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.

Institutions are Over-Rated

Economic institutions are not the same as economic functions. "Saving" and "investment" are economic functions. A bank is an economic institution that provides an economic function (bringing savers and investors together). But the function can occur without a particular institution, because alternative institutions can take its place.

The retained earnings of corporations are an example of an institution that could substitute for a bank in bringing saving and investors together. When banks were operating well, corporation ABC earning profits would often pay out some of those profits to its shareholders as a dividend. The shareholders would deposit those dividends in a bank, who would lend them out to corporation XYZ, who would undertake an investment project. Would the economic function be fundamentally different if corporation ABC reduced its dividend and loaned the funds to corporation XYZ directly? Or merged with corporation XYZ? Or invested internally?

You might observe that banks have close substitutes from competing institutions in some areas, but not others. You might say, for example, that banks are the only institution lending money for home purchases. But even if your observation were not exaggerated (employers often make home loans to employees), it comes from a time period when banks were functioning well. The real question is whether alternative institutions would bring funds to home purchases EVEN IN THE ABSENCE OF WELL-FUNCTIONING BANKS. I think they would. That's not to say that the world would be completely the same without banks. But the basic economic functions would still happen.

Democracy is another institution with an impact that has been good (I kinda like this free speech thing), but highly exaggerated. Operating the monopoly on force, and mediating between competing groups served by that monopoly, is a very important function. But a political institution such as election is only one way to serve that function. 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.

Construction and Autos

A critical empirical question right now is whether the "credit crunch" itself is reducing investment (and/or spending on consumer durables) in the nonfinancial sector. The observation that investment has declined in some sectors does not answer the question one way or the other.

I expect, for example, that construction spending and automobile purchases are down. But is that to be blamed on a credit crunch? Or would construction spending have fallen anyway? After all, market demand for housing seemed to be down well before Bear Stearns or Lehman failed. Regardless of banking conditions, housing construction would be down.

I suppose it is also true that persons with low credit scores are having trouble obtaining mortgages. Again, that's no evidence of a credit crunch because those types of mortgages were supposedly the source of the problem in the first place. If that's right (I do not agree, but arguing against that conventional wisdom is for another day), then it is a good thing that those mortgages are not happening.

Wouldn't a constriction of credit supply of historic proportions show itself in very high mortgage rates? We have not seen those high rates yet. It seems to be that persons with strong credit ratings can obtain mortgages at rates that resemble those clearing the mortgage market of the past couple of years.

Automobile purchases would also be down, regardless of credit conditions, because oil prices are much higher than they were for years. Today drivers want to "be green" and get good gas mileage. American automanufacturs are not fulfilling those needs right now, so we cannot blame their low sales on a credit crunch.

Other sectors have to be examined if we are to discern an effect of the credit crunch. Furthermore, if the credit crunch is really significant outside the financial and other fundamentally weak sectors, then we should not have to use a magnifying class to find evidence for it.

I am still digesting this, but the Executive Board seems to find that major corporations are NOT suffering from a credit crunch. Mr. John Haskell wrote me that his surveys show that "Most large companies are still in an extremely safe liquidity position; they have long-term credit facilities and large cash holdings." I have not reviewed those surveys myself, but will update if and when I do.

[Added Oct 13: Mr. Haskell elaborated further: "The Corporate Executive Board finds that large multinationals are using good times of past to buy themselves time – they have long-term credit facilities and large cash holdings. One of their recent polls found that more than 70% were not planning on proactively drawing down on their credit facilities, and that they believed they could still access 80-90% of their credit lines. Obviously the experience for the lowest rated CP issuers may be different, but most major corporations are not currently suffering from a credit crunch."]

Credit Crunch in the Non-Financial Sector? Chew on This

The William Wrigley Jr, Company is a Chicago-based gum and confection company. It has lots of growing earnings, new products, and new locations. Back in April when stocks were very high (by today's standards), the Mars Corporation arranged to purchase the Wrigley Company for $23 billion in cash. The deal was set to close 6-12 months later.

By this fall, with the market down and people crying "credit crunch", it would seem that Mars might be tempted to back out of the deal -- perhaps to complain about credit even if were not really a problem. But Mars made no excuses: this Monday (October 6), Mars showed up on time with the $23 billion in cash. Much of that cash was borrowed. Mars now owns the Wrigley Company.

The lesson is that opportunities exist in the non-financial sector, and at least some of those opportunities are being realized despite the so-called credit crunch.

