Saturday, October 11, 2008

Professor Barro - Where Are You?!

This week the Treasury has proposed spending some of its revenue purchasing equity in struggling banks. This proposal echos the proposals of a number of academics, including Professor Mankiw. But not this academic!

I voiced some objections in an earlier blog post about the Profitable Government Enterprise Myth. I omitted another caveat -- that Treasury capitalization would recapitalize the banking industry MUCH LESS than each dollar expended by the Treasury. I was hoping Professor Barro would voice this opinion, because I learned it from him (not in 2008, but back in 1989 when I enrolled in his courses). Quite simply, Treasury capitalization will crowd out private capitalization.

To see this, assume for the moment that future taxes are lump sum (with a known incidence) and the economy is closed -- i.e., that all potential bank stockholders are also U.S. taxpayers. Professor Barro has explained that taxpayers will recognize that the Treasury has invested more in bank stocks, and has implicitly done so on their behalf because the taxpayers will reap the gains and pay the losses of those investments. As a result, taxpayers will attempt to reduce their holdings of bank stocks by the same amount that the Treasury increased them.

You might say that taxpayers cannot reduce their investments in bank equity, because those investments are already zero. If you say this, you err both in fact and in logic. In fact, Bank of America announced this week that it would issue $10 billion worth of stock. Even if we ignore that fact and accept the premise that taxpayers have no intention to invest in the equity of existing banks, I cannot believe that investors would not invest in new banks, or would not invest in alternative institutions that could compete with banks. Thus, at best, the Treasury plan reallocates capital FROM new entrants to the banking industry and TOWARD the existing (and struggling) banks. What a plan for strengthing an industry -- to take from the young and strong and give to the weak and old! As I have written many times, public policy needs to ENCOURAGE entry, not discourage it.

We cannot assume that taxes are lump sum, or have a known incidence. But recognizing taxation deadweight costs and uncertain incidence only increases taxpayer exposure to bank stock risk, which might cause them to reduce their bank industry investments MORE than the Treasury increases them! What a plan for strengthing the banking industry -- to decapitalize it!


Another concern of this type: that banks could use the cash they obtain to buy back bank shares from the panicking public. After all, those shares look pretty cheap! In this case, the Treasury purchases literally puts the cash into a revolving door, without boosting bank capital. I have seen no economist account for this concern.

This analysis also needs to relax the closed economy assumption ... more on that later today. But this is a good example of why I call this blog "Supply and Demand (in that order)" -- supply is too often ignored in public policy analysis. Proponents of Treasury bank stock purchases are guilty of a superficial analysis of the SUPPLY of private capital to the banking sector. That supply very much depends on public policy.

3 comments:

Don said...

"As a result, taxpayers will attempt to reduce their holdings of bank stocks by the same amount that the Treasury increased them."

Won't their investment depend on what they perceive is their expected return on investment, irrespective of what the government does?

"I cannot believe that investors would not invest in new banks, or would not invest in alternative institutions that could compete with banks."

This might be true, but surely a question would be how long would this take, and would they wait for a government bailout to lift the overall economy before doing so.

Gabriel said...

Prof. Barro is also a noticeable absence from this list too.

Peter said...

"The possibility of ready institutional substitution for democratic political institutions is why democracies and autocracies have similar public policies in so many areas. It is critical that the basic economic function be performed, but there are multiple institutions that can perform it."

The argument is fundamentally flawed. A sociopathic killer may well be a good son (as is now fashionable to point out in movies and literature). A person dying of cancer needs to urinate as well as a healthy individual. What does that prove?

The problem is a lovial one of condusing a statement with its converse (rather than contrapositive).