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The Future Spelled Out

November 1, 2009

from Baseline:

America needs a new framework to harness that growth.   That framework needs to address the following problems with our current economic structure.
Problem 1:  With the recent financial sector bailouts, we have sent a simple message to Americans: The safest place to put your savings is in a bank, even if that bank is so poorly managed, and has such large balance sheet risks, that just six months ago it almost went bankrupt.
Despite being near to bankruptcy six months ago, Bank of America credit default swaps now cost only 103 basis points per year to protect against default, and the equivalent rate for Goldman Sachs is a mere 89 basis points.  Goldman Sachs is able to borrow for five years at just 170 basis points above treasuries.  This is not a sign of health; rather it indicates the sizable misallocation of capital promoted by current policies.  American’s leading nonfinancial innovators would never be able to build the leverage (debt-asset ratio) on their balance sheet that Goldman Sachs has, and then borrow at less than 2% above US treasuries.  The implicit government guarantee is seriously distorting incentives.
Problem 2:  We have not changed the incentive structures for managers and traders within our largest banks.  Arguably these incentives are more distorted than they were before the crisis. So the problems of excessive risk taking and a new financial collapse will eventually return.  Financial system incentives are a first-order macroeconomic issue, as we have learned over the past 12 months.
Today bank management is strongly incentivized to take large risks in order to raise profits, increase bank capital, and pay large bonuses to “compete for talent”.  Since they have access to a pool of funds effectively guaranteed by the state through being “too big to fail”, there is the potential to make large profits by employing funds in risky trades with high upside.  Such activities do not need to be socially valuable, i.e. it could be that the expected return on the investments is negative, but as the downside has limited liability, the banks can go ahead.
Problem 3:  We have not changed the financial regulatory framework in a substantive way so as to limit excessive risk taking.  The proposals currently proceeding through Congress are unlikely to make a significant difference.
Problem 4:  The policy response to this crisis, with very low interest rates and a large fiscal stimulus, is merely a larger version of the response to previous similar crises.  While this was essential to stop a near financial collapse, it reinforces the message that the system is here to stay.
Problem 5:  The public costs of this bailout are much larger than we are accounting for, and people who did not cause this crisis are ultimately paying for it.   Taxpayers and savers are the big losers each time we have these crises.  We are failing to defend the public purse.
Our financial leaders have emphasized that our banks are well capitalized, and no new public funds are likely to be needed to support them.  This is misleading.  The current monetary stance is designed to ensure that deposit rates are low, and the spread between deposit rates and loan rates is high.   This is a massive transfer of public funds to the private sector, and no one accounts for that properly.
It is striking that the Chairman of the Federal Reserve himself, in a recent speech, stated that no more public funds were needed to bail out banks.  His institution continues to provide massive transfers to the banking system through loose credit and low interest rate policy.  That credit could instead go to others; the Federal Reserve has chosen to transfer those funds to banks.  This policy was used in the past to recapitalize banks (e.g., after 1982), but we have now a very different financial sector – with much more capacity to take high risks and a greater tendency to divert profits into large cash bonuses.
Today, depositors in banks earn little more than the Federal Funds rate and are effectively financing our financial system.  We are giving them very low returns on their savings because the losses in the financial system were so large in the past.  This is essentially public money – it is the pensioners, elderly people with savings, and other people who have no involvement in the financial system, that are being required to suffer low returns to support the banks.

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