Last fall the Federal Reserve Bank of Minneapolis published a working paper suggesting that much of what officials were saying about the financial crisis, and how to solve it, was wrong. The paper, “Facts and Myths about the Financial Crisis of 2008,” attracted some media attention at the time but was quickly swallowed up in the air of panic over the unfolding calamity.
Yesterday I spoke with one of paper’s co-authors, University of Minnesota economics professor and Fed consultant V.V. Chari. Chari believes the U.S. government is following a wishful, piecemeal policy that’s doomed to fail. The solution he advocates–bankruptcy reorganization of troubled institutions–is functionally similar to the one proponents of nationalization have extolled.
“What these policymakers, in their wisdom, have done is to start down the same path that Japan did,” he says. “Which is, hope like crazy that just by pushing this off for another six months or so, markets will recover and everything will be fine. I think it makes the problems much, much worse over the medium term. I don’t even mean the long term. I mean over the course of a year or two, it can make the problems really bad.
“Preventing short-term disruptions by bailouts, I think, doesn’t even postpone the problem that long. That’s one of the things that these guys don’t seem to understand. They think, if we can just get by today with an appropriate bailout package, then it will be all right.”
I also talked with Chari about the decline of Minnesota’s economy in recent years; I’ll post that segment tomorrow.
SP: Last fall you co-authored a Fed working paper that proved fairly controversial. It argued that the Fed’s own data disproved the claims of a system-wide credit freeze-up that were being used to push for the $700 billion TARP program. Could you briefly explain the findings?
V.V. Chari: The paper was not so much about system-wide credit freeze-up. It was about very specific claims that senior officials of the Federal Reserve system as well as senior officials of the administration had been making. Those claims were that banks had stopped lending, to consumers and to each other, and that rescuing the financial system with a very substantial, unprecedentedly large infusion of public funds was needed to save the economy.
We showed that the specific claim that bank lending had declined seemed contradicted by the Federal Reserve’s own data, in the sense that bank lending across a wide variety of categories–the dollar amounts had in fact grown during this period.
There are several things worth keeping in mind. That there was a financial crisis, and that there is a financial crisis, is beyond dispute. The nature of that crisis is that several major financial institutions have failed, others are close to failure if not actually insolvent, and spreads–the difference in interest rates between various kinids of credit market instruments have widened very dramatically.
So the question had to do with how those changes were going to affect the broader economy. And the most important question for ordinary citizens is, how are their particular policy interventions going to solve the overall problem? To the extent they believed there was a credit market freeze outside the banking system, then it’s not clear how injecting funds into the banking system is going to solve the problem of pension funds, hedge funds, mutual funds not buying enough debt. I don’t see how it’s going to solve that problem, simply because banks are only about 20 percent of the overall financial market in terms of debt instruments. It wasn’t clear how this policy intervention was going to work.
They defended the intervention as needed because the banks were not lending. That claim, factually, just doesn’t seem right based on the data we’ve got. That’s how I would summarize our findings.
SP: So was it a matter of politically overclaiming on the part of officials, or misunderstanding the problem?
Chari: I don’t know what motivated their interventions. One possibility is that the larger financial system, outside of the banks, was for a variety of reasons reluctant to hold on to any kind of debt instruments; instead they all wanted to hold Treasuries. And the policy interventions were directed at the banks because that’s the only place the Federal Reserve and the Treasury could intervene directly in a straightforward way. That’s one charitable interpretation of what happened.
The other possibility, which I think has a little more promise, is that policymakers simply had fundamentally the wrong model of how the financial system interacts with the overall economy. One of the things they thought the financial system does is to take funds from consumers and households and hands it out to firms. What we showed in our Facts & Myths paper is that exactly the opposite is true. Essentially, firms are in the business of generating cash, which is then sent to consumers and individuals rather than the other way around. So therefore, severe disruptions in the financial system do not necessarily have to lead to disruptions in productive capacity. So that was a basic misunderstanding about the nature of the financial system that, I think, motivated their interventions.
The other thing that I think motivated their interventions is that the financial markets, over the last 25 to 30 years, have been remarkably tranquil, relatively speaking. So they saw these kinds of problems and they imagined that the worst was coming upon them. But in fact, a longer history would suggest that if you don’t over-react to financial crises, if you handle them in a responsible fashion, you can contain them to the financial system and they don’t have to spill over to the rest of the economy.
My guess is that, having fundamentally the wrong model of the economy and relying too much on the experience of the last 10 or 20 years, led to what I view as significant policy mistakes.
SP: What would policymakers have done last fall if they understood the system correctly, in your view?
