“There’s a chance that it might work,” Columbia’s Stiglitz says of the government’s attempt to boost confidence.

TO BE NOTED: From Bloomberg:

"Bank Profits From Accounting Rules Masking Looming Loan Losses

By Yalman Onaran

June 5 (Bloomberg) -- Big banks in the U.S. say they’re on the mend. The five largest were profitable in the first quarter, rebounding from record losses for the industry in the fourth quarter. Share prices have jumped, with the KBW Bank Index doubling since March 6.

Treasury Secretary Timothy Geithner, after “stress testing” 19 banks on their ability to withstand a worsening economy, declared in early May that Americans can be confident in the banks’ stability and resilience. Wells Fargo & Co. and Morgan Stanley were among banks raising $43 billion in new capital since then through share sales.

“With our capital and assets, stressed as they have been, we can go back to focusing all our attention on managing our business and restoring value,” Citigroup Inc. Chief Executive Officer Vikram Pandit said after Geithner’s examinations were completed.

The revival may be short-lived. Analysts who have examined the quarterly profits and government tests say that accounting rule changes and rosy assumptions are making the institutions look healthier than they are.

The government probably wants to win time for the banks, keeping them alive as they struggle to earn their way out of the mess, says economist Joseph Stiglitz of Columbia University in New York. The danger is that weak banks will remain reluctant to lend, hobbling President Barack Obama’s efforts to pull the economy out of recession.

‘Bogus’ Profit

Citigroup’s $1.6 billion in first-quarter profit would vanish if accounting were more stringent, says Martin Weiss of Weiss Research Inc. in Jupiter, Florida. “The big banks’ profits were totally bogus,” says Weiss, whose 38-year-old firm rates financial companies. “The new accounting rules, the stress tests: They’re all part of a major effort to put lipstick on a pig.”

Further deterioration of loans will eventually force banks to recognize losses that their bookkeeping lets them ignore for now, says David Sherman, an accounting professor at Northeastern University in Boston. Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago, says the government stress scenarios underestimate how bad the economy may get.

The accounting rule changes that matter most for the banks came on April 2, when the Financial Accounting Standards Board gave companies greater latitude in how they establish the fair value of assets. Lawmakers, including Representative Paul Kanjorski, a member of the House Financial Services Committee, had complained that existing mark-to-market standards worsened the financial crisis.

Debt Valuation

Along with that change, FASB also let companies recognize losses on the value of some debt securities on their balance sheets without counting the writedowns against earnings. If banks plan to hold the debt until maturity, they can avoid hurting the bottom line.

At Citigroup, the recipient of $346 billion in fresh capital and asset guarantees from the government, about 25 percent of the quarterly net income came thanks to the debt securities rule change, the bank said.

Another $2.7 billion before taxes came from an accounting rule that lets a company record income when the value of its own debt falls. That reflects the possibility a company could buy back bonds at a discount, generating a profit. In reality, when a bank can’t fund such a transaction, the gain is an accounting quirk, Weiss says.

Citigroup also increased its loan loss reserves more slowly in the first quarter, adding $10 billion compared with $12 billion in the fourth quarter, even as more loans were going bad. Provisions for loan losses cut profits, so adding more to this reserve could have wiped out the quarterly earnings.

Wells Fargo

Without those accounting benefits, Citigroup would probably have posted a net loss of $2.5 billion in the quarter, Weiss estimates. In the five previous quarters, Citigroup lost more than $37 billion.

Wells Fargo also took advantage of the change in the mark- to-market rules. The new standards let Wells Fargo boost its capital $2.8 billion by reassessing the value of some $40 billion of bonds, the bank said in May. And the bank augmented net income by $334 million because of the effect of the rule on the value of debts held to maturity.

Wells Fargo spokeswoman Julia Tunis Bernard declined to comment, as did Citigroup’s Jon Diat.

The higher valuations Wells Fargo put on its securities probably won’t last, as defaults increase on home mortgages, credit cards and other consumer and corporate lending, Northeastern’s Sherman says.

Fed’s Optimism

“These changes will help the banks hide their losses or push them off to the future,” says Sherman, a former Securities and Exchange Commission researcher.

The Federal Reserve, which designed the stress tests, used a 21 percent to 28 percent loss rate for subprime mortgages as a worst-case assumption. Already, almost 40 percent of such loans are 30 days or more overdue, according to Tavakoli, who is the author of three primers on structured debt. Defaults might reach 55 percent, she predicts.

At the same time, the assumptions on how much banks can earn to offset their losses are inflated, partly because of the same accounting gimmicks employed in first-quarter profit reports, Weiss says.

“There’s a chance that it might work,” Columbia’s Stiglitz says of the government’s attempt to boost confidence. “If it does, then they’ll look like the brilliant general. But all these efforts also bank on the economy recovering and housing prices not falling too much further. Those are not safe assumptions.”

Indeed, while the government and accounting rule makers try to help the banks look their best, they may make the U.S. economy worse. As long as lenders are stuck with bad loans, they can’t provide new money to consumers or corporations to fuel a potential recovery. The banks may look pretty, but they’ll be zombies until they clean up their books.

(Published in the July issue of Bloomberg Markets magazine.)

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net."

politics wins over economics every time

From Yglesias:

"Someone Needs to Talk to Congress About the Banks

According to Hendrick Hertzberg’s writeup of a recent New Deal 2.0 event, some of the critics of the administration’s approach to the banks are shifting to an interpretation of what’s happening that’s closer to what the administration’s friends are saying:

Stiglitz said he has the impression that while the Administration’s policymakers are familiar with the approach he and Solow advocate and have discussed it among themselves, it hasn’t been given the kind of in-depth consideration that has been extended to the solutions preferred by the big banks. “When push comes to shove,” Solow said, “politics wins over economics every time. It’s the unanswerable objection: ‘You can’t get it through Congress.’”

I totally get this. What I’m not sure I do get is why, if the administration’s had the ability to convince a large swathe of outside analysts that congressional politics are making a highly sub-optimal response necessary, we’re not seeing more signs of an effort to persuade congress that this is a problem."

Me:

1. Don the libertarian Democrat Says:
   April 30th, 2009 at 2:43 pm

   “March 25, 2009
   tg-70

   Treasury Proposes Legislation for Resolution Authority

   Treasury Secretary Timothy Geithner on Monday called for new legislation granting additional tools to address systemically significant financial institutions that fall outside of the existing resolution regime under the FDIC. A draft bill will be sent to Congress this week and several key features are highlighted below.

   The legislative proposal would fill a significant void in the current financial services regulatory structure and is one piece of a comprehensive regulatory reform strategy that will mitigate systemic risk, enhance consumer and investor protection, while eliminating gaps in the regulatory structure.”

