TARP and Leviathan
Monday, November 30, 2009
In the world after the crisis, how can we move toward reprivatization? Alternately stated, how can we put the enlarged Leviathan on a diet?
The great philosopher of the authoritarian state, Thomas Hobbes, had this to say in 1651: "By art is created that great LEVIATHAN called a COMMONWEALTH or STATE (in Latin, CIVITAS), which is but an artificial man, though of greater stature and strength … in which the sovereignty is an artificial soul … reward and punishment (by which fastened to the seat of sovereignty, every joint and member is moved to perform his duty) … laws, an artificial reason and will; concord, health; sedition, sickness."
Hobbes did not mention the central bank as a kind of artificial heart, pumping the circulating blood of money—often to an excessive extent, causing financial markets to be overly sanguine. Nor did he mention the financial appetite of government-sponsored enterprises backed by implicit government guarantees, causing in Leviathan obesity and flatulence. (In his defense, when Hobbes was writing, the creation of the Bank of England and Fannie Mae were still four decades and three centuries, respectively, in the future.)
Banks holding deposits at the Federal Reserve is the economic equivalent of their putting currency in the mattress, except that now, the Fed is paying interest on those deposits.
While sedition may be a sickness in Leviathan, financial panic and crisis always move him to great vigor, activity, and expansion, just as has the financial crisis of 2007-2009. As we all know, we have had an immense expansion of the role of the government in the financial system. In the world after the crisis, how can we move toward reprivatization? Alternately stated, how can we put the enlarged Leviathan on a diet?
Let us consider four elements of the problem:
- TARP: Managing on a business basis
- Fannie and Freddie: No GSE should be left
- The Federal Reserve’s balance sheet: Negative interest rates needed
- Deposit insurance: Encouraging new banks
TARP: Managing on a business basis
Having invested more than $300 billion in the capital of more than 600 financial companies, is there hope that TARP (the “Troubled Asset Relief Program” of the Treasury Department) will withdraw over time?
Of course, one element tending to prolong TARP is that Leviathan likes having the expanded control over financial firms that arises from being a major investor. Still, no one is proposing that it should retain permanent stock ownership in the banking system. With the right approach, there should be a reasonably paced, orderly withdrawal—perhaps on the order of three years or so.
The closest historical analogy to TARP is the Reconstruction Finance Corporation (RFC) of the 1930s. In a vastly more destructive financial and economic collapse, it made investments in more than 6,000 banks, or ten times the number of institutions involved in TARP. These included such major banks of the day as National City Bank of New York, Chase National Bank, Manufacturers Trust Company, National Bank of Detroit, and Continental Illinois. Over time, the great majority of these investments were retired in full, after paying dividends along the way, so that overall, the RFC was able to show a modest profit on the program.
A forceful character named Jesse Jones ran the RFC. Jones was a conservative Texas Democrat, a tough-minded and successful entrepreneur who had dropped out of school after the eighth grade to enter business. “The program of putting capital into banks,” he wrote, “was carried out without loss to the government or the taxpayer. On the contrary, it has shown profit through interest and dividends.”
Over the next two or three years, Fannie and Freddie each should be broken into three pieces.
I believe the key to such a result is a business approach to managing the investments. “There was a disposition of the part of President Roosevelt to use the RFC as a sort of grab bag or catchall in his spending programs,” said Jones, “but I insisted on its being operated on a business basis with proper accounting methods.”
A “business basis” means that the goal is for the managers of TARP investments to act as fiduciaries for the taxpayers: to get their money back along with a reasonable overall profit. The predominant discipline should be that of investment management, not politics, as the TARP portfolio is liquidated over the next few years.
Fannie and Freddie: No GSE should be left
We have seen the effective nationalization of Fannie Mae and Freddie Mac. The equity the government continues to put in them looks like it may generate a loss of $100 billion to $200 billion or more for the taxpayer-investors. The government, through the Federal Reserve, has also bought something on the order of $900 billion of Fannie and Freddie’s mortgage-backed securities (MBS) and debt. One might consider what Jesse Jones would have thought of all this.
Well, many of us always knew that government-sponsored enterprises (GSEs) with “implicit” government guarantees—which always were and now obviously are real guarantees—was a bad idea.
Over the next two or three years, Fannie and Freddie each should be broken into three pieces:
1. A dead loss liquidating bad bank in receivership.
2. For its future financial business, a truly private company competing in the market like everybody else, succeed or fail, sink or swim.