I am still digesting this, but the Executive Board seems to find that major corporations are NOT suffering from a credit crunch. Mr. John Haskell wrote me that his surveys show that "Most large companies are still in an extremely safe liquidity position; they have long-term credit facilities and large cash holdings." I have not reviewed those surveys myself, but will update if and when I do.

[Added Oct 13: Mr. Haskell elaborated further: "The Corporate Executive Board finds that large multinationals are using good times of past to buy themselves time – they have long-term credit facilities and large cash holdings. One of their recent polls found that more than 70% were not planning on proactively drawing down on their credit facilities, and that they believed they could still access 80-90% of their credit lines. Obviously the experience for the lowest rated CP issuers may be different, but most major corporations are not currently suffering from a credit crunch."]

An Economy You Can Bank On

Normally, my job is to conjure new hypotheses to explain puzzles in old data. But these days, the marketplace for ideas has a void in the application of the old ideas of supply and demand to the most recent data. So far, here's what I've found:

• New York Times article on today's marginal product of capital and substitute private (sic) providers of banking services. Further elaboration in a September blog entry.
• Recent stock market declines may be partly due to news about corporate earnings, but much (probably most) is a change in the market's willingness to own a given earnings stream. If your willingness has changed less (more), you should buy (sell).
• (Measured) Housing prices will fall further in many places.
• Calculation of the effect of Treasury investments in volatile bank stocks on the deadweight cost of taxes.

What Should be Done?

An earlier post provided a multitude of reasons why the Treasury should not spend any of the $700 billion it was authorized by Congress. I keenly appreciate that the financial crisis is very disturbing, and that it would feel better to do something. But does that mean feeling better by doing something harmful? I assume that the answer is "no". With that in mind, here are two action principles:

1. Rely on the market as much as possible. In my view, it is even more important to rely on the market in a crisis than it is in the calm. When things are calm and prosperous, we can afford anti-market policy mistakes. Arguably, now is not one of those times.
2. Play to your comparative advantage. Don't try to wrestle an elephant when you're a mouse! The money market is a very big place, even from the U.S. Treasury's perspective. Washington has a couple of comparative advantages: (a) the markets love its debt, and (b) it proposes, writes, interprets, and enforces the law.

These principles bring a couple of possible policy actions to mind (I'm sure you can think of more):

• Improve the law to encourage (or at least reduce the amount of discouragement of) exit and entry into the financial industry. We need the weak players to exit, and new players to enter. Expedite bankruptcy for the weak banks. Lower capital requirements for new banks. Allow new and expanding banks to hire talented leaders (that means no ceilings on executive compensation). If people value access to insured, well-capitalized and heavily regulated banks, than have some banks of that type but do not erect barriers for new and innovative entrants by imposing those standards for all institutions. If insured, well-capitalized and heavily regulated banks cannot coexist in a market with the unregulated, then listen to what the market is saying.
• Cut taxes and sell Treasury bills. Taxpayers will be happy and, judging from the very high prices paid for Treasury bills these days, the money market will like it too.
• Perhaps one way to do both of these is to give a corporate tax credit to banks that raise capital or merge with another institution. Or a personal tax credit to persons who purchase new bank shares. To the extent that there be a temporally coordinated private sector supply (i.e., that capital is worth more in bank ABC when bank XYZ is also raising capital), this tax credit could apply to a limited time window, for example between now and March 31, 2009. Whether that tax credit is refundable or not depends on how you want to treat old versus new banks. The law of one price suggests making it refundable, although maybe there is some public benefit to having banks absorbed by existing institutions that are already profitable.

A New Version of the Profitable Government Enterprise Myth

Greg Mankiw's Blog: How to Recapitalize the Financial System proposes to have the Treasury co-invest in banks with private investors. This is a (significantly) watered down version of the profitable government enterprise myth, and thereby dilutes -- but does not eliminate -- the fundamental problems with government enterprises. Government enterprises LOSE MONEY unless they enjoy a legal monopoly, and even in the latter case a government profit is no guarantee. Are you familiar with Amtrak? The U.S. Post Office?


Even if these problems were sufficiently diluted, Professor Mankiw's version does not eliminate the deadweight cost of taxes because the Treasury funds are collected from involuntary taxpayers by the IRS. The widely-accepted principle of deadweight costs says that a dollar in the public treasury costs the economy more (probably about twice, although we can debate the magnitude) than a dollar in a private treasury. Quite simply, the fact that private investors cannot find their own partners proves that the taxpayer would not, under Professor Mankiw's plan, be a voluntary co-investor. A taxpayer's only choice to reduce his or her participation in the government enterprise is to further shift away from taxable activities.

