Why the Federal Reserve should LITERALLY throw money out of helicopters

Cassandra (who normally does Tokyo) has a diary note in which (s)he explains – in layman’s terms – why the Fed printing all that money (expanding its balance sheet) is not inflationary.  The key section quotes Perry Merhling (whom shamefully I had previously not heard of).  Here it is.

 

It seems to me that what we are seeing is simply the balance sheet consequences of the Fed's decision to take the wholesale money market onto its own balance sheet. Banks (and other entities) that used to lend to one another, are now lending and borrowing through the intermediation of the Fed. This is so not just domestically but also internationally (the huge swap line), since foreign banks used to fund dollar asset holdings in the dollar money market.

In this view, inflation seems much less likely. Why not? If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary. 

Posted by: Perry Mehrling at December 22, 2008 05:12 AM

This is of course correct – as far as it goes.  To the extent that Fed balance sheet expansion simply offsets private balance sheet contraction there is no net increase in money and near substitutes – and so the Fed balance sheet expansion cannot be inflationary.  We are – to that end – stuck in our deflationary spiral.

The situation has a name in the economic jargon - a liquidity trap.  An American – not a Japanese version of a liquidity trap – but a liquidity trap nonetheless.  No matter how much “money” the Fed supplies the public will want to hold it.  Monetary policy is thus useless.  

This is usually made out (by Krugman et al) as an excuse for massive fiscal policy.  And I am not averse to that.  

However there is another approach which I detailed in my lessons from shorting JGBs post.  The argument: if you can’t fix the problem with increasing money supply then maybe you can fix the problem with decreasing money demand.  

You need to convince people not to hold money.  You need to convince them that cash is trash.

And to do that you need to convince the public that there will be inflation (the above gross leverage argument notwithstanding).  

To do that the Federal Reserve has to be credibly irresponsible.  It is not enough to print a couple of trillion dollars (which they have) because everyone thinks (with some justification) that they will suck back the money supply when the crisis is over.

No – you have to be more visibly reckless than that.  You have to really convince people that there will be inflation.  

So the suggestion in my title is literal.  The Federal Reserve should hire a couple of hundred helicopters and load each one 10 million dollars in neatly bound parcels of $1000 each.  Total cost $2 billion plus trivial helicopter hire.

It should fly them over 200 randomly picked American cities and throw the money out the window.  It should press release this – but press coverage will be excessive.  Indeed I suspect that the press coverage would give the Fed’s inflation policy greater awareness than the Coca Cola Company.  (The Coca Cola Company’s annual advertising budget is $2.8 billion – so this is already cheap compared to some private sector alternatives.)  

The press release should be simple.  We are doing this to induce inflation.  If there is no inflation as a result we will simply do it again. 

Of course people will fall of roofs after searching for money that might have landed on their house.  They might die.  Of course people might get trampled in the crush.  They might die too.  

All of this increases the visible recklessness of the policy.

But the charm of this.  It may actually induce mass spending of American dollars for (self-fulfilling fear of inflation)– a massive stimulus.  And it will do it all for $2 billon.  Obama has a stimulus package of $1.2 trillion – or about 600 times as large.  This is relatively cheap.

The real case for throwing money out of helicopters is that it looks like it will work better than anything else that anyone has come up with yet.

And it will be cheap.  Much cheaper than alternatives that are actually being implemented.

The secondary benefit is that most of the losses from inflation will be in the hands of the Chinese who have built huge reserves of soon-to-be-deflated US dollars.  

Hey what better – lets kick start the economy and get the Chinese to pay.

I am serious.  At least serious until I can get a credible explanation as to why this won't work at least as well as any of the alternatives being mooted.

John Hempton

Felix Salmon asks the question: is nationlisation contagious?

The answer to that is YES if it is done without giving existing capital holders the belief that they are being treated fairly.  (See Felix's post here.)  

A bank that loses access to capital eventually fails.  Certainly in a current account deficit country if it loses access to intermediate funding it fails - and intermediate funders are not that keen if the bank has no access to capital.

If private shareholders feel that government will ride roughshod over their rights then there will be no private shareholders.  They will have "fear of government".

So there must be a process which respects the capital that private shareholders offer - and which is seen to honour that capital.  

