J. Bradford DeLong (2008), "Contribution to Greenspan Roundtable," Economist (December 18):
Greenspan roundtable: Is $250 billion enough? | Free exchange | Economist.com: FOUR factors impose haircuts on the values of financial assets. The first is default: perhaps your counterparty simply will not be around when the financial asset you hold matures. The second is duration: even if you are certain that your counterparty will be around, and even if you are certain that you understand the situation, and even if you don't care about risk, you would still rather have your money now than at its maturity date in the future. The third factor is information, or rather its lack: maybe you don't understand what you are buying, for if it is such a good deal for you to buy it at this price why is the seller so eager to sell the asset to you? The fourth is risk: even if your counterparty will be around and even if you don't care about getting your money now rather than later and even if you understand the security perfectly, you still are not sure how valuable the security will be to you in your particular situation when it matures.
Duration is not an issue in this financial crisis. Central banks have pushed the time value of money down to zero in nominal terms, and negative in real terms. Default is only a very minor issue in this financial crisis. But risk is a big issue—banks feel that they should be holding less-risky portfolios than they currently hold because just one more bad shock may see them or at least their stockholders' equity and their executives' option wealth disappear, so risky assets are at a deep discount. And information is a big issue—everyone is scared that the assets others are trying to sell are for some reason they don't fully understand assets that nobody would wish to buy.
Alan Greenspan hopes that another $250 billion of capital for the American banking sector would bring information and risk discounts back to normal levels and resolve the financial crisis (at bank capitalisation ratios of 15% as opposed to the 10% that we used to think of as normal a couple of years ago). But he cautions that "[simple] linear calculations, of couxe, can only be very rough approximations."
I hesitate to disagree with Alan Greenspan—by my count, I have been wrong seven out of the ten times that I have, in my mind, had significant disagreements with his policies over the past quarter century. Those are not good odds. But I fear that this time he is wrong: that $250 billion will not be enough of a recapitalization of the banking system to return risk and information discounts to their normal levels.
First, the big information problem is that banks fear that what is being sold to them is simply not worth buying. Government guarantees of assets can resolve that problem, as well as the issuance of safe Treasuries and the purchase of risky assets. But government or private injections of capital into the banking system cannot.
Second, the big risk problem is not so much a fear of long-run default as a fear of a deeper short-run liquidity squeeze. It is not a fear that investing in risky assets will be bad in the long run, it is a fear that investing in risky assets robs you of the cushion needed in the short run, should there be another negative shock and should the government then decide that it must, for political reasons, confiscate the equity of financial institutions that come back to it for more liquidity support. Thus, in my view, banks are more likely to sit on additional capital injections than to increase their risk tolerance and seek to invest them at higher long-run yields.
This is a bad situation. With financial-asset prices at their current low levels, the businesses that should be expanding cannot raise the money for expansion on terms that make expansion profitable, while the businesses that should be contracting are contracting rapidly. We need either a substantial increase in financial-asset prices in order to give the businesses that should be expanding the incentive to profitably expand, or we need massive increases in government spending to provide the demand the private sector is not. We would rather have the first if we have the choice—private-sector demand we know will be for things that people regard as useful, while government-sponsored stimulus programmes have a different more political logic—but we may not have the choice.
Thus I am swinging around toward a more radical proposal than Greenspan's large-scale bank recapitalizations. Have the American government take formal complete ownership of Fannie Mae and Freddie Mac, and give them the mission of borrowing at the Treasury rate and buying up and refinancing mortgages on terms that make a profit for the Treasury. This would be a financial operation on a never before seen scale. But as the government bought and the supply of risky assets on offer to the private sector shrank their price would go up and the mortgage-backed assets that suffer the biggest information problems would disappear from the market. And as asset prices went up the banking sector would recapitalise itself.
Or so it would work, unless the large scale of the intervention cracked financial sector-confidence in the American Treasury bond as the safe asset standard for the global economy.