   What’s wrong with this legislation?

   I’m for Narrow Banking, can you tell me what this means?

   “They see the lack of a thoroughgoing “reorganization of the financial system” as the “most disappointing” feature of the new dispensation.”

The US choosing to act as absentee owner (or merely throwing its weight around on the odd political hot button) is the worst of all possible worlds

From Naked Capitalism:

"Nationalization in Denial?

As this blogger and others have noted, the bank rescue programs have been designed to work around constraints more than to fix the underlying problem, which is a lot of bad debt that needs to be restructured and renegotiated, including the debt of the banks themselves. Instead, the boundary conditions have included "No more Lehmans", "We don't do nationalization", "Sanctity of contracts" (aka no trying to cut the securitization Gordian knot), an unwillingness to have bank bondholders take hits (with WaMu an odd exception) plus a fear of going back to Congress for more dough.

As the economy keeps downshifting, the Administration seems to be coming to the recognition that it has to relax one of those constraints, but it appears to perceive otherwise. From the New York Times:

In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock.

Converting those loans to common shares would turn the federal aid into available capital for a bank — and give the government a large ownership stake in return.

While the option appears to be a quick and easy way to avoid a confrontation with Congressional leaders wary of putting more money into the banks, some critics would consider it a back door to nationalization, since the government could become the largest shareholder in several banks.

The Treasury has already negotiated this kind of conversion with Citigroup and has said it would consider doing the same with other banks, as needed. But now the administration seems convinced that this maneuver can be used to make up for any shortfall in capital that the big banks confront in the near term.

So we may get to the government as majority owner in some banks (with a Citi conversion, its stake would be 36%) and unwilling to act like it (or perhaps only until the next regime change). And let us not forget that significant minority stakeholders generally have significant rights, particularly when they come in as rescuers (they extract more). Board seats and lots of veto rights are the usual minimums.

As Joseph Stiglitz and pretty much any private equity investor would tell you, the worst position is to have ownership and no control. The US choosing to act as absentee owner (or merely throwing its weight around on the odd political hot button) is the worst of all possible worlds. But that seems to be the Obama bank policy hallmark, so why should this decision be any different?

More on this topic (What's this?)

The Citi Market Barometer (Zero Hedge, 4/18/09)

And So It Begins? Biggest Florida Bank Given 20 Days To Find Buyer Or Risk Shut Down (Zero Hedge, 4/18/09)

Watch Out for Bank Stress Tests (, 4/16/09)

Read more on Nationalization, Banking at Wikinvest

Posted by Yves Smith "

Me:

Don said...

You've summed up the administration's assumptions perfectly. We don't like it, but we haven't liked it for a long time. We're stuck talking practical problems now.

Right now, I agree, we're only talking Citi for sure, or as close to sure as we can get. So I'm willing to accept your assessment of giving bondholders stock. However, along with your clear presentation of the assumptions, we now have a much clearer idea of how this is playing out.

http://www.nytimes.com/2009/04/20/business/20trustees.html?ref=business

"3 Trustees of A.I.G. Are Quiet, Perhaps to a Fault
By EDMUND L. ANDREWS

WASHINGTON — In an early sign of just how tricky corporate governance has become in the era of taxpayer bailouts, three little-known trustees with no office, no staff and almost no mission will soon be deciding questions that affect the fate of American International Group, the giant insurance company.

The trustees include a retired Wall Street executive, the head of a Texas pipeline company and the chairwoman of a firm in Bermuda that provides administrative services to hedge funds.

Even though the government has bailed out A.I.G. with $170 billion in federal money, and even though the Treasury owns nearly 80 percent of its shares, the voting power is in the hands of the three trustees. "

Just like in everything else, we're back to September and October.Here, it's AIG as the model. So, we are going to:
1) Take stock for our money
2) Possibly gain controlling interest
3) Have appointed and independent trustees make the decisions for us as to who manages the bank, etc.

In other words, a hybrid, in the sense that:
1) The govt owns shares,and actually controls the bank, but there are also, I presume, private shareholders
2) Trustees will act as private trustees but be public
3) The stock will still be bought and sold

All the problems with hybrids will remain, plus the problem of foreign govts now expecting their bonds to be guaranteed by the US Govt, and stock and asset sales possibly involving us in foreign politics.

I think that this is better than other alternatives given the assumptions above. In fact, this makes sense:

"Officials who helped draw up the plan for A.I.G. said their main goal was a practical one: how to avoid conflicts of interest between the government’s role in setting broad policy and its role as a corporate shareholder."

because we've already seen how silly the decisions are when the two govt sides are at war.

Finally, one point: I earlier said that we should call what we're doing Nationalization whether it is clearly that or not, for motal hazard reasons. The govt disagrees:

"In any other country, such moves would add up to at least a partial nationalization of major financial institutions. But nationalization remains so politically explosive in the United States that President Obama and his top advisers are straining to avoid the slightest hint of it."

So, I call what is being planned nationalization, because it scares the hell out of bankers. Now check this story out:

http://www.nytimes.com/reuters/2009/04/20/business/business-banks-europe.html?ref=business

"U.B.S. Sells Brazilian Unit as Banks Step Up Disposals
By REUTERS

ZURICH/LONDON, April 20 (Reuters) - Two European banks on Monday stepped up efforts to raise capital privately and reduce their reliance on state funding.

Switzerland's UBS AG agreed to sell its Brazilian business for about $2.5 billion while Allied Irish Banks pledged to raise $2 billion possibly through disposals.

Recent asset sales by Britain's Barclays (NYSE:BCS) and Royal Bank of Scotland showed a reluctance to sell assets at low prices may have shifted, with banks acknowledging that "self-help" is a preferable option to taxpayer cash and selling non-core assets may be the best route to take."

And:

"That dilemma faces many banks. Dozens of lenders in Europe and the United States have been shored up with rescue funds from governments, but many are keen to limit their reliance on the state and selling profitable units is the most realistic alternative. "

I say that the fear of nationalization is helping to drive this. Moral Hazard accomplished, as far as taxpayers are concerned.

Don the libertarian Democrat

April 20, 2009 10:51 AM

restore status quo ante and not deal with any remedies that might prove inconvenient to the moneyed classes.

