Wednesday, 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.


  1. Should they? Are there any losers if government goes into a distressed market and provides liquidity -- buying up distressed assets at prices below fair value and holding them until the market has recovered (to maturity if necessary).

    I'm no Paul Krugman, but I imagine there might be an implicit transfer from currency holders to taxpayers: Taxpayers expect to make a net profit on the transaction, but the government purchase is funded by debt that marginally increases inflation. But overall I suspect that the net benefit of market stabilization and taxpayer profit outweighs any inflation risk.

    The only other risk would be that the government might not be able to correctly value assets and could pay too much for them, and then having done so has an extra incentive to intervene in the economy to prop up the value of the assets it purchased.

  2. The government can only alter the environment so much. They are limited to the rules of capitalism and those of the wider world economic system (though the US government has a lot of leeway in both respects).

    If you look at the debt to GDP ratios for the last decade you could make the argument that a majority of the economic growth since the Tech Wreck has been a non-existent phantom. We have been spending increasing amounts of debt on non-productive consumption. We have been buying Chinese DVD players, not manufacturing equipment. As the debt and leverage is removed, this phantom will disappear and it will take real wealth with it. The government only gets to decide who gets charged the pound of flesh.

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  4. This scenario is only viable if you're talking about the U.S. right now. Think Iceland and what it tried to do and the consequences. If the U.S. goes too far and the world feels cheated, the dollar will stop being a reference of value and then the U.S. will be no different from Iceland. It will have to get its loans in a foreign currency and will suffer massive inflation due to the devaluation of the dollar. The world is dynamic, ignoring this fact could be devastating. Remember that the U.S. replaced England as the world power, and England replaced Spain, and so forth, and so forth...

  5. The government is different from you and I in another way as well. It should not act to maximize its profits (or minimize its losses). For example, the primary considerations for the Treasury to decide whether to push mortgage rates lower should not be driven by the exposure of the government to holdings of mortgage assets but rather whether it is good for the nation as a whole.

    Of course, that does mean that the financial cost to the government (ultimately taxpayers) should certainly be considered but it is far from the only one.

    But, the strategy should not be focussed on how the government should play it to make money out of the bailout but how best to help the economy out of the crisis while minimizing direct and indirect costs.

  6. Replying to skeptic, I agree. I do not think making a profit should be the main aim of the government. But it might well be that government programs would lead to such a profit. The more likely that is, the lower the concern of the government providing such a huge package.

  7. The expectation of profit is the only way to prevent politics from perverting market interventions. If government can interfere at times and in ways in which it does not expect to make a profit then you may as well tell special interests to grab their sacks and form a line to have them filled with taxpayer money.

    But if there is a true financial crisis then, by definition, there is an objective opportunity for a liquidity provider to realize excess profits in the distressed markets.

    If we insist that government can only intervene in times and ways in which it can expect a long-run profit (without abusing its power to "change the facts on the ground"), then we take most of the political hazard out of the equation. Instead of the current debate we see -- are Paulson and Frank just funneling tax revenue to their friends and cronies in NYC? -- the only debate would be on whether the long-run fair value of assets being bought by the government is clearly above the price at which the government can buy them.

  8. Capital provision should be done with an orientation of making good investments. I agree that there should be profits to be made from providing liquidity (especially in this environment).

    And, of course, that they should not be funneling money to cronies or squandering it.

    But, I would hope that decisions such as whether to allow bankruptcy judges to modify mortgage terms would be made with a concern for the common good and that only a small part of that is what impact it might have on the value of assets they have assumed or guaranteed. [Note: I realize as I write this that I am jeopardizing my claim to the title "skeptic".]

  9. "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."

    OMG, I don't think you are joking here. This is the absolutely most idiotic statment ever posted on this blog. What you describe here is financial dictatorship, which of course is what the leftist agenda is all about.

    What kind of risk manager advocates that when the sh*t blows up, just change the rules? No wonder every place you were a risk manager at blew up eventually.

    Maybe you should read some von Mises and read up on the Swedish approach that essentially enforces the rules of the market (if you blow up you lose, you dont bailout the idiots) as the only successful approach - not changing the rules.

  10. Most people are staying away from assets that are under pressure because: 1. They don't have a lot of capital free to invest (or cannot get financing to lever); 2. They are more risk averse than in normal times (or their boards or investors are more risk averse even if they are not); and 3. They see these assets as being much less liquid than in the past, so that if things do go poorly, they will be unable to get out of them. The government does not have these constraints. And the government can take any number of actions -- actions that are considered reasonable and are being proposed -- which would have a good chance of improving conditions. This all sounds good to me. By the way, the only place I was a risk manager that "blew up" is Citigroup, and that was ten years after I left. I spent the last year at Bridgewater, and they have been doing fine. Although you could argue that the space they are in, macro, has been doing well in general.

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