Reply to Comments--May 11 to May 15

I reply here to some (in fact all but one) of last week's comments. Since each commenter is listed together with a link to his or her comment, I do not need to summarize the comments.

Stevens. I did not say that nationalizing the banks would create a more acute problem of evaluation of the overvalued assets (various forms of securitized debt, first misleadingly called by the government and the media "toxic assets," now absurdly called "legacy assets"), but only that the problem could not be avoided by nationalizing. Since the banks that the commenter proposes to be nationalized are not insolvent, the government could not seize them (which is what nationalizing means--the seizure of property by the government) without compensating the shareholders for the value of the banks' assets.

Alternatively, however, the government could simply buy the banks, which is to say buy a controlling interest in them, paying the market value of whatever common stock it bought in order to obtain its desired interest. Then it could do what it wanted with the overvalued assets, such as selling them. If it sold them, and by doing so cleansed the banks' balance sheets, it could then resell its stock in the banks to the private sector.

Sounds sensible--but deciding which banks to buy, how to prevent the stated aim of the government of buying the banking industry (or most of it, weighting number of banks by the assets held by the banks) from driving up the price of the shares that the government would be bidding for, disposing in some way or another of the overvalued assets, and then executing the return of the banking industry to private control, would be, I believe, beyond the capacity of the federal government, especially at the present time, with the Treasury Department appearing to drown in the flood of the depression-recovery measures that it is trying to implement.

A further complication is that the commenter wants the government to use its control of the banks to make them lend more than they are currently lending under private management. The problem is that such a policy of forced lending would be likely to cause the banks to lose money, which would reduce the price at which the government could sell them back to the private sector. Moreover, if the aim of nationalization is to force banks to do more lending than is profit maximizing, the government would have to hold on to the banks for an indefinite length of time, since as soon as banks were returned to private hands they would reduce their lending in order to maximize their profits.

JP22. I don't regard "middlemen as parasites" and that is one reason that I do not like the term "real economy." Economists use the term to distinguish between the production and distribution of goods and services (other than finance) on the one hand--the "real" economy--and lending on the other hand. There are people who want to borrow money to enable them to undertake various "real" projects, whether on the consumption or the production side of the economy, now rather than later, and other people who want to defer some of their consumption or production for the future, and there are gains of trade between the two groups. But the gains are difficult to measure, because they are intermixed with gains and losses that are the result simply of uncertainty. The interest rate on a long-term loan may be only a little better than a guess about future interest rates. If higher than anticipated, the lender loses; if lower, the borrower. The shift in wealth need not increase overall economic value. So expenditures (for example in hiring talented mathematicians) to gain an advantage in predicting future interest rates may result in shifts of wealth that exceed the social benefit of improving those predictions.

The issue of the net marginal contribution of banking to the economy is important in balancing the gain from a more competitive banking industry against the risk to economic stability. That balance must be struck in order to determine how far to go in reregulating what had become a largely deregulated industry.

Hackensack. John P. Hussman is a mutual fund manager who writes a weekly online column. The column to which the commenter refers me contains a number of suggestions for dealing with the current travails of the banking industry. One suggestion is that the government, instead of bailing out the banks with federal money, somehow induce the banks' bondholders to convert their bonds to common stock in the banks. This would increase the banks' equity cushion and by doing so enhance their solvency and so perhaps their willingness to lend more of their capital (rather than hoard it in cash or use it to acquire assets other than new loans) than they are doing. Swapping bonds for stock is the kind of restructuring that commonly occurs in a reorganization under Chapter 11 of the Bankruptcy Code, but it presupposes bankruptcy. It is unclear how the swap would be forced on solvent banks.

Hussman's concern is with the "moral hazard" problem, and that concern underlies other suggestions that he makes as well, such as that the recipient of mortgage relief by the government should be required to give a portion of any future appreciation in the value of the property to the government. If the beneficiary of a bailout, whether it is a bondholder or a homeowner, has to pay a price for the benefits of being bailed out, this will avoid encouraging bondholders to make risky loans, or homeowners to borrow imprudently. Hussman's concern is valid, though I will not attempt to evaluate the details of his proposals.