From Naked Capitalism:

"US to Impose Conditions on TARP Repayment

The Administration is trying to look like it is not rolling over to banks' demands on the issue of repayment of TARP money. But despite the tough-ish talk, the problem described by John Gapper remains. Whether the bank pay back the TARP or not, they and the wider world clearly know that they will not be permitted to fail, at least in their current (big and interconnected) incarnations. That in turn means they should be kept on a short leash until industry reforms and/or restructuring has taken place, since they are in effect gambling with house money, no matter what the formal balance sheet arrangements are. Keeping them in TARP is one way of addressing this conundrum; imposing other sorts of interim restrictions on "too big to fail" concerns is another approach. But Team Obama seems determined to try to restore status quo ante and not deal with any remedies that might prove inconvenient to the moneyed classes.

From the Financial Times:

Strong banks will be allowed to repay bail-out funds they received from the US government but only if such a move passes a test to determine whether it is in the national economic interest, a senior administration official has told the Financial Times.

“Our general objective is going to be what is good for the system,” the senior official said. “We want the system to have enough capital.”

Yves here. Note the turn of phrase? This crowd is fond of tests as being objective measures, when in fact they are being run by the industry on data not independently verified, through risk models shown to be unreliable in the face of extreme events. And first the official talks of "national interests" and sees that as tantamount to "what is good for the system". That line of reasoning conveniently ignores the problem that the system we have in place, per Simon Johnson, may be diametrically opposed to our collective best interest. Back to the article:

On Sunday, Lawrence Summers, President Barack Obama’s top economic adviser, told NBC’s Meet the Press that repayments could eventually help the government provide further resources to help the sector. Such a move could also allow healthier institutions to differentiate themselves from weaker banks and free them from constraints on executive pay, and other activities, that come with bail-out money.

Yves here. Again, ideology rampant. Being "free from constraints" is seen as being aligned with the general good, when pretty much everybody except the banksters and their buddies at the Fed and Treasury think more regulation is in order. To the FT;

“Not surprisingly different banks are in different situations; they are going need different levels of assistance of taxpayers,” Mr Obama told a press conference at a summit in Trinidad on Sunday, while promising: “I’m not going to simply put taxpayer money into a black hole.”

Yves here. Ooh, and pray tell what is AIG? Oh, because it is not a bank, merely a back channel to recapitalize bank, it's exempt from the black hole consideration. Back to the article:

The official, meanwhile, said banks that had plenty of capital and had demonstrated an ability to raise fresh capital from the market should in principle be able to repay government funds. But the judgment would be made in the context of the wider economic interest. He said the government had three basic tests. It needed first to “make sure the system is stable”. Second, to not create “incentives for more deleveraging which would deepen the recession”. Third, to make sure the system had enough capital to “provide credit to support the recovery”.

Yves again. The banks are ALREADY adding to pressures to delever by cutting consumer credit lines, In fact, if you buy Tyler Durden, banks are squeezing shorts by cutting credit even further to prime brokers, which is leading to less stock market liquidity and makes it (and other markets) more vulnerable to downturns. One of the big impetuses to goose the market would be for banks like Goldman to sell stock at more favorable prices to get out of the TARP. So if you buy argument #2, you wouldn't let any bank who is a major prime broker (Goldman, Morgan Stanley, JP Morgan) pay back TARP proceeds,

And how much capital is needed to provide for recovery very much depends on your view of the future of securitization. Right now, it's on government life support. Without fundamental reform, that market will not come back in a meaningful way (at least until the lessons of this disaster are forgotten and people make the same mistakes all over again). And the economics will not be anywhere near as favorable under a new regime that fixed incentives properly. For instance, requiring banks to hold enough of the paper they originate would increase costs and require better capitalized intermediaries all along the food chain. And even that didn't succeed last go round; recall Merrill held a lot of the risky late vintage CDOs on its books when the market turned.

If the private securitization market does not come back in a meaningful way, that means either phony government diddled credit markets indefinitely, or vastly bigger balances sheets in the financial sector, since banks will originate and hold loans (probably trading some loans among themselves to create better diversification). That too argues against returning TARP funds.

More on this topic (What's this?)

Warren Interview: Wall Street’s “system has collapsed” (Option ARMageddon, 4/12/09)

TARP Has Lost 40% Since Inception (Zero Hedge, 3/9/09)

Genworth Fails To Qualify For TARP, Shares Plunge (Zero Hedge, 4/9/09)

Read more on Troubled Assets Relief Program (TARP) at Wikinvest

Posted by Yves Smith"

Me:

Don said...

I'm having a hard time understanding what people are proposing. I do not believe that we can seize the banks at the present time. It would certainly be a mess. I guess if you believe that we can, all this seems silly to you. I too would rather have an FDIC seizure, but I don't see how this can be done with creating an enhanced FDIC or new agency, like the RTC, first.

If you can't do that, I'm assuming that people want us to get stock from the banks and, possibly, even get controlling interest in the banks. That has problems like the following:

http://www.nytimes.com/2009/04/20/business/20bailout.html

"The Treasury would also become a major shareholder, and perhaps even the controlling shareholder, in some financial institutions. That could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers.

Those are exactly the kinds of conflicts that Treasury and Fed officials were trying to avoid when they first began injecting capital into banks last fall. "

And:

"Each conversion of this type would force the administration to decide how to handle its considerable voting rights on a bank’s board.

Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them."

In other words, as I said, all the hybrid problems would remain, and the international problems would be worse.

Finally, Stiglitz said the following:

"Rather than continually buying small stakes in banks, weaker banks should be put through a receivership where the shareholders of the banks are wiped out and the bondholders become the shareholders, using taxpayer money to keep the institutions functioning, he said....

“You’re really bailing out the shareholders and the bondholders,” he said. “Some of the people likely to be involved in this, like Pimco, are big bondholders,” he said...."

Legally, I'm not sure what he's proposing, but the largest holders of these bonds, as I've pointed out before, are:

1) Pensions
2) Insurers
3) Foreign Governments
4) Foreign Investors

1 and 2 are bailouts waiting to happen, and 3 and 4 are very bad news going forward.

As Inner Workings has pointed out:

http://blog.atimes.net/?p=901

"Reminder: why the Treasury needs the banks to look better
April 14th, 2009
By David Goldman

The next sector to collapse would be the insurers: as I’ve said here again and again, the big pyramid scheme in the US financial system is that the insurers own the bottom of the capital structure of the banks. Bank preferreds, trust preferreds, hybrids, etc. were the favorite repast of yield-hungry insurance portfolio managers.

The big insurance companies all are trading like junk, still. Here is the cost of five-year credit protection on two of the biggest:

It’s cheaper to refloat the banks than to go in and bail out insurers after public confidence collapses."

All the recent stories about pensions, insurers, and annoyance with the dollar are related to this. I'm just having a hard time understanding what some people are actually proposing.

