The rationale of the rescue

A quick comment on the story of the day: bank bailouts, coordinated interest rate cuts, and further stock market falls. In my view, the first point is more important than the second, and the third is scarcely important at all.

The UK Government has handled the issue pretty well. It will inject £25 billion of preference share capital across several banks, and make available a further £25 billion of preference capital if needed. I did a brief slot on Newsnight last night when the principle of the plan was clear though the numbers were not yet announced, and I welcomed it.

Also on the programme was a stock market historian who believed - mirabile dictu - that the plan was a dangerous precedent auguring state intervention in the banking sector. That critic's objection was mistaken, and it has a counterpart among commentators on the Left. For example, my colleague Alice Miles maintains that the bailout recalls the old Clause 4 of Labour's constitution, about common ownership of the means of production, distribution and (in this case) exchange. Alice has thus grasped quite the wrong end of another kettle of red herrings.

Here is why I believe the bailout is right.

The Government's plan is better than the original Paulson proposal, under which the US Treasury would bid for the toxic assets of the banks. The Paulson proposal was an indirect approach to the underlying problem, which is that the banks are undercapitalised. It also implied that the Treasury could reliably assign a value to these assets, even though the banks themselves could not. The UK Government's plan addresses the problem directly. It deliberately involves overpaying for the assets of the banks - if it didn't, then the banks wouldn't be able to rebuild their capital - in return for which the taxpayer gets a stake.

It is surpassingly unlikely that the Government intends to maintain its equity stakes beyond the point at which those can be sold in the market at a better price, and in a stronger economic climate. This is not a socialist measure. Government has no expertise or role in running banks, and no legitimate interest in expropriating existing shareholders. It does have an essential function in restoring liquidity to the market, and thereby enabling banks once again to borrow against their assets according to their intrinsic value. Some of those assets - in particular those relating to mortgage debt - will be rubbish, and have been misvalued by the ratings agencies. (Those agencies' income is derived from the debt issuers, incidentally - a clear conflict of interest, and an arrangement that needs to be reformed.) But some will be good, and merely cannot be sold in today's market.

There is, incidentally, a conservative criticism that the credit crunch derives from government meddling in the housing market, forcing the US quasi-government agencies Fannie Mae and Freddie Mac to make loans to less creditworthy borrowers. I don't buy this. Governments and central banks have made the problem worse, by failing to restrain a credit expansion. But the underlying reason that we are where we are is that there has been so much capital around, not least owing to the enhanced role of China in the global economy. The development of China is a good thing, bringing millions of people out of poverty. But it also entailed that interest rates were kept too low and for too long. That's why borrowing expanded, and why banks sought to provide financial products that offered higher yields (notably by securitising mortgage debt and selling it on). Hence the ructions that have crippled the global financial system. And for its rescue plan to deal with the weakness of the UK banks, the  Government merits a modicum of credit after all the attacks it's recently weathered.

Comments

[Snorri Godhi]

When the UK government takes its cue from Warren Buffett, it is probably doing the right thing.

"There is, incidentally, a conservative criticism that the credit crunch derives from government meddling in the housing market, forcing the US quasi-government agencies Fannie Mae and Freddie Mac to make loans to less creditworthy borrowers."

This is an ambiguous statement, and I am not sure what to make of it. Let me ask a few (non-rhetorical) questions:
* weren't Fannie+Freddie conceived to make it easier for people to buy homes?
* doesn't the very founding of Fannie+Freddie qualify as government meddling?
* didn't loans to less creditworthy borrowers play a key role in the crisis?
* didn't Fannie+Freddie make it easier for less creditworthy customers to get loans?

It is true that Fannie+Freddie have been around for quite a while, and in the absence of other factors, no crisis would have occurred. But then, some of these other factors did make it easier for less creditworthy customers to get loans, even though that was not intentional.

[Tony Francis]

It is difficult to argue that government meddling into bank practices forcing them to make unsound loans is not at the heart of the problem. When these bundled assets began to fail, the money borrowed and lent by banks was put at risk. Normally, banks should keep 10-20% of real assets to back up loans. Fannie and Freddie were keeping 3%, with Democrats in Congress arguing as late as last summer that it could go to 1% or 2%. When the loans began to default, there were no reserves. Interestingly, this massive default corresponded with the skyrocketing price of oil . It is true that emerging markets, mainly China have had billions of dollars, and no place to put them, except by purchasing debt of the US government. While this allowed a source of easy and cheap money for too long, it is hardly the main problem. Where there has been commodity inflation, wage inflation has not occurred. This is because high paying jobs in the industrial world have been shipped to third world companies. If monetary accumulation in the third world allowed for unbridled debt expansion, then your main thesis is probably true.

[Snorri Godhi]

Speaking of Warren Buffett, here are some words of wisdom from him:

"(...) the sole job of OFHEO was to watch over Fannie and Freddie (...) OFHEO has over 200 employees now. They have a budget now that's $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies."