If done that way - and the Scandinavian countries groped towards such a solution, then nationalisation is NOT contagious.  

As noted in my last post Svenska Handelsbanken did not surrender ANY equity to the government even though it took government liquidity support.  It was seen to have capital and the shareholder capital was respected.

There was - and the histories referred to in my last post - a contagion until the due process was implemented an no contagion afterwards.

I have no objection at all to nationalisation - but it must be accompanied by a process that both respects and is seen to respect existing capital holders.

Can we please get this straight?  Contagious nationalisation - and that is where Willem Buiter et al are heading - is a disaster.  It is also an simply not necessary.

John Hempton

PS.  Notwithstanding the above - a pretty-close-to-complete nationalisation will probably happen in the UK.  Due process will lead us there.

Scandinavian bank nationalisation and due process

The proposal in my nationalisation after due process post the proposal I gave was not new.  I probably should have pointed out it had a precedent - Norway.  Norway was the country with the most pervasive nationalisation in the crisis.

You can find the reasonable history of Scandinavian bank nationalisation here.  Read Chapter 3 if you are interested in this stuff.  The biggest nationaliser was Norway - not Sweden - though Sweden did buy out the minority shareholders for token sums.

The process used in Norway was to assess the shareholder capital of the bank.  Shareholders were given FIRST RIGHT to recapitalise it.  If private money could be raised they kept the bank.  If they were short capital the government loans (which had previously guaranteed liquidity) were converted to equity and the old equity was written down.  Here is the key paragraph explaining the Norway result for the biggest banks:

Amendments were also made to the banking law, enabling the government under certain conditions to write down a bank’s shares to zero. This ensured that share capital really was written down to the extent that capital was lost.

It was soon realised that Christiania Bank and Fokus Bank had lost their entire share capital.  The share capital in Den norske Bank was written down by 90% according to losses.  The banks needed more capital, but private investors were unwilling to invest. All three banks thus received a substantial capital infusion from the GBIF [which was an independent but government owned bank manager] at the end of 1991. Conditions were established regarding balance sheet restructuring/downsizing, cost cuts and other measures to improve results. Share capital was written down to cover estimated losses. In both Christiania Bank and Fokus Bank the share capital was written down to zero by government decision (after shareholders had refused to do so). The existing shareholders thus did not receive anything for their shares, and the GBIF became the sole owner of the two banks. The boards and the top management were replaced. The banks received further capital support from the GBIF in 1992.

What we had here was a recapitalistion by government with rules which were widely understood and where the existing shareholders were given first rights of refusal over the recapitalistion.

In other words it was nationalisation without theft and it was not theft because there was a process which treated shareholders fairly.  Because Den Norske Bank had 10% of the required capital when assessed the private shareholders kept 10% of the equity.  Christiana and Fokus had less than zero capital and the shareholders were wiped out without compensation but after due process.

In Sweden similar processes were involved - but like Den Noske Bank the companies mostly had some capital left and so existing shareholders received some value.  One major bank (the very well run Svenska Handlesbanken) never surrendered any ownership to the government.  It had liquidity problems (it actually needed government money from memory) but it had no capital problem when it was assessed. 

Finland also had a crisis - but as far as I can tell (and know no banking expert that speaks the language) it was handled much worse.

The lessons of Scandinavian crisis are many.  One of them however was that if you want to reconstruct a banking sector post crisis (and I presume most people do) then you probably want to treat the existing shareholders fairly.  Fairly can mean confiscation as per Fokus or Christiana bank - but it is fairly after due process.

I only mention this - and also remention Chapter 3 of this document - because Kevin Drum and Interfluidity are maintaining their argument about what happened and how it should be handled.

Nationalisation probably will happen for some banks.  It has already happened for Royal Bank of Scotland for the most part.  It happened without much process - and the lack of process has put the fear of government into everyone who might fund banks.  Lack of process will wind up meaning that everything gets nationalised because if there is no fair process there will be no private money as an alternative to nationalisation.  In that case nationalisation becomes a self-fulfilling prophecy...  

Will the policy makers PLEASE read Chapter 3.

Pretty please.

John Hempton

The last bank with an antidilution clause...

