) if that is the objective, and someone else has remarked that a $5 trillion international facility may have to be contemplated. While interconnectedness has been identified as the catalytic driver for the credit gridlock, the interventions thus far, for the most part, suggest lack of hard data at the institution level regarding the toxic assets and relevant counterparties, which is why Lehman was allowed to bite the bullet and a panic-driven bailout of AIG took place soon after — the authorities were simply surprised that an insurance company could leverage and invest in risky assets to this extent (it was news to the New York Fed!). If interconnectedness had been figured out with some confidence in the first place — and it can be argued that there was ample time — some of this could have been avoided; set-offs of bad assets among interconnected institutions and somewhat smoother deleveraging could have been envisaged (institutions are holding paper originated by each other). The unglamorous task of forensic number crunching by the Treasury and Fed seems to have been lacking.
The transmission mechanism between the financial sector and the real economy has not been adequately deconstructed to quantitatively gauge the knock-on implications of impairment in the mechanism, hence vague statements by policymakers and experts alike. It is an indictment of the economics profession that the financial “veil” around work-horse macro growth models does not go much beyond optimal debt-equity ratios for financing investment; financial accelerator models pioneered by Ben Bernanke and his coauthors are in this category (I am a fan of their work). The extant complexity in financial intermediation is virtually absent in these frameworks, presumably because the former is difficult to embed in a realistic model of the broader economy and then quantify so that it is operationally useful. Another dimension is that academic economists are somewhat sceptical of the effective (as opposed to notional) economic value of many financial sector perturbations that are bread and butter to practitioners. A reason could be that the wrinkles are essentially profitable for intermediaries that can indulge in regulatory and tax arbitrage more than anything else (hence the term shadow banking).
As is often the case, the more heated the disagreement among economists, the less there is to it in bottom line terms. A case in point is the present debate on whether the US government-sponsored TAD should be deployed, or, whether recapitalisation of individually targeted intermediaries should be the instrument to resolve the crisis. If the objective is to enhance the capital-to-risk-weighted assets ratio (CAR), than the two “instruments” on offer are not as independent as they are made out to be. While for calculating the CAR, the numerator (say, plain equity in the simplest case) and the denominator (comprising of risk-weighted loans and investments) may be considered independent, behaviourally they are related; this much has been obvious in recent months. As the denominator of the CAR of individual intermediaries (comprising of both toxic investments and good assets) has plunged in terms of fair, or, exit value, the numerator (market-determined price of the equity) has also dropped. In fact, the elasticity of the numerator with respect to the denominator has been large (in excess of one), hence the CAR of intermediaries has deteriorated in analysts’ models. The “bad assets” carve-out proposal seeks to stem the negative valuation of equity capital (“elasticity”) spiral by taking away the poor quality assets from the denominator; on the other hand, the recapitalisation proposal seeks to infuse the numerator of the CAR with fresh capital. In both cases the CAR should increase. Given the moral hazard that has already swamped the financial system, quibbling about the relative merits of a carve-out or recapitalisation in terms of preserving incentives (doesn’t it sound hollow?) is neither here nor there, except for scoring theoretical points rather late in the day.
