The Central Bank is not a Deus ex Machina

Prominent commentators, whose positions of respect are well-earned, are calling for the ECB to take on the role of lender of last resort.  While I agree that this is part of a complete solution to the Eurozone crisis, I think it is far from clear that now is the time for the ECB to take on this role.

The underlying problem in the Eurozone is the intra-European balance of payments problem.  Until a politically feasible plan to manage European imbalances is in place, the aggressive action by the ECB, called for by Martin Wolf and Paul DeGrauwe, may well turn out to be nothing more than a palliative.  Such palliatives are dangerous, because the need for political action is so great that anything that lulls Europe’s politicians into a sense that they do not need to act boldly today, may have the effect of aggravating the fissures leading to crisis and create a problem that is even harder to resolve.

My reference point in these thoughts is the central bankers’ decision in 1925 to work with the Bank of England in its project of maintaining the peg to gold.  Over six years the imbalances that made the peg unsustainable did not resolve, but instead were aggravated by politicians making parochial decisions and by a general sense of stability that allowed imbalances to grow ever greater.  In 1931 when Britain finally abandoned the peg to gold, the world economy faced a greater crisis than it probably would have faced in 1925.

I think the ECB is doing a good job of making sure that the politicians know that they are the ones who need to act.  While none of us can be sure that Europe’s politicians will successfully muddle through and give birth to a stronger Eurozone, the likelihood of success is much greater while the pressure of looming financial crisis bears heavily on the shoulders of the politicians.

Incrementally reducing your negative equity is not saving

… at least as long as the goal is to assess the effect of the activity on the macroeconomy today.

Rortybomb directs us to Matt Rognlie‘s critique of “deleveraging.”  Rortybomb correctly points out Rognlie’s error in using aggregate data to discuss consumer behavior and links to a year-old analysis explaining that it’s the middle class that’s overleveraged.  I have a different bone to pick.

While Rognlie nominally acknowledges that the deleveraging problem is specific to the aftermath of an asset bubble (“consumers and businesses experienced an enormous hit to net worth”), he restates the problem as something that is not precisely the same, that consumers desire to spend less and save more.

The aftermath of an asset bubble implies that many economic participants owe more than the value of the assets securing the loan.  This has the immediate implication that either (i) defaults must take place, transferring full ownership of the assets to the lenders or (ii) assets are “locked in” and those who hold title to the assets cannot sell them (because the assets undersecure a lien, so in some sense this title is only nominal) or (iii) some combination of (i) and (ii).

The theory to which Rognlie refers tends to assume that (i) takes place instantaneously:  After a bad economic realization,  borrowers who owe more than the asset is worth strategically default, and losses are immediately recognized as lenders sell the foreclosed assets off to the highest bidder == highest value user.  Economic recovery takes place quickly because the model doesn’t allow for assets to be held and used by low value users.

As I understand his argument, Richard Koo sees solution (i) as so full of costs that typical economic models don’t recognize that it can be rejected out of hand.  And indeed most policy-makers seem to agree with him.  Banks are not asked to recognize their losses, borrowers are induced through temporary payment reduction plans like HAMP to continue making payments on loans that would lead to strategic default in an economic model, etc.

The balance sheet recession theory focuses on a world, like the one we are experiencing now, where strategic default does not take place on a large scale, and assets continue to be held by entities that are paying more money for them then they are worth on the market.  Such debtors have the use of the asset, but cannot sell it because the market value is insufficient to pay off the debt.  They are “locked in” at least until such time as they choose to default and transfer ownership to the lender.  This implies that we are now are in a world where assets are not as easily transferred to their highest value use (whether due to policy decisions, social pressures, or other concerns) as economic models tend to assume.

Observe, in addition, that spending less in order to have the means to make a debt payment on an underwater loan to a financial institution is very different in macroeconomic terms than spending less in order to invest the money in some asset.  The reason for this is a simple matter of accounting:  banks assume when they lend that the debt will be repaid (at least until such time as there is a significant default and they transfer the loan to an impaired asset category).  Thus the payment of debt has already been accounted for by the bank in its assets and adds nothing to the economy’s capacity to lend.  Savings/investment are a very different matter, because these are sums that an entity sets aside to provide itself with future income, but there aren’t many realistic future housing market scenarios in which reducing the negative equity in your home from 50% to 49% by making a year’s worth of payments is going to result in future income within the next decade or two.

Thus, it’s not true that all the two-earner households who have become one-earner households and are now cutting back on consumption in order to make their mortgage payments on underwater homes are “saving” in a meaningful macroeconomic sense — because many of these households don’t expect these payments to result in home equity for at least a decade (and since they are likely to lose the house in the end anyhow, they are really just renting == consuming housing services), and the banks’ current balance sheets are founded on the assumption that these payments will be made.  These households are cutting back on their economic activity, but the “savings” from doing so added to economic activity in the year in which they took out the loan and bought the house, not now.  Only if you want to argue that when banks don’t have to recognize losses on the bad loans they made, that also constitutes savings for macroeconomic purpose, can you claim that the vast amounts currently being paid on underwater mortgages are savings.  This is, however, at best a disputable position.

In short, in order for Rognlie’s theory to apply to our current situation he needs to consider the effectiveness of monetary policy in an environment where a principal goal of policy-making is to protect financial institutions from experiencing (or at least realizing) losses and where the policy is implemented at the cost of obscuring the valuation information available to shareholders and of encouraging deeply underwater consumer-mortgagors to continue making payments on their loans (e.g. HAMP).   Confusing the macroeconomic effects of paying off debt for the purpose of incrementally reducing negative equity (and in many cases insolvency) with the macroeconomic effects of saving is a serious error, but one that is easily made by those who work with models that don’t take insolvency and the bankruptcy process into account.

The End of Equity?

Barry Ritholtz is blaming the falling value of bank stocks on the decision not to require mark-to-market accounting.  I’m wondering whether the fall isn’t a delayed reaction to the implementation of broad safe harbors for derivatives in the bankruptcy code (which was completed in 2005).

After all, Lehman Bros. made clear that anyone who holds equity in a financial institution can expect to get nothing when the company is wound up — in fact, it looks like the unsecured creditors will get 20 cents on the dollar.  What happened to the $640 billion in assets and $26 billion in shareholders’ equity that was reported for May 2008?  You can be sure that a large chunk of it ended up being posted as collateral on derivative obligations and thus removed from the control of the bankruptcy estate.

Why after this experience would anyone own the shares of a financial institution that could possibly go bankrupt or be resolved?

Another concern is what will happen when some large real economy firm ends up with such big derivatives exposures that its shareholders get treated the same way as Lehman’s.  Will one-time equity investors decide that, after the recent changes to the bankruptcy code, being a shareholder of a listed stock is just an option on nothing at all?

Unintended consequences, indeed.

Update 10-8-11:  In case it wasn’t clear, the issue that is created by the new bankruptcy code is that is that in the months leading up to a bankruptcy (or resolution) the claims on the firm’s assets are likely to change dramatically with the result that the accounting statements don’t reflect the relevant information.  So the underlying problem is that equity investors are asked to invest blindly.  While this problem is worse for financial firms, it’s far from clear that the problem is limited to them.