Was Washington Mutual. It caused them no end of trouble.

Barclays has one.

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article5563223.ece

Implication - either Abu Dubai waives the clause or it is confiscation for Barclays.

If I were Abu Dubai I would be waiving the clause NOW.

But then I was not long Barclays - unlike SMFG who put almost 700 billion yen in only a little while ago. (Hey what is 700 billion yen between friends?)



John Hempton

Zero in Japan versus zero in America

I don’t have a solid economic model of different types of zero interest rate policies. I guess the number of instances historically doesn’t give us enough material to get a classification. But this is worth stating.

Zero in Japan looks very different from how zero in America looks right now.

How Japan looks

One of the first posts on my blog was about 77 Bank. 77 is a typical mid sized Japanese regional bank. It has vast excess deposits. It has plenty of liquidity – but almost nobody to lend it to. Competition to attract worthy borrowers is intense – and is led by prices. Loans are typically made on less than 50bps of margin.

The banks are bizarrely unprofitable. At 12 times leverage and a spread after costs of about a third of a percent the return on equity – before tax and provisions – is about four percent.

Businesses – at least ones with any claim to be credit worthy – have no trouble borrowing at all in Japan.

There is however a problem with these low spreads – a very big problem. Japanese banks are vulnerable to very low levels of credit losses. A loss rate of a third of one percent wipes out profit. A loss rate of 2 percent sustained over a couple of years would wipe out half the capital.

Summary: Japan has zero rates and the banks can’t make a spread because they have no willing borrowers. The banks have no liquidity problems – but they have a capital problem whenever losses rise to merely low levels from extremely low levels. The reason banks stopped lending was that there were insufficient willing borrowers.

The broken bank in Japan is a “zombie” (living dead). It has insufficient capital and not enough spread to rebuild capital over even a decade. It has enough liquidity to limp on for many years. However it often is attracted to riskier loans in a vain effort to find some spread – and it is prone to blow ups. For a long time Nishi Nippon City bank looked like that.  

Note that Japan is now facing credit losses of a couple of percent - and that is high enough to cause widespread devastation to the low-spread Japanese banking system.  

How the US looks

Most US banks have spreads after costs well above two percent of assets. Wells Fargo for a long time has had an interest spread above five percent. Spreads are still that high or higher.

In the good times background loss rates were one percent or more. Indeed there were plenty of businesses in the US which worked fine with three percent background loss rates (much car lending for instance).

There is no shortage of willing borrowers. Indeed there are plenty of worthwhile projects at the moment that have a hard time being funded because the banks don’t have any money available. Banks can’t fund themselves as the market for senior bank funding has shut down. The reason banks have stopped lending is that there are insufficient people willing to provide funds to banks. In plan parlance banks don’t lend because they can’t borrow.

Some observations

It is trite – but the key difference is between a current account deficit country and a current account surplus country.

The deficit country has to borrow from abroad. Banks intermediate the deficit and the banks are subject to hot money flows.

Being subject to hot money flows the banks are subject to runs – very big and destructive runs.

The banks in those countries fail fast. Japanese banks by contrast remain as zombies (living dead) with insufficient capital but enough liquidity to last decades.

In current account deficit countries nationalisation or part nationalisation is a common end-game for a financial crisis.  

Lots of people talk about Sweden (or better Norway) because they did their nationalisation well. But another example is Korea – where the bank blew themselves up too – and were critically dependent on (Japanese) money which became rapidly unavailable.

Help please

I know how these things look. I don’t have a decent model grounded in facts-on-the-ground.

I am surprised at the tone of the WSJ story about Japanese regional banks needing a bailout. They don’t need it from a liquidity perspective – they need it from a capital perspective. The WSJ story does not make this clear.

In America and the UK the banks have (serious) liquidity problems. I am not sure they have capital problems. Indeed my view is that there is no capital problem in the system – but the banks individually might have issues. The reason there is no capital problem in the system is that the underlying pre-tax pre-provision profitability is about 400 billion per annum.

Am I right that the system has adequate capital?

This view looks really controversial. It is just assumed – more or less by all pundits – that the banks are insolvent. Krugman’s latest piece on zombie banks is just one of many.