Chari: I think they would have recognized that certain financial institutions had to fail–not in a liquidation sense but rather in a bankruptcy sense. We are all familiar with bankruptcies like those of Northwest Airlines and Circuit City. If you remember, Northwest declared bankruptcy, and I do not know anybody who saw any difference on the morning after the bankruptcy, in terms of their ability to fly, compared to the morning before. I did not see any planes grounded because suppliers said, oh my god, they’re not going to pay me, so I’m not going to supply fuel, or food, or aircraft parts.
None of that happened. In other words, bankruptcy is a process whereby we obtain financial restructuring. Bankruptcy doesn’t have to mean that the people working there, the buildings, the equipment suddenly become valueless. There’s a widespread misconception that bankruptcy equals liquidation, and liquidation is extremely costly and extremely painful.
Just allowing AIG, for example, to declare bankruptcy would have been substantially more painful in the short term than the policy that they followed. But my guess is that over the longer term, the kinds of problems we are seeing at AIG and everywhere else would have been avoided had we allowed them to take the normal course of action.
Now, what’s also true is that our current bankruptcy laws with respect to financial institutions are antiquated and very poorly designed. In particular, in the usual process of bankruptcy, certain kinds of financial institutions cannot declare bankruptcy. They must liquidate–in particular banks. Bank holding companies and financial services holding companies can in fact declare bankruptcy. The current process of bankruptcy is unnecessarily and unduly drawn out.
There is no doubt in my mind that had they listened to the people who were advocating this–including Luigi Zingales at the University of Chicago, Ken Rogoff at Harvard, and a whole bunch of other people who were advocating that what we needed was to reform the bankruptcy laws. Now, what we’ve learned from both the TARP package which Congress passed last September and from the stimulus package is that when Congress is given a clear case for action, Congress can move unbelievably fast.
In my judgment, the proper course of action then, and in fact the proper course of action now, is to modify the bankruptcy laws with respect to financial institutions to make it much easier for debt holders, especially long-term debt holders, to become equity holders essentially overnight. And the bank or other financial institution can continue in business as usual until these issues are resolved. Those are the kinds of actions which I and Professor Rogoff and Professor Zingales and a whole bunch of other people were urging on Congress way back in September and October.
At that time, we were all told, well, we’ll deal with long-term reform later. Right now we’ve got an emergency. We raised the same kind of questions in December, and we were told, well, the old administration’s leaving. Wait until the new administration comes in. New administration came in, and it was, well, we’re really busy putting out fires. We don’t have time for structural reform.
The longer you postpone that kind of structural reform, the more severe the problems will get and the deeper our financial mess will be. One of the important lessons we learned from the Japanese experience–as contrasted with our own experience of the S&Ls, or with the Swedish experience in their financial crisis–is that attempts to keep insolvent institutions alive artificially in the hope that someday, somewhere, things will turn around seems to lead to much more prolonged problems. Part of what a capitalist system does is to constantly reshuffle assets and capital from people who have demonstrated that they cannot manage those assets well to new hands–some of whom will be able to manage it better, some of whom will manage it worse. But that process of dynamic reshuffling is central to a well-functioning capitalist economy.
What these policymakers, in their wisdom, have done is to start down the same path that Japan did. Which is, hope like crazy that just by pushing this off for another six months or so, markets will recover and everything will be fine. I think it makes the problems much, much worse over the medium term. I don’t even mean the long term. I mean over the course of a year or two, it can make the problems really bad.
Preventing short-term disruptions by bailouts, I think, doesn’t even postpone the problem that long. That’s one of the things that these guys don’t seem to understand. They think, if we can just get by today with an appropriate bailout package, then it will be all right. And any critics are dismissed by saying, you’re not really close to the markets. You don’t understand the panic. You don’t understand the chaos that would result if we didn’t intervene.
And I guess my response is, look at what the financial system does. Severe disruptions over the course of a week or two weeks or even a month are things the economy can take. What it cannot take is assets in the hands of people who have demonstrated their inability to manage those assets.
SP: What you’re advocating as the “take your medicine now” appeal of bankruptcy sounds like what a lot of economists are saying about nationalization. What’s the practical difference between those approaches?
Chari: The important thing about bankruptcy, and these kinds of proposals–let me start with some basics, actually. The basics are very simple. For a large number of financial institutions, what has happened is that the market value of their assets is less than the accounting value of their liabilities. They owe more money than the value of the assets they have on their balance sheet.
This is simple arithmetic: Somebody has to take the hit. This is confronting basic economic reality. Somebody has to reconcile the two sides of the balance sheet. It can either be taxpayers, through the injection of public funds on the asset side of the balance sheet, or it can be the liability holders–the debt holders–who bear some of that hit.
