This Is the End


Markets, Risk and Human Interaction

January 21, 2009

Changing the Reality on the Ground: Why the Government is not Like You and Me

One of the great things about having Obama as president is that Paul Krugman will now put more focus on economics and less on polemics. I was a classmate of Paul’s at MIT, and I remember him as the most natively brilliant of all of us in terms of economics. There were others who had stronger mathematical skills or who walked in the door with more economics training, but it seemed that he was genetically wired for economics. And now that there are fewer Republicans for him to kick around, he can get focused on what he does best.

But that doesn’t mean he is always right. Well, when it comes to economics I doubt he is ever actually wrong, but he might not fit the full story within the space constraints. And this is the case with a recent column of his in the New York Times related to government bail outs. He used a fictional bank called GothamGroup – I don’t know if he had any particular bank in mind, I suppose it was based on some Batman reference – to explain how the government cannot alter the basic math of the markets. If a bank has liabilities that are greater than its assets on a mark to market basis, then the bank is effectively in default. The government cannot change that; if it does not want it to fail, then it has to give the bank enough money to push it back into solvency, which means giving the equity holders a gift at the taxpayer’s expense.

The point left unsaid is that the government, unlike you or me or some corporation, is in a position to change the reality on the ground. They can take steps to alter the nature of the markets. They can push down mortgage rates, add tax benefits for new mortgage holders, and push losses forward by forcing changes in accounting rules. They can push inflation up to make all debts lower in real terms, thereby differentially taxing the lenders to the benefit of the borrowers. They can encourage the formation of clearing corporations for swaps or other instruments, thereby improving the liquidity and credit-worthiness of those markets. They can buy up weakened assets and lock them up for as long as they want, so that no one needs to look over the shoulder and wonder if an avalanche of securities is going to sweep them away should they start to invest.

An investor may be hesitant to take on the assets that are clogging up the banks. They would have a hard time finding the capital to buy them, and they have uncertainty about the future. And they fear that once they take assets on, they may not be able to dispose of them if the economy continues its tailspin. Little capital to invest, uncertainty about the future, illiquidity: no wonder the mark to market on these assets is so low.

But not so for the government. The government has no capital constraints, no concern of being forced into liquidation, and as far as uncertainty about the future, to a large extent it creates that future. The government makes the rules; if the government were clever about it, my bet is that they could make a windfall from this mess by buying up everything in sight and then changing the market reality.