But the pre-crisis net tangible capital of the US banks was about 1.4 trillion. About 500 billion has been raised or defaulted since the crisis began. So call it 1.9 trillion. The pre-tax, pre-provision profitability has added another 400 billion per year to the pool – so we are at 2.3 trillion or more. A few hundred billion of the losses are borne outside the banking system.

If total losses get to the 3 trillion numbers that Roubini talks about. the system will get to neutral capital in two years and be fully recapitalised in five. If those numbers are right this is not a capital problem – it’s a liquidity problem.

The problem is serious though – and nationalisation may be the right prescription. It appears – as a matter of fact – to be the end game in countries which have current account deficits and banking crises (see Korea, Sweden, Norway). I am just not sure how to do it right – and when people (like Krugman) borrow the expression “zombie banks” from Japan I think they are substituting words for clear thinking.

I guess the thinking is hard though. If I thought all this stuff through clearly enough I would have that Nobel Prize in economics. Alas I did my last academic economics twenty years ago.

John Hempton

PS.  UK banks have (a) lower spreads and (b) lower starting capital.  The problems in the UK are thus more serious even with a lower level of losses than the US.  I am not sure that Barclays can ever be made solvent.  Barclays by comparison think they are solvent now.  But then I am a noted doubter of Barclays as one of my early posts show.  

PPS.  I was a little quick when I described Nishi Nippon City bank.  It is in fact a merger of two banks (Nishi Nippon and Fukuoka City bank).  Both were zombies.

Decline and fall of the British Aristocracy

Just a link.  A fine book review from the Investor's Consigliere.

Buiter's Modest Proposal

It is funny how I spend a lot of my time arguing with people I fundamentally agree with. Today’s blog post by the well respected Professor Willem Buiter has really got my goat. He advocates nationalisation of the UK banking system. I think he is right.

He also advocates the scrapping of anything that looks like process. Here is his “modest proposal”:*

(1) Take into complete state ownership all UK high street banks. This has to be mandatory, even for the banks that still like to think of themselves as solvent.

(2) Fire the existing top management and boards, without golden or even leaden parachutes, except those hired/appointed since September 2007.

(3) Don’t issue any more guarantees on or insurance for existing assets - regardless of whether they are toxic, dodgy or merely doubtful. Issue guarantees/insurance only on new lending, new securities issues etc. A simple rule: guarantee the new flows, not the old stocks. This will reduce the exposure of the government to credit risk without affecting the incentives for new lending.

(4) Transfer all toxic assets and dodgy assets from the balance sheets of the now state-owned banks (or from wherever they may have been parked by these banks) to a new ‘bad bank’. If possible, pay nothing for these toxic and dodgy assets. Since the state owns both the high-street banks (I won’t call them ‘good’ banks) and the bad bank, the valuation does not matter. If the gratis transfer of the toxic or dodgy assets to the bad bank would violate laws, regulations or market norms, let an independent party organise open, competitive auctions for these assets - auctions in which the bad bank, funded by the government, would be one of the bidders. Whatever price is realised in these auctions is paid by the new bad bank to the old banks.

My only real problem here is in step 1. It is spoken with the true arrogance of someone who has never traded markets for a living.**

Now I am as sure as anyone about the parlous state of UK banking. Here are two very early posts on this blog about the state of UK banking – see this post on Royal Bank of Scotland and this one on Barclays. These posts were over six months ago. (I declare victory on them.)

Bethany McLean did a story in Fortune magazine about Royal Bank of Scotland. The story looks fantastic now – have a look. Although I was anonymous at the time (the story pre-dates this blog) I was one of the people she spoke to for that story.

But I wasn’t absolutely sure then that the banks were insolvent and I am not absolutely sure now. Indeed whilst I thought that Barclays would probably fail but that Royal Bank of Scotland might survive. The pair – long RBS, short Barclays was one I talked about but (fortunately) did not do.

The problem. There is no way that I am buying a bank stock – any bank stock – unless I know the new rules. I have no problem with nationalisation – indeed I blogged about it in the context of Norway as early as July– and the feedback was all negative – with the general view being “that it is unrealistic for America”. What I would like however is process for dealing with the residual rights of shareholders and preference share holders. [There was such a process in Norway - and one bank was only ninety percent nationalised...]