This point can also be seen by a couple of examples (these examples have been improved, thanks to comments from Professor Mankiw). Suppose that the Treasury borrows to make its co-investment. In one state of the world, the investment returns exactly enough to repay the Treasury borrowing -- no problem. In another state of the world, the investment loses, say, $x (relative to borrowing cost) -- a shortfall that has to be made up by the taxpayer. Because taxpayers don't like to pay taxes, the taxpayer has to be harmed $2x in order to get $x in the Treasury to make up the shortfall. In the third state of the world, the Treasury makes a profit of, say $x (again, relative to borrowing cost).

Example 1. Taxpayers are not full owners of windfalls. Suppose for a moment that the $x profit (if it occurs) were paid to taxpayers in a lump sum fashion. Even in this lucky case, the taxpayer has been forced to take a gamble with possible outcomes +$x, 0, and -$2x, whereas the private co-investor's gamble was +$x, 0, and -$x.

Now back to the assumption of lump sum subsidy. In reality, a profit of $x for the Treasury will be the subject of political competition between groups wanting more than their share of the $x. So, even when the rosy scenario plays out, the $x profit benefits the taxpayer far less than $x.

Example 2. Even if taxpayers were full owners, deadweight costs are convex. You might say that taxpayers own as much of Treasury windfalls as they own of the shortfalls -- that is, the $x windfall would be to cut taxes, which would save the taxpayers $2x. So Professor Mankiw's plan gives taxpayers a gamble with outcomes -$2x, 0, and +$2x? A problem with this argument is that, aside from the fact that the taxpayer's risk is twice his private co-investor's, deadweight costs are convex, so that taxpayers are more risk averse in their role as taxpayers than they are in their roles as investors [I wrote about this in my senior thesis at Harvard; Professor Hehning Bohn has published some articles on this too]. That is, the deadweight costs suffered from a tax hike are more than the deadweight costs saved from a tax cut.

Assuming that deadweights costs are convex and, absent the plan, would be about equal to Treasury revenue, the contribution of Professor Mankiw's plan to expected deadweight costs depends on (i) the degree to which Treasury portfolio shocks can be smoothed over time, and (ii) the coefficient of variation of the portfolio of financial companies to be purchased by the Treasury. For (i), the opportunity for intertemporal tax smoothing can be pretty powerful -- a $700 billion gamble looks pretty small compared to the present discounted value of taxes. In other words, a $700 billion gamble is more like a $50 billion gamble on an annual basis. So the $700 billion adds about $50 billion * (coef of var)^2 to the expected deadweight costs of taxes.

For (ii), I looked today at options traded on XLF (the financial component of the S&P 500) for expiration in January 2010, which suggest that the coefficient of variation of the XLF is 0.6 over that horizon. [This is likely an under-estimate of volatility of any portfolio to be formed by the Treasury, because (a) troubled banks are probably more volatile, (b) the Treasury horizon is more than 15 months, and (c) in any case the Treasury will not own the entire XLF. I admit that January 2010 options are not the most liquid.]

So that comes to at least $18 billion worth of deadweight costs imposed on taxpayers.

In summary, Professor Mankiw's plan has three kinds of social costs: (1) the costs of underperforming government enterprises (mitigated, but not absent, because his plan co-invests with private parties), (2) the costs of uncertain incidence of the tax hikes and cuts that would result from good and bad performance of the government investment, respectively, (Example 1 above) and (3) the convexity of the costs of tax collection (Example 2 above). All of these costs can be avoided if the market alone decides whether and how much banks should be recapitalized. Taxpayers should be allowed to make their own investment decisions, and do not need to be herded by the Treasury.

The Relative Importance of Dividend News and Discount Factors in the 2008 Stock Market

Here is my back-of-the-envelope version. Let me know if you have a more precise decomposition.

It’s easy to see how the stock market might fall by a fifth when it is learned (or market participants think they have learned -- see my earlier blog post) that a one year recession will occur that would not have occurred otherwise. Suppose that, absent a recession, corporate earnings grow perpetually at rate g. A recession means that earnings drop by 15% for one year, after which they resume their previous growth rate g. A 10-15% drop in earnings is typical of postwar recessions. Relative to the counterfactual, the 15% drop lasts forever, so this by itself reduces equity values by 15%. In addition, growth does not occur for twelve months, which reduces earnings in all years after the recession by exp(-g). So values are hurt by almost 15% + g, which is somewhere between 15 and 20 percent. If the recession lasted 2 years instead of one, values would be hurt by less than 15% + 2g, which is still not much beyond 20%.