Don the libertarian Democrat

April 19, 2009 11:51 PM

shareholders of the banks are wiped out and the bondholders become the shareholders, using taxpayer money to keep the institutions functioning

TO BE NOTED: From Bloomberg:

Stiglitz Says White House Ties to Wall Street Doom Bank Rescue

Share | Email | Print | A A A

By Michael McKee and Matthew Benjamin

April 17 (Bloomberg) -- The Obama administration’s bank- rescue efforts will probably fail because the programs have been designed to help Wall Street rather than create a viable financial system, Nobel Prize-winning economist Joseph Stiglitz said.

“All the ingredients they have so far are weak, and there are several missing ingredients,” Stiglitz said in an interview yesterday. The people who designed the plans are “either in the pocket of the banks or they’re incompetent.”

The Troubled Asset Relief Program, or TARP, isn’t large enough to recapitalize the banking system, and the administration hasn’t been direct in addressing that shortfall, he said. Stiglitz said there are conflicts of interest at the White House because some of Obama’s advisers have close ties to Wall Street.

“We don’t have enough money, they don’t want to go back to Congress, and they don’t want to do it in an open way and they don’t want to get control” of the banks, a set of constraints that will guarantee failure, Stiglitz said.

The return to taxpayers from the TARP is as low as 25 cents on the dollar, he said. “The bank restructuring has been an absolute mess.”

Rather than continually buying small stakes in banks, weaker banks should be put through a receivership where the shareholders of the banks are wiped out and the bondholders become the shareholders, using taxpayer money to keep the institutions functioning, he said.

Nobel Prize

Stiglitz, 66, won the Nobel in 2001 for showing that markets are inefficient when all parties in a transaction don’t have equal access to critical information, which is most of the time. His work is cited in more economic papers than that of any of his peers, according to a February ranking by Research Papers in Economics, an international database.

The Public-Private Investment Program, PPIP, designed to buy bad assets from banks, “is a really bad program,” Stiglitz said. It won’t accomplish the administration’s goal of establishing a price for illiquid assets clogging banks’ balance sheets, and instead will enrich investors while sticking taxpayers with huge losses.

“You’re really bailing out the shareholders and the bondholders,” he said. “Some of the people likely to be involved in this, like Pimco, are big bondholders,” he said, referring to Pacific Investment Management Co., a bond investment firm in Newport Beach, California.

Bigger Losses

Stiglitz said taxpayer losses are likely to be much larger than bank profits from the PPIP program even though Federal Deposit Insurance Corp. Chairman Sheila Bair has said the agency expects no losses.

“The statement from Sheila Bair that there’s no risk is absurd,” he said, because losses from the PPIP will be borne by the FDIC, which is funded by member banks.

“We’re going to be asking all the banks, including presumably some healthy banks, to pay for the losses of the bad banks( NB DON ),” Stiglitz said. “It’s a real redistribution and a tax on all American savers.”

Stiglitz was also concerned about the links between White House advisers and Wall Street. Hedge fund D.E. Shaw & Co. paid National Economic Council Director Lawrence Summers, a managing director of the firm, more than $5 million in salary and other compensation in the 16 months before he joined the administration. Treasury Secretary Timothy Geithner was president of the New York Federal Reserve Bank.

‘Revolving Door’

“America has had a revolving door. People go from Wall Street to Treasury and back to Wall Street,” he said. “Even if there is no quid pro quo, that is not the issue. The issue is the mindset.”

Stiglitz was head of the White House’s Council of Economic Advisers under President Bill Clinton before serving from 1997 to 2000 as chief economist at the World Bank. He resigned from that post in 2000 after repeatedly clashing with the White House over economic policies it supported at the International Monetary Fund. He is now a professor at Columbia University.

Stiglitz was also critical of Obama’s other economic rescue programs.

He called the $787 billion stimulus program necessary but “flawed” because too much spending comes after 2009, and because it devotes too much of the money to tax cuts “which aren’t likely to work very effectively.”

“It’s really a peculiar policy, I think,” he said.

Plan Deficient

The $75 billion mortgage relief program, meanwhile, doesn’t do enough to help Americans who can’t afford to make their monthly payments, he said. It doesn’t reduce principal, doesn’t make changes in bankruptcy law that would help people work out debts, and doesn’t change the incentive to simply stop making payments once a mortgage is greater than the value of a house.

Stiglitz said the Fed, while it’s done almost all it can to bring the country back from the worst recession since 1982, can’t revive the economy on its own.

Relying on low interest rates to help put a floor under housing prices is a variation on the policies that created the housing bubble in the first place, Stiglitz said.

“This is a strategy trying to recreate that bubble,” he said. “That’s not likely to provide a long run solution. It’s a solution that says let’s kick the can down the road a little bit.”

While the strategy might put a floor under housing prices, it won’t do anything to speed the recovery, he said. “It’s a recipe for Japanese-style malaise.”

is concerned about the potential inflationary risk of the US Federal Reserve printing money

TO BE NOTED: From the FT:

"China wants dollar replaced as reserve currency

By Jamil Anderlini in Beijing

Published: March 23 2009 12:16 | Last updated: March 23 2009 14:22

China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.

The goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies,” Zhou Xiaochuan, governor of the People’s Bank of China, said in an essay posted in Chinese and English on the central bank’s website.

Although Mr Zhou did not mention the US dollar, the essay gave a pointed critique of the current dollar-dominated monetary system.

“The outbreak of the [current] crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Mr Zhou wrote.

Analysts said the proposal was a clear indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China. (NB DON )

“This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC. ( NB DON )

For now, China has little choice but to hold the bulk of its $2,000bn of foreign exchange reserves in US dollars and this is unlikely to change in the near future.

To replace the current system, Mr Zhou suggested expanding the role of Special Drawing Rights, which were introduced by the IMF in 1969 to support the Bretton Woods fixed exchange rate regime but became less relevant once that system collapsed in the 1970s.

Today, the value of SDRs is based on a basket of four currencies – US$, Yen, Euro and Pound Sterling – and they are used largely as a unit of account by the IMF and some other international organizations.

“The US dollar is still the most important currency for settling international trade, pricing and payment in the current international monetary system,” Hu Xiaolian, director of the State Administration of Foreign Exchange, which manages the country’s foreign exchange reserves, said at a press conference earlier in the day. “Investing in US Treasury bonds is an important element in China's forex reserve investment and we will continue this practice.”

China’s proposal would expand the basket of currencies forming the basis of SDR valuation to all major economies and set up a settlement system between SDRs and other currencies so they could be widely used in international trade and financial transactions.

Countries would entrust a portion of their SDR reserves to the IMF to manage collectively on their behalf and SDRs would gradually replace existing reserve currencies.

