Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.
By Kenneth Rogoff
CAMBRIDGE – Spend in haste; repent at leisure. With minds concentrated by fears of another 1930’s-style Great Depression, America’s political leaders developed, virtually overnight, a $700 billion bailout plan to resuscitate the country’s rapidly deflating financial sector. But, just as stunningly, rank-and-file members of the US House of Representatives have rejected it – at least for now. Perhaps they were right to be skeptical.
The plan’s central conceit is that government ingenuity can disentangle the trillion-dollar “sub-prime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so. To boot, we have been told that government is so clever that it might even make money on the whole affair.
Perhaps, but let’s not forget that a lot of very smart people in the financial industry thought the same thing until quite recently.
Just a year ago, the United States had five major freestanding investment banks that stood atop its mighty financial sector. Collectively, their employees shared more than $36 billion dollars in bonuses last year, thanks to the huge profits these institutions “earned” on their risky and aggressive business strategies.
These strategies typically involve far more risk – and sophistication – than the activities of traditional commercial banks.
In mid-August, I had the temerity to predict that risks had come home to roost, and that a large US investment bank might soon fail or be forced into a highly distressed merger. Little did I imagine that today, there would be no freestanding investment bank left on Wall Street. Indeed, after years of attracting many of the world’s best and brightest into ultra-high paying jobs, collapsing investment banks are now throwing them out left and right. One such victim, a former student, called me the other day and asked, “What am I supposed to do now, get a real job?”
This brings us back to the US Treasury’s plan to spend hundreds of billions of dollars to unclog the sub-prime mortgage market. The idea is that the US government would serve as buyer of last resort for the junk debt that the private sector has not been able to price. Who, exactly, would the Treasury employ to figure all this out? Why, unemployed investment bankers, of course!
Let’s ponder this. Investment bankers have been losing their cushy jobs because they could not figure out any convincing way to price distressed mortgage debt. Otherwise, their firms would have been able to tap the trillions of dollars now sitting on the sidelines, held by sovereign wealth funds, private equity groups, hedge funds, and others.
Now, working for the taxpayer, these same investment bankers will suddenly come up with the magic pricing formula that has eluded them until now.
Little wonder that academics across the political spectrum have expressed considerable skepticism. True, the Treasury would take equity stakes in some firms, so there would be some upside potential. But the main concern centers around the Treasury’s apparent intention to pay more than double the current market price (20-30 cents on the dollar) on the premise that its success in untangling the mortgage market would make any discount seem like a bargain.
Does such nitpicking fail to recognize the urgency of fixing the financial system? Isn’t any plan better than none?
I, for one, am not convinced. Efficient financial systems are supposed to promote growth in the real economy, not impose a huge tax burden. And the US financial sector, in greasing the wheels of the real economy, has been soaking up an astounding 30% of corporate profits and 10% of wages. Thus, unlike in the 1930’s, the US faces a hypertrophied financial system. Isn’t it possible, then, that rather than causing a Great Depression, significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?
I am not suggesting that the government should sit on its hands. It needs to provide an expanded form of deposit insurance during this time of turmoil, so that there are no more Northern Rock-style bank runs.
That was a big lesson of the 1930’s. The government may also need to consider injecting funds more directly into the mortgage sector while the private sector reconstitutes itself.
Certainly, the government must also find better ways to help homeowners and their lenders work out efficient bankruptcy proceedings. It makes no sense for banks to foreclose on homes when there are workout options whereby people could stay in their homes and banks could recover far more money.
Eventually, after further twists, turns, and huge expenditures, the US will emerge from its epic financial crisis. The proposal that was defeated was not sufficiently targeted at pruning back insolvent banks, but it will almost certainly not be the last word, regardless of how Congress now proceeds.