Source:
http://www.marginalrevolution.com/marginalrevolution/2008/10/regulation-a-di.html

[Michael B]

I agree with snorrigodhi's comment concerning ambiguity. I don't see that it's an either/or, which is not to say the sheer immensity of available credit did not represent its own potent gravity and force. I'm prone to agree/disagree, mostly the latter however, unless the emphasis being placed is upon the most fundamental and the most critical factor. But human agency and responsibility is inextricably involved in this.

Of course the GSEs problems can be separated from the still wider and deeper problem, so perhaps I do agree.

[dirigible]

Which order from our evil government overlords forced banks to create an entire industry around selling on these unsound loans after the arrangement fees were taken, then disguise them by mixing them with other debt?

As for governments being foolish for listening to bankers' demands for less regulation I quite agree. But this hardly means that the problem is how to prevent government interference in the financial sector.

The nine most terrifying words in the English language are "I'm an economist and I'm here to explain things."

[Gavin]

Ah, yes, economists. Well, as there is no predictive value to economics, I offer the economists the opportunity to admit that they are actually involved in humanities rather than remain in the charlatan-infested ghetto of witch-doctory otherwise known as social science. Still, I'm sure they could get jobs in the financial services sector come the next mysterious upturn from the magical invisible hand once the current wave of sacrifices to Mammon have been made.

[Tony Francis]

According to former FDIC chairman Bill Seidman, UK banks are under capitalized because they follow Basel II requirements. This places them in a fundamentally different position from US banks, which in general, have more capital:
http://www.cnbc.com/id/15840232?video=883562114&play=1

Concerning Basel I and II requirements:
http://www.en.wikipedia.org/wiki/Capital_requirements
http://www.en.wikipedia.org/wiki/Reserve_requirements
Seidman said McCain's plan to buy up and renegotiate bad loans (using $300 billion), was more workable than Obama's plan, which he says is non-existent. This was somewhat of a surprise to me. He is neither impressed with Obama, nor his advisers, who include Paul Volker and Larry Summers. Again, this was surprising, since Volker was key to ending the last recession/inflation crisis arising out of Carter/Reagan.

[Get Shorty]

I am still of the mind that Fannie & Freddie are at the root of the problem in America. Sure easy money was the lubricant but the idea of the State strongly encouraging people to buy a property is dangerous. As soon as house prices started falling in the UK the professional class rose up and demanded state support. Stamp duty was cut. More is demanded. During the British bubble no action was taken to hinder the mad speculation in buy-to-let, in fact the government then gave grants to trap key workers in over priced property. I think the fateful day for Britain took place in 2005 when the MPC cut rates with Dr. King voting against. The property bubble reignited and then buy-to-let went nuts. There was an unconscious collusion between the state and media, who become intoxicated on the free money. Copious propeprty porn filled newspapers and television. Many in the country got the fever - no more than Gordon Brown who believed he had abolished the business cycle. Had he never read the Great Crash!!! He had lived through the TMT bubble - maybe he did not want to see the property bubble? People lose their minds with bubble fever. There are many ingredients to a bubble but the all start with the same premise = greed!

[Snorri Godhi]

"the underlying reason that we are where we are is that there has been so much capital around, not least owing to the enhanced role of China in the global economy."

Thinking back about this sentence, perhaps I see Oliver's point, which I must have missed before: when there is too much capital sloshing around, an asset-price bubble is bound to happen. It happened some 20 years ago, when Japan ran a current-account surplus with the US, and now we have seen it again.

OK, fine, but there are a couple of issues:

First, it is not clear to me that the asset whose price inflated would have been housing, were it not for counter-productive State attempts to keep housing affordable. I am thinking specifically (a) of the government making it easier to get mortgage loans and (b) of the implicit guarantee given by the US government to Fannie+Freddie, which made it look like a safe bet for China to invest in mortgage-backed securities. See point 2 made by Tyler Cowen here:
http://www.marginalrevolution.com/marginalrevolution/2008/09/did-we-really-n.html

Second, those very attempts to keep housing affordable might have been sufficient by themselves to inflate a housing bubble: a slower and smaller bubble perhaps, but a bubble nonetheless. Still, if the bubble had grown more slowly, it might have been contained to parts of the country where habitable land is scarce (mainly the North-East and West coasts, I suppose): that would have been good for the Republicans, since those parts of the country vote Democrat anyway.

[Snorri Godhi]

PS: it occurs to me that Oliver's diagnosis can easily be turned into a different conservative argument: The current-account imbalance which caused the injection of so much Chinese capital into the US would not have happened, were it not for the mercantilist policies of the Chinese government.

The guilty government might not be American, but the conclusion is the same: Government is not the solution to our problems; government is the problem.

Nothing against the Chinese people, of course, who stand to lose more than the Americans from their government's mistakes.