Mr Zhou said the proposal would require “extraordinary political vision and courage” and explicitly acknowledged a debt to the theories of John Maynard Keynes, who made a similar suggestion in the 1940s.

More recently, US economist and Nobel prize winner Joseph Stiglitz, who is visiting China this week, has suggested expanding the role of SDRs to lay the foundation for the creation of a world currency.

In the short term, China expects the IMF to “at least recognize and face up to the risks resulting from the existing system, conduct regular monitoring and assessment and issue timely early warnings,” Mr Zhou’s essay said."

And:

Reform the International Monetary System

Zhou xiaochuan

The outbreak of the current crisis and its spillover in the world confronted us with the long existing but still unanswered question��i.e., what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF? There were various institutional arrangements in an attempt to find a solution, including the Silver Standard, the Gold Standard, the Gold Exchange Standard and the Bretton Woods system. The above issue, however, as the ongoing financial crisis demonstrates, is far from being solved, and has become even more severe due to the inherent weaknesses of the current international monetary system.

Theoretically, an international reserve currency should first be anchored to a stable benchmark and issued according to a clear set of rules, therefore to ensure orderly supply; second, its supply should be flexible enough to allow timely adjustment according to the changing demand; third, such adjustments should be disconnected from economic conditions and sovereign interests of any single country. The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history. The crisis called again for creative reform of the existing international monetary system towards an international reserve currency with a stable value, rule-based issuance and manageable supply, so as to achieve the objective of safeguarding global economic and financial stability.

I. The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries' demand for reserve currencies. On the one hand��the monetary authorities can not simply focus on domestic goals without carrying out their international responsibilities��on the other hand��they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they tries to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triniffin Dilemma, i.e., the issuing countries of reserve currencies can not maintain the value of the reserve currencies while providing liquidity to the world, still exists.

When a national currency is used in pricing primary commodities, trade settlements and is adopted as a reserve currency globally, efforts of the monetary authority issuing such a currency to address its economic imbalances by adjusting exchange rate would be made in vain, as its currency serves as a benchmark for many other currencies. While benefiting from a widely accepted reserve currency, the globalization also suffers from the flaws of such a system. The frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits. The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies. Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws.

II. The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.

1. Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back to the 1940s, Keynes had already proposed to introduce an international currency unit named "Bancor", based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted. The collapse of the Bretton Woods system, which was based on the White approach, indicates that the Keynesian approach may be more farsighted. The IMF also created the SDR in 1969, when the defects of the Bretton Woods system initially emerged, to mitigate the inherent risks sovereign reserve currencies caused. Yet, the role of the SDR has not been put into full play due to limitations on its allocation and the scope of its uses. However, it serves as the light in the tunnel for the reform of the international monetary system.

2. A super-sovereign reserve currency not only eliminates the inherent risks of credit-based sovereign currency, but also makes it possible to manage global liquidity. A super-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity. And when a country's currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances. This will significantly reduce the risks of a future crisis and enhance crisis management capability.

III. The reform should be guided by a grand vision and start with specific deliverables. It should be a gradual process that yields win-win results for all

The reestablishment of a new and widely accepted reserve currency with a stable valuation benchmark may take a long time. The creation of an international currency unit, based on the Keynesian proposal, is a bold initiative that requires extraordinary political vision and courage. In the short run, the international community, particularly the IMF, should at least recognize and face up to the risks resulting from the existing system, conduct regular monitoring and assessment and issue timely early warnings.

Special consideration should be given to give the SDR a greater role. The SDR has the features and potential to act as a super-sovereign reserve currency. Moreover, an increase in SDR allocation would help the Fund address its resources problem and the difficulties in the voice and representation reform. Therefore, efforts should be made to push forward a SDR allocation. This will require political cooperation among member countries. Specifically, the Fourth Amendment to the Articles of Agreement and relevant resolution on SDR allocation proposed in 1997 should be approved as soon as possible so that members joined the Fund after 1981 could also share the benefits of the SDR. On the basis of this, considerations could be given to further increase SDR allocation.

The scope of using SDR should be broadened, so as to enable it to fully satisfy the member countries' demand for a reserve currency.

l Set up a settlement system between the SDR and other currencies. Therefore, the SDR, which is now only used between governments and international institutions, could become a widely accepted means of payment in international trade and financial transactions.

l Actively promote the use of the SDR in international trade, commodities pricing, investment and corporate book-keeping. This will help enhance the role of the SDR, and will effectively reduce the fluctuation of prices of assets denominated in national currencies and related risks.

l Create financial assets denominated in the SDR to increase its appeal. The introduction of SDR-denominated securities, which is being studied by the IMF, will be a good start.

l Further improve the valuation and allocation of the SDR. The basket of currencies forming the basis for SDR valuation should be expanded to include currencies of all major economies, and the GDP may also be included as a weight. The allocation of the SDR can be shifted from a purely calculation-based system to one backed by real assets, such as a reserve pool, to further boost market confidence in its value.

��. Entrusting part of the member countries' reserve to the centralized management of the IMF will not only enhance the international community's ability to address the crisis and maintain the stability of the international monetary and financial system, but also significantly strengthen the role of the SDR.

1. Compared with separate management of reserves by individual countries, the centralized management of part of the global reserve by a trustworthy international institution with a reasonable return to encourage participation will be more effective in deterring speculation and stabilizing financial markets. The participating countries can also save some reserve for domestic development and economic growth. With its universal membership, its unique mandate of maintaining monetary and financial stability, and as an international "supervisor" on the macroeconomic policies of its member countries, the IMF, equipped with its expertise, is endowed with a natural advantage to act as the manager of its member countries' reserves.

2. The centralized management of its member countries' reserves by the Fund will be an effective measure to promote a greater role of the SDR as a reserve currency. To achieve this, the IMF can set up an open-ended SDR-denominated fund based on the market practice, allowing subscription and redemption in the existing reserve currencies by various investors as desired. This arrangement will not only promote the development of SDR-denominated assets, but also partially makes the management of the liquidity in the form of the existing reserve currencies possible. It can even lay a foundation for increasing SDR allocation to gradually replace existing reserve currencies with the SDR.

Submit Date:2009-3-23 17:39:00

The well of money may be running dry, and so, too, may be America's legendary optimism and hope.

From the Economist's View:

"Stiglitz: How to Fail to Recover

Yet another voice saying the stimulus package was too small, and that the bank bailout plan is inadequate:

How to Fail to Recover, by Joseph E. Stiglitz, Project Syndicate: Some people thought that Barack Obama's election would turn everything around... Because it has not, even after the passage of a huge stimulus bill,... a new program to deal with the underlying housing problem, and several plans to stabilize the financial system, some are even beginning to blame Obama and his team.

