How exactly should the banks be rescued?
I wrote this piece on 8th November, and I should have published it then, but I'm publishing it now over a month later. I have just recently bought a few book on economics (including Keynes' famous book) to read over the holidays. Hopefully this post will still make sense to me after I've educated myself a bit more!
There are a number of schemes that have been discussed about how to stop all the banks going bankrupt and taking down the basic banking system with them. A paper by "Chicago Business School Professor Luigi Zingales" goes through the various options briefly, but I'm surprised at his main thrust and have a few questions and concerns about it and would value any thoughts:
He argues that all the creditors of the banks should be forced to give up their debt and instead be given a share in the ownership of the bank. The would involve wiping out the existing shareholders. Essentially, the business is taken from the current incompetent shareholders and given to the creditors. This idea is contrasted by Zingales with the current approaches which involve taxpayers giving money to banks.
I'll attach a comment to this post below to briefly give some background to the whole mess and the various options, but for now I'll return to Zingales' plan to avoid taxpayer payouts
Many, but not all, of the banks were mismanaged and they now owe more than they own. They like to find excuses, but the fact is their assets are worth a lot less than they paid for them. At the bottom of this pyramid scheme of inflated prices was a fairly basic overspend: giving a lot of money to an individual who was never certain to repay in order for that individual to buy a house at an inflated price.
But the creditors that Zingales intends forcing to give up debt aren't limited to complex Wall Street entities, they include pension funds and even the simple depositors at the banks. If somebody has a few thousand dollars or pounds saved in the bank, you can't expect them to give that up for a few shares only worth a fraction of that.
Zingales may say that he would make an exception and allow depositors to keep their debt. But where do you draw the line? Many of this banks would find that they would be unable, even if all other debts were wiped out, to pay their depositors. Do not forget that debt forgiveness would wipe out many bank assets too, the debt is often to other banks.
You may well ask, who owns all this debt? You may think that, if all the banks wipe their debts to each other, that they could wipe their slate clean and start afresh. I think this is where Zingales plan falls down. A lot of this money has already left the system, in the form of paycheques to construction workers and the profits of speculators who sold out at the right time.
And there's the biggest depositor of them all, China. China has $1.8 trillion of reserves and who is suggesting that the US government force debt forgiveness on the Chinese. Imagine the US government defaulting on $1.8 trillion of debt to China!
I'm not impressed with the current theories of how this came to be, of how China have $1.8 trillion. My theory is that if the US imports lots of stuff from China, a trade deficit from the US's point of view, than the inevitable result is that China has lots of currency. And it is no surprise that this deficit occured. Rich Americans, and Americans who thought they were rich (pyramid scheme remember), would get their hands on consumer goods and other luxuries. America itself often couldn't or wouldn't supply these, so they would be imported from China. China was paid in dollars and these dollars were just glorified IOUs written by banks.
Returning to Zingales plan: it can't work because of all the depositors, including the Chinese, whose deposit would need to be protected.
Any thoughts? I'm quite confident of much of this, but some of the details are complex and I don't want to pretend to be an expert.
Comments
Background on the details of various taxpayer-funded rescue
For any readers who aren't familiar with the dilemma, the situation is this: many banks, all around the world, lent out studendous amounts of money that they could never reasonably expect to get back. They lost huge amounts of money and are effectively bankrupt. They cannot complain about 'fire sale prices'. The reality is their assets are worth a lot less than they paid for it. Banks assets are much smaller than their liabilities. Hence, the only solution is for somebody, somewhere, to hand over huge amounts of money to the banks.
If the taxpayer hands over the money, the two options are for the taxpayer to hand over free money without strings attached or for the taxpayer to get something in return. In Britain, the government has taken preference shares in the banks which, as far as I recall, has a 12% dividend rate. However, the Paulson plan in the US does not have any upside for the taxpayer. It is the purest form of charity which will punish the few better-run banks as they won't get this free money. Shame on McCain for also peddling this nonsense!
One advantage of the British scheme, and I must admit I'm wary of it as we should blame the likes of Gordon Brown, who was in charge of Britain's economy since 1997, for the mess we are in, is that the more incompetent banks will have to pay back all the money at a high interest rate. This should reward the better-run banks who may be able to minimize, or even avoid, their involvement in the UKs taxpayer backed scheme.
Aaron