The Washington Post quickly discovers and applies Ricardian Equivalence

The Washington Post calls dividend freedom "the biggest hole in Treasury's financial plan." Good work! Ricardian Equivalence can work through a variety of mechanisms, but dividend policy is a great example.

Tino -- thanks for this citation and several others related to the dividends paid by the financial sector!

The Imperfect Information Excuse

Imperfect information plays a role in our economy. For example, a person diagnosed with a fatal illness may like to purchase life insurance for his family even if he had to pay an actuarially fair (thereby, high) price. But life insurance companies will not sell insurance to such a person because the cost of verifying exactly how fatal is his illness (expensive doctors and testing would have to be hired) exceeds the patient's willingness to be insured.

Imperfect information cannot stop a transaction with billions of dollars of benefits unless the costs of verifying that information is even greater than that.

Professor Kashyap and Diamond are blaming lack of troubled bank equity sales on imperfect information. Specifically, they say that a fairly strong bank would fail to raise equity because investors fear that the bank is actually quite weak (i.e., have some hidden troubled assets). They error both in fact and in logic. In fact, troubled banks have raised some equity from the private sector, which demonstrates that information problems have been overcome in this situation.

Regarding the logic, their story has some sense to it if it were a story about a small bank. But they are applying that story to the large banks (such as those receiving the "equity injections" from the U.S. Treasury) who have hundreds of billions of dollars in assets. Whatever private information those bank managers have could be made sufficiently public (or revealed to a single large scale investor) or sufficiently incentivized for far less than billions of dollars.

I suppose that the Professors would say that "it takes too long to make those discoveries." Where is the evidence for that claim? How many hours did the bank managers currently (and allegedly) holding the private information take to acquire it in the first place? Haven't some of these banks known for months that they would need more equity -- why weren't those months long enough to sufficiently publicize the private information? Why can't some of the managers in-the-know be made part of a new investment group and thereby given an incentive to blow the whistle? A lot of problems can be sufficiently solved in short order when there are billions at stake.

A more coherent story for the lack of equity sales is that the cost of capital is too high (many investors do not want to own bank stock regardless of what a detailed audit would show) and, even if it weren't, subsidized public capital is on the horizon and raising private equity would make them less eligible for the subsidy.

Economic Outlook: Anticipation

Until Lehman failed, I and most of the world had not realized that Fall 2008 would be the time when commercial paper markets would freeze, some major commercial banks would fail (or be gobbled up moments before failing), or that the once-libertarian economist Bernanke would propose spending circa $1 trillion of taxpayer funds helping the banking sector. One story commonly told after the Lehman failure is that banks would cease lending, and this would take a sharp bite out of national investment, which in turn would bring down the economy. Since then, we have been waiting with anticipation to see what would happen to the economy as a whole.

It is quite possible that we do not have to wait. Suppose that, while most of the world did not anticipate these events, the troubled banks themselves understood this much earlier this year. I cannot guarantee you that the troubled banks knew this, but it seems very likely that they did. After all, they were involved in the daily operations in a way that most of the world was not. So let's pursue this possibility to its logical conclusion.

If the soon-to-be-troubled banks understood in 2008 Q1 and 2008 Q2 that they were flirting with bankruptcy, wouldn't they cease lending in 2008 Q1 and 2008 Q2 in order to improve their short term asset positions? Why give a loan to a mediocre customer in Q2 when you recognize that you likely will be cutting off your best customers in Q3 and Q4?! In other words, we should have already seen much of the lending and investment impact of the bank troubles already in Q1 and Q2. [recall my blog entry from yesterday where I explained how the 1930's economy suffered well before the banks actually went broke]

We already have data for Q1 and Q2. Residential investment was down, of course, following the downward trend that began mid-2006 when housing prices peaked. But non-residential investment was UP (a bit), not down. In 2008 Q3, gross nonresidential investment was 4.64% of the capital stock, as compared to 4.55% a year earlier and 4.58% two years earlier.