Obama, however, inherited an economy in freefall, and could not possibly have turned things around in the short time since his inauguration. President Bush seemed like a deer caught in the headlights - paralyzed, unable to do almost anything - for months before he left office. It is a relief that the US finally has a president who can act, and what he has been doing will make a big difference.

Unfortunately, what he is doing is not enough. The stimulus package appears big ... but one-third of it goes to tax cuts. And ... Americans ... are likely to save much of the tax cut. Almost half of the stimulus simply offsets the contractionary effect of cutbacks at the state level. ...

In short, the stimulus will strengthen America's economy, but it is probably not enough to restore robust growth. ...

The real failings in the Obama recovery program, however, lie not in the stimulus package but in its efforts to revive financial markets. America's failures provide important lessons...:

- Delaying bank restructuring is costly...

- Governments do not like to admit the full costs of the problem, so they give the banking system just enough to survive, but not enough to return it to health.

- Confidence is important, but it must rest on sound fundamentals. Policies must not be based on the fiction that good loans were made, and that the business acumen of financial-market leaders and regulators will be validated once confidence is restored.

- Bankers can be expected to act in their self-interest... Perverse incentives fueled excessive risk-taking, and banks that are near collapse but are too big to fail will engage in even more of it. Knowing that the government will pick up the pieces if necessary, they will postpone resolving mortgages and pay out billions in bonuses and dividends.

- Socializing losses while privatizing gains is more worrisome than the consequences of nationalizing banks. ...

- Don't confuse saving bankers and shareholders with saving banks. ...

- Trickle-down economics almost never works. Throwing money at banks hasn't helped homeowners: foreclosures continue to increase. ...

- ...The Obama administration is promising to pick up losses to persuade ... private investors to buy out banks' bad assets. But this will not establish "market prices," as the administration claims. With the government bearing losses, these are distorted prices. Bank losses have already occurred, and their gains must now come at taxpayers' expense. ...

- Better to be forward looking than backward looking, focusing on reducing the risk of new loans and ensuring that funds create new lending capacity. Bygone are bygones. ...

The era of believing that something can be created out of nothing should be over. Short-sighted responses by politicians - who hope to get by with a deal that is small enough to please taxpayers and large enough to please the banks - will only prolong the problem. An impasse is looming. More money will be needed, but Americans are in no mood to provide it - certainly not on the terms that have been seen so far. The well of money may be running dry, and so, too, may be America's legendary optimism and hope.

Posted by Mark Thoma on Friday, March 6, 2009 at 05:40 PM"

Me:

I agree with the entire post. I simply believe that a sales tax cut which would be for a limited time could help encourage consumption. I also favor a QE plan that does not include borrowing. Infrastructure can be increased as we go along, but it should be carefully spent. Add more social safety net spending if you want more spending other than infrastructure.

Posted by: Don the libertarian Democrat | March 06, 2009 at 10:41 PM

Nationalising the dodgy banks would not solve the problem of how much to pay for the banks

From Buiter:

"Good Bank/New Bank vs. Bad Bank: a rare example of a no-brainer

February 8, 2009 8:41pm

The truth of a proposition is independent of how many people believe it to be correct. The merits of a proposal are likewise not enhanced by the number of people supporting it or making similar proposals. Still, humans, like other pack animals, thrive on companionship. It is therefore comforting that the logic behind my proposal (January 29, 2009) for one or more new ‘good banks’ to be established, capitalised with public money and with additional financial support from the state for new lending and new funding, while the toxic assets of the old banks are left with the owners and creditors of the ‘legacy banks’, is being echoed in proposals from Joseph Stiglitz (February 2, 2009), George Soros (February 4, 2009) and Paul Romer (February 6, 2009), to name but a few. I claim no authorship or originality for the ‘good bank’ proposal. The idea is obvious and no doubt was floating around the blogosphere and elsewhere as soon as the magnitude of the insolvency disaster in the banking sector became apparent.

The various proposals differ in detail. Romer’s proposal is essentially the same as my own. Stiglitz argues, according to the British Daily Telegraph that “the government should allow every distressed bank to go bankrupt and set up a fresh banking system under temporary state control rather than cripple the country by propping up a corrupt edifice”.

Soros proposes not to remove the toxic assets from the banks’ balance sheets (which would require them to be valued, which is not possible) but instead put them into a “side pocket”. The necessary amount of capital — equity and unsecured debentures — would be sequestered in the side pocket. Soros’ ‘side pocket’ is effectively the same as my ‘legacy bad banks’. Soros notes that about $1.5 trillion is likely to be required to recapitalise the existing banks properly. This money could be leveraged a lot more effectively if most of it were injected into the new good banks, unencumbered with the toxic waste of the existing banks.

Under the Soros proposal, some additional capital might have to be injected into the ‘side pockets’, presumably by the state. Under my new good banks proposal, the new good banks would take on the (guaranteed or insured) deposits of the legacy bad banks (which would lose their banking licenses) and would buy the good assets of the legacy banks. Should deposits exceed good assets, the state would have to make up the difference initially with government debt on the balance sheet of the new good banks. Should deposits be less than good assets, the new good banks would be able to borrow from the sovereign to finance the acquisition of the good assets from the legacy bad banks. This would cleanse bank balance sheets and transform them into good banks but leave them undercapitalized. Soros suggests that $1 trillion of the estimated $1.5 trillion required to recapitalise the existing banking system should be directed to the cleansed banks. Soros believes or hopes that some of the money required to capitalise the new, cleansed banks could come from the private sector. Under my proposal, and that of Stiglitz, the state would initially capitalise the new banks on its own.

A common logic

The logic is simple. Many (probably most, possibly all but a handful) high-profile, large border-crossing universal banks in the north Atlantic region are dead banks walking - zombie banks kept from formal insolvency only through past, present and anticipated future injections of public money. They have indeterminate but possibly large remaining stocks of toxic - hard or impossible to value - assets on their balance sheets which they cannot or will not come clean on.

This overhang of toxic assets acts like a tax on new lending. Banks are required, by regulators or by market pressures, to hoard capital and liquidity rather than engaging in new lending to the real economy. The public financial support offered in the form of capital injections (in the US mainly through preference shares and other non-voting equity), guarantees for assets and for liabilities (old and new), insurance of toxic assets (as provided to Citigroup by the US sovereign) and possibly in the future through direct purchases by the state of toxic assets (using TARP money in the US) and the creation of one or more publicly owned ‘bad banks’ has been a complete failure.

