Toxic assets and the macro-economy
Bloomberg reported yesterday that the US Treasury is scaling back its initial plan to subsidize private purchases of the banks’ toxic assets:
The U.S. Treasury Department may begin its program to spur purchases of mortgage-backed securities from banks with about $20 billion in public and private money, down from as much as $100 billion when it was announced in March, two people familiar with the matter said.
The Treasury plans provide about $1.1 billion in capital to eight to 10 money managers it will pick for the Public-Private Investment Program, according to the people, who asked not to be identified before the details are announced. The firms will raise about $1.1 billion each for funds to buy distressed mortgage securities, less than they had expected the government to support. The plan also will include about $10 billion in government-backed loans.
Earlier I said that I did not think Geithner would back away from his original plan, given that doing so would undermine the cumulative efforts of the Obama administration to date. It looks like I was wrong. Investors now appear rather confident that the banks would not be nationalized, hence the apparent lack of hesitation in aiding the banks’ recapitalisation:
The government unveiled the program when losses tied to home loans hobbled banks such as Citigroup Inc. and Bank of America Corp. and threatened to choke off lending needed to revive the economy. Since then, the 19 largest U.S. banks raised more than $100 billion by selling equity and assets, swapping preferred shares for common and offering debt, easing concern that the lenders couldn’t handle a deeper, longer recession.
This reminds of something Paul Krugman posted on Feb 17th 2009. What does this latest development say about what the government should do next? It may be too early to draw any conclusions yet on the banking crisis. But just as encouraging news from the financial sector (pedantic point: the news isn’t so much promising as it is “not-as-bad-as-feared”) becomes more common, the economy as a whole appears to be a long way off from recovery.
Although the recession precipitated from a credit crunch in the financial industry which then spilled over to Main Street, the apparent divergence between the financial sector’s health and that of the larger economy is clearly a signal that monetary policy isn’t sufficient to overcome the recession, especially given what some (especially the Austrians) have called the neutrality of money. The two problems though inter-related, are now sufficiently distinct to warrant individual approaches. It is now becoming more apparent that fiscal policy cannot be neglected. In a March 8th reply to Luigi Zingales as part of a debate, Brad Delong made essentially the same point:
What is the crisis? The crisis comes in six stages:
- American mortgage originators lose $2 trillion due to their irrational exuberance investing in mortgages.
- American mortgage securitizers who are supposed to follow an originate-and-distribute model in order to lay off the risk associated with mortgage lending onto the broad pool of savers in the global economy originate but do not distribute.
- As a result, a large share of the $2 trillion in losses falls onto and must be eaten by Wall Street’s largest institutions.
- In response to these losses, trust in financial intermediaries and thus the risk tolerance of the private sector collapses–with $2 trillion in mortgage losses inducing a stampede away from risky assets that ultimately lowersthe global value of financial assets by $30 trillion and renders nearly all if not all major financial institutions insolvent (at least temporarily insolvent).
- Businesses that ought to be expanding thus find that they cannot obtain financing on terms that make expansion profitable–while businesses that ought to be contracting still contract.
- Thus employment collapses.
Delong says that while fiscal policies such as the stimulus bill, spending and cutting taxes won’t help points 1-5, it will make a difference for 6. The unemployment figures for the 2nd quarter was released yesterday, and it ain’t pretty. Krugman also notes that wages have been falling, which makes a deflationary spiral a lot more likely compared to inflation. It has been odd, to put it mildly that while we have been worrying that credit easing policies of the Fed would drive up inflation in the short and long run, we fail to notice that the threat of deflation from the macro-economy is more probable than its opposing twin.