Economic Outlook: Indicators of the Marginal Product of Capital

Corporate profits per dollar invested were very high through 2008 Q2. Indicators of 2008 Q3 are coming out now:

NonFinancial Corporations

• IBM 3Q profit a positive sign for tech sector
• Coca-Cola's 3Q profit up 14 percent
• Hershey's 3Q profit doubles
• Continental Airlines posts 3Q loss on fuel costs
• Nokia 3Q profit falls 30 percent
• Economy stalls, but Google's 3Q profit still rises. This article offers zero evidence for the "economy stalls" part.
• Schlumberger revenues soar to $7.26 billion. Profit up 13% YOY
• Honeywell 3Q profit rises 16 percent.
• AMD narrows Q3 loss

Financial Corporations

• JPMorgan Chase beats estimates with an 84 pct profit drop, revenue is worse than expected. But they still have profits! And their profit drop didn't stop them from acquiring WaMu.
• Wells Fargo profit falls 25 percent. Again, they have profits. And their profit drop did not stop them from outbidding Citigroup for Wachovia.
• Citigroup posts another loss. They have losses. Interestingly, these losses (among the biggest in the industry) did not prevent them from bidding for Wachovia although, admittedly, they could not outbid Wells.
• Insurer UnitedHealth reports 3Q profit drop. Still have profits.
• Merrill 3Q loss widens.

I see no evidence here that a credit crunch is getting in the way of important business. In case you want to weight these items, note that total earnings for the quarter are $2.8 billion (IBM), $1.89 billion (Coke), $0.12 billion (Hershey), -$0.24 (Contin), $2.7 billion (Nokia), $1.35 billion (Google), $1.53 billion (Sch), $0.92 billion (Honey), $0.53 billion (JP), $1.64 billion (Wells), -$2.8 billion (Citi), $0.92 billion (UnitedHealth), -$5.2 billion (Merrill). I never said that it would be pretty for the FIRE industry!

The Profit Rate during the 1930s Era Bank Panics

As recently as 2008 Q2, corporate earnings were quite high by historical standards. This by itself predicts high rates of economic growth -- the baseline from which we can subtract any adverse growth effect of the today's so-called credit crunch. Moreover, corporate profits are an important substitute for bank loans (see my earlier posts). So an economy with high corporate profits is probably more resilient to banking sector failures than would an economy with low corporate profits.

According to Friedman and Schwartz' A Monetary History of the United States, the first (short) banking crisis of the Great Depression was in November 1930 and, in Professor Lee O'Hanian's words, "The first banking crisis of any national significance didn't occur until the fall of 1931." Regardless of which date you choose, the economy was already in bad shape. Friedman and Schwartz (p. 306) explain how the economy had already declined very significantly by October 1930: "Even if the contraction had come to an end in late 1930 or early 1931 ... it would have been ranked as one of the more severe contractions on record."

The marginal product of capital was above average in 1929 (although not nearly as far above the average as we are today). Maybe that means that, absent crop failures, etc., the economy might have grown well otherwise. Maybe that means that the 1929 economy would have been resilient to a severe bank panic. But I see 1931 as the more relevant comparison, because in the fall of that year the serious bank panics began. The 1931 marginal product of capital was 2.5%/year less than it was in 1929. By 1931, there were not extraordinary corporate profits that could be rolled back into corporations as a substitute for bank funding. The low 1931 marginal product of capital was by itself predicting a low rate of subsequent economic growth.

In summary, the marginal product of capital in the months prior to today's liquidity crisis was much higher than it was in the months prior to the 1931-3 bank panics. This not only raises the growth rate forecast from which to subtract any adverse impact of liquidity crisis, but also reduces the expected magnitude of that impact.

Query to New Keynesians -- What do You Have Against the DOJ?

Last week, the Treasury proposed spending some of its revenue purchasing equity in struggling banks. This proposal echoed the proposals of a number of academics. However, none of the academics have discussed whether Treasury capitalization would crowd out private capitalization (one caveat noted below). This irritates one of my pet peeves with New Keynesian economics -- that they propose to use macroeconomic policy to deal with industry-level problems. Even if public policies were generally potent, I cannot imagine that such an oblique approach to a problem would have much impact.

Let's begin with the proposition that the proposed Treasury transactions will be fully neutralized by private sector transactions in the opposite direction, and explore how New Keynesians might attempt to refute it. In the simplest model, 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. In much the same way that taxpayers behave in Barro’s (1974) model, 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.