The bad bank proposals the Obama administration and other governments are considering are non-starters, for the simple reason that they require the valuation of assets whose true value (even on a hold-to-maturity basis) can only be guessed at. The good bank proposal only requires the valuation of those assets on the balance sheets of the existing banks that are easy to value: transparently valued assets. The toxic stuff is left on the balance sheet of the existing banks, which become the legacy bad banks.

Offering to pay enough to the existing owners of the toxic assets to induce these owners to sell them would require paying over the odds. That might not leave enough fiscal resources to support the new lending activities that are so urgently needed. It would also be an unfair and moral-hazard-maximising bail out of the existing owners and creditors of the banks. Nationalising the dodgy banks (or even the entire cross-border universal banking sector) would only solve the valuation problem of the new owner (the state) after nationalisation. The toxic assets could be transferred into a bad bank at any valuation, including zero. The owner of the bad bank and of the cleansed bank are the same. Nationalising the dodgy banks would not solve the problem of how much to pay for the banks, however, because that would depend in part on the valuation of the toxic assets. The good bank proposal creates new, publicly owned banks which only purchase good assets from the legacy bank. There is no valuation issue involving toxic assets for the tax payer.

Crisis fighting, moral hazard and fairness

The existing packages of support measures in the US, the UK and elsewhere have failed to get lending to the real economy going again. In the US especially, but also to some extent in the UK, It has been a shameful boondoggle for the banks that are at the heart of the financial mess - bank CEOs and other top managers, bank shareholders, holders of unsecured bank bank debt (subordinated, junior and senior) and other creditors.

The US, the UK and several other continental European countries are at risk of emulating Ireland, where the government first guaranteed all the liabilities of the banks (other than equity) and only after that began to nationalise the banks. This leaves the Irish government today in the not too enviable position of having to choose between sovereign default and bleeding the tax payer and the beneficiaries of normal public spending to make whole all the creditors of the banks.

Bailing out the holders of existing bank debt and other bank creditors would be outrageously unfair: they did the lending and made the investments, they should eat the losses. In addition, many of the creditors are likely to be much better off, even after they write down/off their claims on the banks, than most of the tax payers and public expenditure beneficiaries that pay for the bail out. Bailing out the existing creditors would also create dreadful incentives for excessive future risk taking by banks.

Especially in the US, the disdain for moral hazard displayed since the beginning of the crisis by regulators and by the fiscal and monetary authorities has been shocking. It has been justified with the claim that you cannot afford to worry about medium- and long-term incentives for appropriate risk taking when your house is on fire. That argument is logically flawed.

Two things are systemically important. The first is to restore the operation of key financial markets that have become illiquid. The Fed is doing a reasonable job in that regard. The second is to restore bank lending to the real economy. Neither objective requires that the existing banks be saved, let alone that their existing shareholders and creditors receive any financial support from the state. We can save banking without saving the banks or the bankers. The ‘good bank’ proposal demonstrates how to do this.

Regulators, central bankers and policy makers should be pursuing three key objectives. The first is to get lending by the banks to the real economy, especially to the non-financial enterprise sector, going again. The second is to minimize moral hazard by creating the right incentives for future risk taking by banks, their creditors and their customers, by ensuring that the losses incurred by the failed banking system are born first and foremost by those who invested in the banks in any capacity. For reasons that are partly sensible (protecting small unsophisticated savers from financial ruin and forestalling inefficient attempts by financial illiterates to monitor complex financial institutions) and partly populist pandering, most retail deposits have ended up insured or guaranteed by the state (often at least in part ex-post). Moral hazard should be stopped, however, beyond the magic circle the state has drawn around retail depositors. The third objective is to pursue justice in burden sharing.

The legacy bad banks would, under their existing ownership and with whatever balance sheet they end up with after shedding their insured/guaranteed deposits and after selling their good, easily valued assets, have as their sole activity the management of their existing assets. No new investments would be undertaken, no new loans made and no other new exposures incurred. Their liabilities and other funding decisions would be managed in the interests of the existing shareholders. No doubt many of them would fold. Chapter 11 or Chapter 7 would be ready and waiting for them.

Conclusion

By focusing scarce fiscal resources on supporting flows of new lending and new funding to support new lending, rather than on supporting stocks of existing bad assets and/or toxic assets assets and on guaranteeing or insuring stocks of existing liabilities, the state meets its three key objectives. First, its short-run economic stabilisation and crisis-fighting objective; second, its medium and long-term banking sector incentive-enhancing, moral-hazard-minimising objective; and third, its fairness objectives: the polluter pays or, you break it, you own it.

Establishing legal and institutional clear water between the legacy bad banks and the new good banks is a necessary condition for fulfilling the economic imperative to support flows of new lending and borrowing rather than to protect existing stocks of toxic assets and their owners."

Me:

6. "Nationalising the dodgy banks (or even the entire cross-border universal banking sector) would only solve the valuation problem of the new owner (the state) after nationalisation. The toxic assets could be transferred into a bad bank at any valuation, including zero. The owner of the bad bank and of the cleansed bank are the same. Nationalising the dodgy banks would not solve the problem of how much to pay for the banks, however, because that would depend in part on the valuation of the toxic assets. The good bank proposal creates new, publicly owned banks which only purchase good assets from the legacy bank. There is no valuation issue involving toxic assets for the tax payer."

I'm trying to understand this:
1) Everybody agrees that the new banks will be good banks.
2) We loaned money to LBBs. We also own stock. What's to become of this?
3) Following from 2, who says that we're going to have to pay anything for the TAs?
4) If the banks go bust, the FDIC seizes them. Right? Isn't that nationalization?
5) Can the LBBs continue to lobby? Don't write them off if they can?
6) As for moral hazard, it is better to rule a LBB than be nationalized.
7) Even though the TAs are probably crap, wouldn't it be better for us to have control of the ones that turn out to be worth something?
I understand, I think, the benefit of just going ahead and creating a good bank now. But, again, since we have loaned money to these banks, own stock in them, and will have to deal them when they explode, I don't see the point of waiting, unless that will somehow save us money and aggravation. Leaving these LBBs wandering in a kind of financial limbo seems an unnecessary risk, and one likely to get worse before ever getting better.

Posted by: Don the libertarian Democrat

"The majority, and their families, are poor already before taxation hits them"

From Adam Smith's Lost Legacy:

"Stop Taxing the Poorest Incomes at 20 Per Cent

Joseph Stiglitz write in FT.com (via Economist’s View, Mark Thoma):

“Do not squander America’s stimulus on tax cuts

and

“Joseph Stiglitz: Just Say No to Tax Cuts”

“Do not squander America’s stimulus on tax cuts, by Joseph Stiglitz, Commentary, Financial Times”:

“As news of the US economy worsens, he worries about whether a stimulus could restart the economy ...”

