I am not afraid of the N word (nationalisation). Real capitalists nationalise – meaning if the taxpayer takes the risk the taxpayer gets (any) upside. However I want to take issue with Professor Krugman’s NYT editorial today. Krugman accuses members of the incoming administration of believing in voodoo rituals to keep banks alive. He takes a worthy shot at the person I most dislike amongst the continuing economic team (Sheila Bair). But I still think Paul has his maths wrong.
Here is the key part of the article – with Gotham being a thinly disguised moniker for Citigroup.
On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.
PK is wrong. With sufficient trust Gotham is far from bust on PK’s numbers. Suppose – and this is an understated assumption – that the normalised pre-tax spread on Gotham’s assets was two percent – say – and for the same of simplicity – the bank would earn 3% on assets and pay 1% on liabilities.
Then the bank (if it did not have the bad loan problems) would earn $60 billion on its (normal) $2 billion in assets and pay out $19 billion on its $1.9 trillion in liabilities. The pre-tax profit of Gotham would be $41 billion dollars.
But – as Krugman suggests – the real assets of Gotham are not $2 trillion, but in fact $1.8 trillion. The liabilities are (unfortunately) solid. They remain worth $1.9 trillion.
Then – if the bank can continue to operate – it will earn $54 billion on its assets still pay out $19 billion on its liabilities. Pre-tax profits will still be $35 billion.
If the bank runs for three years it will again be solvent. If it runs for less than six years it will be fully and adequately capitalised. This is in fact how the Japanese mega-banks recapitalised. I blogged about it here. At the spreads in America – which are several percent – the recapitalisation will happen much quicker than this and much quicker than in Japan. Indeed it is likely that with quasi government guarantees for bank funding and market rates for bank loans the spreads would be over five percent in America right now.
Paul thinks the bank has value only because there is a perception that it will be bailed out. I think it has value because it still has positive operating cash flow (provided it does not have a run). The value - which I believe is large - might mean that widespread nationalisation is (ex-post) profitable for government - though it may not be profitable on an (ex ante) risk adjusted basis.
Paul Krugman might consider it voodoo economics to give implicit guarantees to banks – but the Japanese experience shows – and this post explains – that things that stop a run will eventually recapitalise a bank. It worked in Japan. It was not a particularly pretty way to run things from a macroeconomic perspective – though people like Nihon Cassandra think that Japanese capitalism works pretty well.
Paul is accusing Sheila Bair et al of voodoo economics. I am inclined to agree with almost anything nasty about Sheila Bair. But in this case PK is publishing voodoo maths.