Sure: guarantee new funding. You don’t want to guarantee old funding because that increases contingent state liabilities to some enormous level. This buys you time. Use that time for a process to determine (fairly and with a right of refusal to old shareholders) the situation for new shareholders. The sort of idea that I have is that shareholders should be able tip in new capital in exchange for government guarantees on the new funding. There should be substantial new capital required (perhaps an amount determined by a third-party independent accounting structure) in exchange for these guarantees. Moreover the government should be paid an amount for the guarantees. Taxpayers take risk and should be compensate for that risk.

My guess – is that faced with a true accounting – there will be no new capital. But I really am not sure. HSBC probably could raise some. Barclays I doubt. RBS – well – it is too late for them.

A six week process which leads to nationalisation is not a major change to Professor Buiter’s modest proposal – and it can be made to fit centuries of thinking about what constitutes good government.

America’s long nightmare of bold and decisive government is over – Mr Buiter’s suggestion is so yesterday...

It is time for a nightmare of due process.



John Hempton


*For those of a less literate bent the phrase “modest proposal” has form. Jonathon Swift circulated a straight faced pamphlet (titled “A modest proposal”) that described – in harrowing terms – poverty and starvation amongst the Irish. He then – with an equally straight face – advocates that the solution is for the Irish to eat their own children. Is Buiter’s modest proposal a suggestion that the British eat their own (banking) children. If so then I have misunderstood Willem Buiter completely.

**I used the phrase “with the true arrogance of someone who has never traded markets for a living”. The people who are really good at trading markets are firm but modest. They are prepared to admit that they are wrong – and will always entertain the possibility. There is a stereotype of the blindingly arrogant bond trader – someone from Bonfire of the Vanities – or more colloquially the “big swinging dick”. Those people are dangerous in markets – and I suspect they are also dangerous giving policy advice too.

Obama: hotter than sex

The official Whitehouse website is whitehouse.gov. However I am so used to typing a site as ctrl enter “whitehouse” that I was a frequent (if accidental) visitor whitehouse.com.

Whitehouse.com was a pornography site – selling photos of hot teen sex.

But now it feeds news related to Barrack Obama.

Conclusion: there is more money in politics than pornography.

Stock conclusion: avoid all listed pornography companies.

Luigi Zingales has it right

Luigi Zingales knows a few things about how the new administration should behave.

He may be a little too jaundiced about nationalisation - but here is the money quote:

Get a strategy

To begin, you (Mr Geithner) need an overall strategy. Even a mediocre strategy is better than an ad hoc approach that confuses markets and fuels the perception of playing favorites. Legendary portfolio manager David Swensen (who in 23 years transformed the $1 billion of Yale endowment into $23 billion) in reference to the government intervention in this crisis commented “the government has done it with an extreme degree of inconsistency. You almost have to be trying to do things in an incoherent and inconsistent way to end up with the huge range of ways they have come up with to address these problems.”

The cost of ad hocery

The cost of this inconsistency is that it has forced the private capital to stay on the sideline. Short of a complete nationalization of the financial sector (which we hope is not in the plan), the problem cannot be resolved without the help of private capital. But a necessary condition to attract private capital back is a consistent and predictable strategy by the government. Without it any other effort is in vain.

I should note I disagree with a lot the rest of Zingales paper - and will explain why in a later post.

I do not oppose nationalisation - but I would prefer that private money came to the fore. Private money will not pony up if they do not know the rules.

The way to do nationalisation is nationalisation AFTER due process. Due process (anywhere) does not seem to have been a hallmark of the Bush administration.

Confiscation without process (WaMu springs to mind) guarantees that there will be a private capital strike.

With a private capital strike everything eventually needs the government to bail it out. Everything - JPM and Goldies included.






John

Lest you think I disagree with Krugman too much

Krugman makes the obvious point that being fixed to the Euro hardly imunizes you from financial crises.

http://krugman.blogs.nytimes.com/2009/01/19/the-pain-in-spain/

I still do not get Willem Buiter's pamphleting for the UK joining the Eurozone.  This post was more softly stated than normal.  

John Hempton