In fact, the U.S. stock market has fallen by about third. Even the nonfinancial components of the stock market have fallen 30%. This seems hard to explain merely with bad news about earnings. Rather, it likely reflects a change in the valuation of a given earnings stream. In other words, you can buy the same earnings stream cheaper now than you could last year. I am not the first one to suggest that time-varying discount factors (as opposed to news about “fundamentals” or earnings streams) are an important reason for stock market fluctuations – see the last couple of decades of asset pricing research.

How Far Will Housing Prices Fall?

Here is a simple approach to the question. Let's revisit this next year as see how well it does compared to more sophisticated approaches!

For the 10 years prior to Jan 2000, both the Case-Shiller price index and the OFHEO price index indicate that housing prices increased about at the rate of inflation. If real housing prices had followed inflation since then, they would have been 47% below their actual peak in summer 2006, according to Case-Shiller.[1] If real housing prices had followed inflation through July 2008, they would have been 27% below their actual values in July 2008. In other words, as of July 2008 housing prices had 27% more to fall in order to reach the real value they had for several years prior to the “bubble.” To put it yet another way, as of July 2008, the house price decline was not yet even half way complete.

Capital theory suggests that housing prices have a long run relationship to construction costs, not necessarily relative to the overall CPI. The PPI for residential construction increased about 10% (depending on which components are considered) relative to the CPI over the years 2000-2008, after decreasing somewhat relative the CPI over the prior 10 years. If today’s construction costs are expected to remain, then July 2008 housing prices had only 20% more to fall. On the other hand, it can be argued that construction costs themselves will fall once the energy price spike recedes. To a rough approximation, this means that, as of July 2008, housing prices had fallen about half way from their peak to their ultimate real value. This process is closer to completion (more precisely, closer to being evident in actual housing market transactions) in some regions than in others, but perhaps by summer 2009 it would be complete in most of the nation.


The basic logic of this approach implies that these basic trends – namely that housing prices had increased much more than construction costs – were readily discernible in 2006, and before. So where was I with the warnings? First of all, it is perfectly consistent with capital theory that housing prices would temporarily exceed construction costs because, in the short run, there is a limited supply of houses until the construction industry can catch up with demand. Persons who insist on purchasing a house when prices exceeded construction costs were, in effect, (probabilistically) paying for the privilege of owning a house earlier rather than later (when the construction industry would have produced all of the houses that were demanded). Second, no one knew for sure when supply would catch up with demand. In, say, 2005, market participants might have rationally forecast that prices would remain above construction costs through 2010 (by which time the persons purchasing houses then would either have grown into their mortgages or have sold their house without a significant capital loss) even while they understood that eventually house prices would fall back to construction costs. That forecast was ultimately wrong, but hindsight is 20-20.

[Added Oct 10: Two days after I wrote this, the Wall Street Journal had an article showing a graph of real housing prices. You can see there how real housing prices are still above historical levels.]

[Added Oct 11: Whenever I have a tough question about urban/housing economics, I ask Professor Glaeser. You can learn from him directly on his blog. For example, he says that housing prices will keep falling. I don't know whether he agrees with my forecast as to the amount of the reduction.]

[1] The OFHEO index shows the peak in 2007, which tells me that it is not suited for high-frequency analysis. Relative to January 2000 (and in nominal terms, the Case-Shiller peak is 30% higher than the OFHEO peak).

Mr. Paulson, There’s Still Time to Return Your Grinch Costume

Although the law “Emergency Economic Stabilization Act of 2008” now authorizes U.S. Treasury Secretary to use taxpayer funds to accumulate a portfolio of “troubled assets” unwanted by the private sector, it does not obligate him to do so. Thus, it is not too late for the Treasury Secretary to determine that he will not use taxpayer funds in this way, or for President Bush to replace Secretary Paulson with a new Secretary who has made that determination.