“We are in uncharted territory in this crisis. But household tax cuts, except for
possibly the poorest, should have no place in the stimulus.”

Comment
It seems to me that Joseph Stiglitz does not emphasis the correct and moral policy. Across the board tax cuts may not be efficacious in the current climate, but the case for removing the poorest consumers from the taxation system is convincing. ( I AGREE WITH THIS IN GENERAL )

Raising the personal, non-taxable allowance from about £6k to £16k (even higher) would largely be passed on in spending and stimulate the economy fairly quickly.

Reducing tax rates in the higher income brackets may not have an such an immediate, or lasting, effect.

The poor spend; they do not save much as a group. Legends of poor-pensioner, miserly ‘millionaires’ are news, when revealed, because they are so rare.

The majority, and their families, are poor already before taxation hits them, if they have jobs, and raising the tax threshold will not make them rich; only a little less poor.

It’s not that this change would ‘solve’ poverty. The moral compulsion for removal is that paying income tax (20 per cent, thanks to the ‘Labour’ government) when they already very poor is itself immoral.( I AGREE )

Removal of the income tax from the very poor may mean that the richer would pay ‘proportionally’ more on their much larger incomes, which Adam Smith said was appropriate in other contexts, and not at the expense of the poor, ‘who are least able to supply it.’ [WN V.i.d.13: p 728; Edwin Canaan, 1937 edition, Random House, p 686]

posted by Gavin Kennedy at 3:16 PM 0 comments"

I agree with this post in principle, which is why I support a Guaranteed Income. However, a sales tax cut or payroll tax cut which will be phased out in the future does help the poor and give the better off an incentive to spend now. This doubly effective aspect of both of these tax cuts goes very far in recommending them.

it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending

When I first read about this, I believed that Stiglitz really disagreed with me. Let's take a peek on the FT:

"Do not squander America’s stimulus on tax cuts

By Joseph Stiglitz

Published: January 15 2009 19:48 | Last updated: January 15 2009 19:48

As news of the US economy worsens, worries about whether a stimulus could restart the economy are growing. Making matters more complicated is the fact that our 2009 fiscal deficit will exceed 8 per cent of gross domestic product( TRUE, WHICH IS ONE MORE REASON THE BUSH YEARS HAVE BEEN A NIGHTMARE ), even before the stimulus.

What is clear is that tax cuts will not help much. When Barack Obama, president-elect, last week proposed to use nearly 40 per cent of the stimulus for tax cuts, he was rightly told this would be less effective than, say, spending on infrastructure( HERE, I DON'T AGREE ). It has been surprising, then, to see President George W. Bush’s former economic advisers, including Greg Mankiw, argue that tax cuts are the way forward.

Mr Mankiw cites a recent study by Christina Romer and David Romer, economists at the University of California, Berkeley, who found that each dollar of tax cuts raises GDP by about $3 (€2.30). Such studies, based on past data, may have little to say about the situation the world now faces( CHUCK THEM ). Americans confronted with debt, shrinking retirement accounts, houses worth less than mortgages and a tough credit environment will save more of their money than in the past( TRUE. FOR A WHILE. ). That was the experience with the February 2008 tax cut, where less than half of it has been spent. It matters who gets the break – if it is lower income Americans, the fraction spent will, on average, be greater( TRUE ) than for wealthier Americans.

Tax breaks for business may prove to be a sink-hole as bad as the troubled assets relief programme. Particularly worrisome are rumours that companies will be allowed to set off their losses against profits made in the past five years to get tax rebates( I AGREE ) – a big gift to those who mismanaged risk, including banks such as Citibank. Some suggest that, having exhausted the more transparent bail-out strategy, banks are seeking less transparent help through the tax code. We learnt the lesson from Tarp: we need to link handouts to changes in behaviour( I AGREE ). We should have insisted banks commit to more lending. Now we should insist any tax breaks for business are linked to investment( HE AND I AGREE ).

Similar caution needs to be exercised in evaluating each element of the stimulus package. The Obama team has issued a report projecting its potential for job creation. In estimating the impact of offering relief to the states, it assumed, based on experience, that 30 per cent of the relief would be used to stall tax increases that would otherwise have occurred. (States are facing a shortfall of perhaps $150bn a year.) But with property values plummeting, there is pressure to cut property taxes. And, in any case, state taxes are more regressive than federal taxes – more of the burden of taxation is borne by those with lower incomes. This means that if tax cuts come partly at the expense of state relief, and states are forced to raise taxes, the net effect on the economy is likely to be negative.

There is a more fundamental point that the Bush team missed. Tax cuts have increased our national debt. They encouraged( ONLY THAT ) America to live beyond its means, increasing our liabilities without commensurate increases in assets( WEREN'T HOUSES ASSETS ). Further tax cuts would do the same. Good accounting looks at assets and liabilities. Spending on infrastructure, education and technology create assets; they increase future productivity( IF THEY ARE WELL SPENT. OTHERWISE, THEY CAN DO GREAT HARM. IT'S NOT A PRIORI A GREAT INVESTMENT. ).

Some of the spending in the stimulus serves multiple ends. Increased unemployment benefits ( NOT A STIMULUS )have the largest multiplier effects – cash-strapped families spend every cent given – and meet vital social needs. It is imperative to provide health insurance to the unemployed( NOT A STIMULUS ): without that, a single serious incident can push a family into bankruptcy. Helping the unemployed meet house payments reduces foreclosures, addressing one of the underlying causes of the crisis. There are thus triple benefits.( BUT NOT A STIMULUS. THIS IS SOCIAL SAFETY NET SPENDING. )

We are in uncharted territory in this crisis. But household tax cuts, except for possibly the poorest, should have no place in the stimulus. Nor should business tax breaks, except when closely linked with additional investment( I AGREE ). The one tax cut that should be included is a temporary incremental investment tax credit; it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending( I AGREE ). Increased investments in infrastructure, education and technology, relief to states, and help to the unemployed need pride of place.

This is a stimulus that some Republicans will find less attractive than previous give-aways. But Americans voted for change they could believe in. I trust that that is what we will get.

The writer was awarded the Nobel Prize in economics in 2001. His latest book is The Three Trillion Dollar War, co-authored with Linda Bilmes (2008)"

My only disagreement is about one tax cut, but it's big. I would like a sales tax cut or payroll tax cut which will be phased out in the future, giving people an incentive to spend now instead of waiting. Some people will save money by not spending, but that's fine as well.