A number of “realistic” modifications to Barro’s (1974) model have been proposed, but they do not necessarily weaken the basic result that public transactions are at least partly offset by private transactions, and may strengthen it. Consider first the possibility that taxpayer portfolio decisions are at a corner solution, so that taxpayers desire to reduce their holdings of the equity of existing banks but cannot.[1] If bank management were responsive to shareholder demands, banks would use the cash they obtain from Treasury investment to buy back bank shares from the public. In this case, the Treasury purchases put the cash into a revolving door, without boosting bank capital. [I saw a comment by Professor Stein that seemed to suggest that bank executives would raise dividends in order to enrich themselves at the expense of other bank creditors. This may be a concern too, but I think that the Ricardian force is at least as fundamental as corporate governance issues.]

Again for the sake of argument, suppose that Treasury purchases were accompanied by (perhaps implicit) regulations restricting share repurchases and dividend payments.[2] Investors still desire to hold equity in new banks or in alternative institutions that would compete with banks and likely view that equity as (imperfectly) substitutable for equity in existing banks. In other words, the portfolio-at-corner-solution view may explain how Treasury transactions would not be precisely neutralized by private sector transactions, but it predicts that the Treasury plan reallocates capital from new entrants to the banking industry and toward the existing (and struggling) banks. Tino pointed out that smaller banks are resentful of the bailout, because it props up their larger competitors. This reallocation harms the future efficiency of the banking industry.

Another modification to the Barro (1974) model assumes that taxpayers are unaware of what the Treasury is doing, and therefore have no motivation to offset Treasury transactions. This modification may be applicable in some situations, but seems quite inapplicable today when (a) the entire country is focused on the financial crisis and public sector responses to it and (b) taxpayers have loudly voiced their displeasure with the tax liabilities they perceive to be created by the Emergency Economic Stabilization Act of 2008.

One reply to all of this might be to have the Treasury invest in the bank equity across-the-board. At worst, Barro’s model applies and the Treasury investment does nothing. With enough Treasury investment, all of the private capital will be crowded out so that Treasury investment can have a real impact at the margin. Is that amount too much even for the U.S. Treasury? Can we trust that the Treasury will locate all possible competitors to existing banks? Should the Treasury invest in Walmart too (Walmart wants to operate its own bank)?

The Role of Complementarity in the Neutrality Result
By this point, I have pushed New Keynesians to start telling me about details of the banking industry. Unfortunately, the logical escape route in this direction is narrow and unpleasant.

How might industry detail trump Barro’s analysis? Suppose that, when industry capitalization rates become low, each bank’s output is complementary with the others.[3] In this case, the most direct public policies for raising bank output would facilitate cooperation among banks by encouraging mergers or the formation of other private-sector institutions such as clearing houses or commercial paper exchanges to align each bank’s incentives with the industry-level complementarities.[4] Once banks were the proper size, the industry could otherwise be analyzed as if the complementarities were absent (with the same neutrality or non-neutrality results).

Suppose for the sake of argument that mergers and other private sector efforts were insufficient to internalize the complementarity, and that banks can be prevented from buying back shares or cutting dividends. Even so, the impact of Treasury equity purchases depends on the terms of the purchase. Professor Mankiw has proposed that the Treasury co-invest (on a non-voting basis) with private investors who decide “on their own” to make a purchase of a bank’s stock. If (some subset of) taxpayers wanted to invest, say, $20 billion in bank ABC absent the Treasury plan, then there is nothing to stop them to investing $10 billion in the presence of the plan, thereby bringing the total ABC equity sale to $20 billion. In this case, other banks in the industry are unaffected by the Treasury’s purchase, because bank ABC sells $20 billion regardless of whether the Treasury participates. Professor Mankiw’s plan does nothing to align the incentives of the private co-investors with those of the industry as a whole, and is premised on two of the mechanisms that can deliver Barro’s result (that private investors are willing to invest even absent Treasury action and that bank managers are free to make dividend decisions, etc., to the shareholders’ advantage).

In order to use complementarity to predict a significant effect of Treasury purchases on bank capitalization, we must also assume that private investments are at a corner solution. In this case, a judicious and carefully micro-managed choice of Treasury investment will raise the marginal product of capital throughout the industry, and presumably stimulate private investment.