There are a multitude of good reasons for keeping taxpayer funds with the taxpayers. Any one of these reasons by itself justifies my proposal, even if the others did not have merit:

(a) The Treasury’s plan for acquiring “troubled assets” may not avert a financial industry crisis because the $700 billion authorization is small relative to aggregate financial market activity, even while it is large from U.S. taxpayers’ perspective. Bloomberg reports “There are lots of reasons to think the Paulson plan won't succeed in cleaning up banks' balance sheets any time soon,” [Edmund] Phelps, an economics professor at Columbia University, said ….

(b) The Treasury’s plan for acquiring “troubled assets” may not avert a crisis because it is not designed to stop the reduction in the prices of houses and other real capital that collateralize many of the assets of trouble banks. See Professor Feldstein’s recent article in the Wall Street Journal.

(c) Even if the crisis could be averted by a one-time realignment of the assets and liabilities of financial institutions, bankruptcy proceedings could serve this purpose – at financial institution owner expense rather than taxpayer expense. If averting the crisis requires that such a realignment happens quickly, then expedited bankruptcy proceedings could be used – again at financial institution owner expense – see Professor Zingales’ article.

This has been criticized because expedited bankruptcy may be inconsistent with the law, but I am baffled as to why we need to pass a $700 billion law in order to avoid changing whatever laws supposedly get in the way of expediting bankruptcy proceedings for banks whose liabilities now exceed their assets.

(d) Even if a financial market crisis could only be averted with taxpayer dollars, this aversion is not worth what it costs. Each dollar brought into the Treasury costs taxpayers about two dollars, because the actions taxpayers take to reduce the tax liabilities. These are known as the “deadweight costs of taxes.” Economists may argue about the magnitude of deadweights costs, but all admit that they are real.

Some have claimed that the Treasury will make a profit on its transactions pursuant to the bailout plan. This is the "profitable government enterprise" myth. Government enterprises LOSE MONEY unless they enjoy a legal monopoly, and even in the latter case a government profit is no guarantee. Are you familiar with Amtrak? The U.S. Post Office?

Others have claimed that the Treasury will not lose the full $700 billion, because it will receive assets in return. I agree (at least if we do not aggregate this bailout's $700 billion with the funds used for past and future bailouts) that the net Treasury subsidy from this $700 billion will be less than $700 billion. But that does not mean that the cost to taxpayers is less than $700 billion. Because of the deadweight costs of taxes, a subsidy in the amount of, say, $400 billion, costs taxpayers about $800 billion.

Furthermore, the smaller is the Treasury subsidy, the more powerful are the arguments (a) and (b) above! You cannot have it both ways -- either the Treasury subsidy is large enough to dramatically impact financial markets, or the Treasury subsidy is small, or neither.

Professor Mankiw's related proposal is to have the Treasury co-invest with private investors. This is a (significantly) watered down version of the profitable government enterprise myth, and thereby dilutes -- but does not eliminate -- the fundamental problems with government enterprises. Furthermore, it does not eliminate the deadweight cost of taxes because the Treasury funds are collected from involuntary taxpayers by the IRS. Quite simply, the fact that private investors cannot find their own partners proves that the taxpayer is not a voluntary participant.

(e) Even if a financial market crisis could only be averted with taxpayer dollars, and these taxpayer dollars did not have deadweight costs, each dollar spent on trouble assets likely creates additional deadweight costs by increasing the supply of troubled assets. If the Treasury pays for troubled assets, the market will oblige!

(f) Even if a financial market crisis could only be averted with taxpayer dollars, and the various deadweights costs of the Treasury’s activities taxes were sufficiently small, averting the crisis would not be worth what it costs because financial market performance has little correlation with the real economy. Don’t let bank advocates let you think that banks are an indispensable part of capital formation. For more on likely non-financial sector responses to a financial market crisis, see my earlier blog post, and a forthcoming post that elaborates further on these issues.

(g) Even -- especially -- if banks were an indispensable part of capital formation, a banking crisis cab be resolved by new entry into the banking industry. Any time existing producers in an industry fail to supply their eager customers, there are profits to be made by new entrants. The banking industry is no exception, at least if it were sufficient deregulated. Indeed, I expect that the prospect of additional government bailouts (reinforced by the Bernanke/Bush/Paulson plan) hinders this powerful margin of market response because potential entrants see even greater profits after the government pays its subsidies, rather than before.

(h) In the past, we economists have not analyzed the marketplace the way epidemiologists analyze contagious diseases. I see no reason to start now. Rather, the marketplace has shown time and time again that it absorbs and dissipates shocks, rather than magnifying them. The process of entry cited above is one important mechanism achieving this end.