3. For dispensing of housing subsidies, a truly government entity, requiring congressional appropriations for expenditures, merged into the Department of Housing and Urban Development.
No GSEs would be left.
The Federal Reserve’s balance sheet: Negative interest rates needed
We mentioned above the central bank as the artificial heart of Leviathan. The combined balance sheet of the Federal Reserve Banks—about half of the total is the Federal Reserve Bank of New York—has expanded to over $2 trillion during the crisis—about two and a half times its pre-crisis level. It now includes (as of October 28, 2009), $774 billion of MBS, $142 billion of agency debt, and $65 billion of risky MBS and derivatives acquired from Bear Stearns and AIG.
The combined balance sheet of the Federal Reserve Banks has expanded to over $2 trillion during the crisis—about two and a half times its pre-crisis level.
In this sense, financing the crisis has made the Fed look more like a commercial bank. So did its great growth in deposits.
At present, Fannie and Freddie buy mortgages, then sell MBS and their own debt to the Fed. The Fed could finance such purchases by printing money (“monetization”), but it also can do so by itself taking deposits.
Risk-free deposits kept by banks at the Fed have grown to over $1 trillion, about 65 times their pre-crisis level. Banks holding deposits at the Federal Reserve is the economic equivalent of their putting currency in the mattress, except that now, the Fed is paying interest on those deposits.
This means that banks can earn income simply by keeping a risk-free deposit with the Fed, rather than having to lend out or invest their excess reserves to do so in, for example, the Fed funds market. Lending Fed funds always incurs some degree of credit risk, but it also finances other banks’ credit operations.
Former Chairman of the Federal Reserve Paul Volcker recently said to Minneapolis Fed President Gary Stern in an interview, “well, I asked you and others a question some months ago as to why the Federal Reserve is paying interest on excess reserves.”
“You did,” Stern replied, “I don’t think anybody gave you a good answer.”
In my view, the right answer under current economic conditions, as we strive to reprivatize credit availability, is that excess reserves merely stuffed into the mattress of the Federal Reserve by banks should have a negative interest rate, as a cost of not lending or investing the cash. It may sound odd, but not only can it be done, it should be done. (See my article “Why Not Negative Interest Rates?”)
Deposit insurance: Encouraging new banks
Deposit insurance appears to be a permanent government intervention in the financial system, which has been greatly expanded in the current crisis. Whatever its merits, deposit insurance is intended to make and does make the main way banks borrow money from the public—deposits—immune to market discipline.
Whatever its merits, deposit insurance is intended to make and does make the main way banks borrow money from the public—deposits—immune to market discipline.
But in making good on its guaranty, the deposit insurance corporation can itself come under financial pressure during a crisis. FSLIC (the Federal Savings and Loan Insurance Corporation) did not survive its insolvency of the 1980s. The FDIC (Federal Deposit Insurance Corporation) has announced that now its liabilities exceed its assets by $8 billion. This is as it faces hundreds more bank failures in the coming year or two.
Hence it has a strong incentive to force all new capital available to banking into solving the problem of failing banks, and new banking charters have become exceptionally difficult to achieve. From the perspective of the FDIC’s own problems, this is easy to understand. But from the broader public policy perspective, the opposite approach would be better. As Randall Forsyth recently wrote in Barron’s, “it’s been the best of times for giant corporate borrowers storming the bond market, but about the worst for small businesses dependent on bank loans.”
Public policy should encourage new capital to form new banks, which will be unencumbered by past losses, unencumbered by TARP, unencumbered by the nonperforming loans of the bubble—unencumbered, in other words, by the unfortunate past, to get into business of making private credit available to enterprises and individuals which are creditworthy.
In sum, movement in the direction of these ideas would be progress toward reprivatizing the financial system. It would by no means render Leviathan a skinny weakling, but we could make his presence less overwhelming.
Alex J. Pollock is a resident fellow at the American Enterprise Institute.
FURTHER READING: Pollock recently wrote “Ten Ways to Do Better in the Next Financial Cycle” and “Is a ‘Systemic Risk Regulator’ Possible?” Also in THE AMERICAN, Pollock wrote “A Theory of Two Big Balance Sheets,” explaining the recent period of bubbles, busts, and bailouts, “Did They Really Believe House Prices Could Not Go Down?,” and “Your Guide to the Housing Crisis.”
Image by Darren Wamboldt/Bergman Group.