In summary, economic theory reminds us that Treasury transactions are at least partly offset by private sector transactions. Each Treasury dollar spent on bank equity will reduce private ownership of bank equity by some multiple. More research is needed to determine whether the multiple is close to zero, close to one, or even larger.
[1] This logical possibility probably does not accord with the facts, because Bank of America announced in early October 2008 that it would issue $10 billion worth of stock.
[2] Note that these regulations are counter to the spirit of many of the academic proposals, which are to keep the public sector out of bank business decisions.
[3] Presumably the complementarity was not significant at normal capitalization rates, or else banks would have merged or cooperated with each other by contract.
[4] Among other things, I owe these examples to Fernando Alvarez.

P.S. The DOJ is short for the Department of Justice. Most Industrial Organization economist believe that it is the appropriate public forum for alleviating industry malfunctions.

Congratulations Professor Krugman!

I don't know much about international trade theory, so it is a testimony itself that I have known about and admired Professor Krugman's work on that subject. Take a look at Professor Glaeser's explanation of why Professor Krugman is a highly deserving recipient of the prize.

Congratulations!

Your comments help advance economic science!

My goal is to make the application of supply and demand be both accurate and accessible. Time does not permit me to respond to the comments individually, but I read them. A large fraction of the comments have helped me make improvements in that direction -- thank you!!

Economic Outlook: An Analysis of Two Shocks

There are two shocks supposedly hitting the non-financial sector (which is most of our economy) as a result of the banking crisis. One of them is an adverse saver-investor intermediation shock. That is, the return to saving is low even while the cost of borrowing is high. The second shock is one of "confidence" (and also recognition that the stock market has crashed) -- an adverse wealth effect on consumption and leisure. These two shocks have exactly the opposite effects, which is why I am much less confident than the rest of America that GDP will fall as a result of the last month's events.

Intermediation Shock

I have argued that the intermediation shock is not that large, and at worst short-lived, because the entry motive pushes toward reducing that shock. Nevertheless, I will analyze it as if it were quantitatively important. By itself, this shock INCREASES consumption, because the alternative (saving) does not look as attractive. It decreases investment and raises the marginal product of capital because the cost of capital is temporarily high.

Capital is fixed in the short run, so any effect on GDP has to come from labor supply or productivity. Labor supply should fall due to an intertemporal substitution effect (i.e., working hard is one way to save, but now is, according to the theory, not a good time to save). This effect may not be large, because there are other intertemporal substitution effects to worry about (e.g., Obama's winning the election and eventually hiking tax rates). Productivity will be down somewhat, only because the banking sector is terribly unproductive and the banking sector is part of the aggregate. So the intermediation effect will reduce output in the short term, but increase output post-crisis above what it would have been absent the crisis.

Wealth Effect

Owners of equities are undoubtably poorer now than they were a year ago. Even persons who do not own equities may fear an eventual reduction in their labor income. This INCREASES labor supply, DECREASES consumption, and increases investment (with an ambiguous effect on the marginal product of capital). For example, baby boomers may delay their retirement because their 401k values no longer afford them as comfortable a retirement. This increases output now, and post-crisis compared to what it had been absent the crisis.

You may have read in the newspaper that consumption is 2/3 of GDP, so that a reduction in consumer confidence reduces GDP by reducing consumption. But, not surprisingly, that analysis ignores supply (that's why I call this blog "Supply and Demand (IN THAT ORDER)"). Baby-boomers are productive, knowledgeable people. If they stay in the workforce rather than retiring, that will result in more output, not less.

Combined Effect

These two shocks have exactly the opposite effects. The intermediation shock favors current activity (consumption and leisure) over the future. The confidence shock does the opposite. The lesson here: this is yet another reason why the intermediation shock's effect will be muted. I have already explained why I don't think the intermediation shock is very big. But even if it were, it has the wealth effects pushing in the opposite direction. These are two reasons why I am much less confident than the rest of America that GDP will fall as a result of the last month's events. [but note that the effect on efficiency and welfare is clear: the economy is less efficient and people are worse off -- ie, they'd rather live in a world without these shocks. But that doesn't mean less GDP]

Flashback: How Washington Helped Decapitalize the Banking Industry

Do you remember way back in 2005 when Walmart tried to enter the banking industry? They ran into one little problem: the Washington buzz-saw operated by banking industry incumbents to create barriers to entry. You do not have to believe my version of the story: just read it at Business Week or MSN.com, among other places.

Do you think the banking industry would be poorly capitalized today if Walmart were a major player?

Do you think Treasury policies today will suddenly reverse this course? At least ONE economist needs to join me in reminding the public of the virtues of free entry.