What are the costs and benefits of having the taxpayers cough up? Quite apart from the distributional issues–why should some poor taxpayer in Kansas City have to bail out some rich fat cat on Wall Street?–the problem is that if debt holders become convinced that they will be bailed out every single time, their incentives to monitor what the banks are doing are diminished greatly. So you lose market discipline. Losing that market discipline means that the smart thing for managers of financial institutions to do is to take on lots more risk. Because the debt holders don’t care, the shareholders will benefit, and the taxpayers will be left holding the bag.
So this moral hazard, this too-big-to-fail problem, sets the stage for recurring financial crises. That’s the problem. And so what you do by bailing out an individual bank today is avoid the short-term pain, but inflict on yourself the longer-term pain that the likelihood of financial crises is going up sharply and you’re going to be in this mess for a long time.
And regulators, because they understand that the likelihood of financial crises goes up in the future, they sensibly step in to try to regulate the banks and financial institutions much more closely. In many cases, to the extent that happens, that tends to retard innovation and reforms in the banking system. You end up in this really nasty vicious circle where financial crises become more likely, regulators regulate more stringently, financial innovation declines, and assets don’t move from the hands of people who aren’t equipped to handle them to the hands of people who are equipped to handle them.
That’s the kind of stage you’re setting. And I’m not talking about problems 20 years down the road. I’m talking about problems that Japan saw a year or two years, or even six months, down the road. That’s the kind of chaos that you’re setting yourself up for. And you’d think that the policymakers would understand that, but they don’t seem to understand the lessons of history particularly well. I’m confused and puzzled about why.
So then, to get back to the question of nationalization, in Sweden’s case they nationalized the banks but they protected the debt holders. I think that is not a solution [for the U.S. crisis].
There are a bunch of people who are talking about nationalization in the sense of taking over, wiping out the equity holders and wiping out the debt holders. To the extent that they’re talking about wiping out part or all of the debt claims that uninsured debtors hold against the financial institutions, I would say economic theory says that that’s a really good idea. To the extent they continue to protect the existing debt holders–if you nationalize just in terms of wiping out the equity holders–that does not solve the medium-term and long-term problem. In fact, it’s going to exacerbate it, because as we have seen with AIG and Bear Stearns and a variety of other institutions, the U.S. government is singularly ill-equipped to run major financial institutions.
So any proposal for nationalization–even the most ardent advocates–propose a relatively speedy return to private hands. If you’re going to return it to private hands without wiping out the debt holders, you haven’t solved the fundamental problem. Nationalization is fine if it means wiping out the equity holders. It’s not fine if it means leaving the debt holders completely unaffected. That’s the way I’d describe it.
I think these code words and buzzwords miss the fundamental underlying reality: Somebody has to take the hit because the market value of the assets is less than the market value of the liabilities. Any mechanism that does not impose some of that hit on existing debt holders is a mechanism that’s setting us up for problems in the future.
SP: So in everyday terms, it sounds as if you’re saying that the whole U.S. strategy is to put them in a position to “grow their way out of it.”
Chari: Yes. I would describe it as, cross your fingers and hope that manna showers down from heaven. It is unbelievably misguided, in my view, to think that by keeping the existing institutions alive for another six months, and spending trillions of dollars on them, somehow magic is going to happen. That’s not the lesson of history. Magic is not going to happen just by handing money over to people who have demonstrated their inability to manage money. Managing money requires urgent reform, and it’s fairly straightforward reform. Fairly simple revisions in existing bankruptcy procedures would do it. Alternatively, nationalization could [do it].
Even with nationalization, [we would need revised laws]. I think it’s fairly clear that the U.S. government, under our Constitution and our current statutes, cannot simply go in and tell Citigroup, you are part of the government. They just don’t have the powers to do that. In some countries, say Sweden or China or India, the statutes permit the government to declare by executive order that some financial institution is now the property of the government.
The problem here is that any attempt to do something like that is going to lead to a long, messy legal struggle. What advocates of nationalization are realistically saying, I think, is let’s go to Congress and get Congress to change the law. To the extent that’s the case, I have no problem with nationalization as long as debt holders take a substantial part of the hit.
And I guess my thought is, if Congress is going to write a law anyway, why don’t they just revise the bankruptcy procedures for financial institutions and be done with it? It’s pretty much the same thing. I guess the bottom line is, rather than getting hung up in words like “nationalization” and what they mean, it’s simpler to think about the economic reality: Who is going to make up for the fact that the market value of assets is less than the market value of liabilities? Who is going to bear that hit? That’s the central economic question. And then there are a lot of legalistic details about how we arrange who gets to take that hit.