We Need to Recapitalize the Banks

Let's have cash infusions in return for warrants.

When the speculative fever finally broke in America's housing industry and house prices began falling in search of equilibrium levels, banks everywhere suffered defaults and subsequent losses on a range of assets. In short order, the housing contraction morphed into a banking crisis.

David Gothard

Among most economists, it came as a surprise that the banking industry and, indeed, most of the financial sector, was so devoted to houses. We had not realized that the investment and innovation in the country's business sector was largely getting by on rich uncles, a tiny cottage industry of venture capitalists out West, and a few private-equity funds doing alternative energy. And we didn't foresee that a trillion or two of losses in an economy with $40 trillion of financial wealth could bring high anxiety and, two weeks ago, near panic.

The banks' losses might seem poetic justice after their abominable performance. But costly feedback effects on the rest of us are in prospect. Uncertainty over the quantity and valuation of banks' "toxic assets" has meant that many cannot count on loans from each other to meet daily needs, and this illiquidity in the markets has impaired their ability to lend. Among banks that had excessively leveraged their capital through borrowing and other devices, the losses wiped out much or all of their capital, and this near-insolvency has dampened their willingness to lend.

The resulting credit contraction is starting to crimp working capital and investment outlay at small businesses and is having wider effects on business activity through its impact on interest rates, exchange rates and consumer loans. This feedback is causing a fall of employment on top of the direct effect of the housing contraction on employment in construction and finance. The added fall in jobs will in turn add to mortgage defaults.

Will this chain reaction produce a deep slump, like Japan's in the 1990s or, worse, America's in the 1930s? In my view, the claim by Keynesians that the economy can be stabilized around a satisfactory employment level, thanks to economic science, is false. So is the claim by latter-day neoclassicals that such stability is automatic, thanks to the market. Both dogmas fatally miss the point that the normal activity level is driven by structural shifts, which monetary policy and price-level changes usefully accommodate but cannot reverse. The end of the speculative fever and the credit crunch each have structural effects on the real prices of business assets, real wages, employment and unemployment. As I see it, the former has pushed up the normal, or "natural," volume of structural unemployment. The latter (and the excess houses) is pushing the economy into a temporary slump. It will last as long as required for the banks' self-healing and government therapy to pull us out of it and into the neighborhood of our new, postboom normalcy.

I believe that leaving the process of recovery entirely to the healing powers of the banking industry, as libertarians suggest, would be imprudent, even if the banks could manage it. Lacking much government intervention, Japan's recovery took a decade. Sweden's recovery, with state intervention, took hardly any time at all.

Right now our banking industry is barely operational. Whatever the corrective surgery indicated, the priority is to get the system operating again. Delay would be costly and risky.

The most discussed of the proposed programs would address banks' toxic assets by authorizing the Treasury to buy them, issuing debt to finance the purchase. Proponents of this program add that the government's eventual sale of the assets purchased might repay the investment with a profit — grossing, say, an 8% rate of return while paying 4% interest.

House Republicans and some economists object, saying that the government could attain its goal with a bigger or surer profit by selling the banks "default insurance" on their distressed assets: the premiums paid are hoped to far exceed the default costs. To me, government entry into the default insurance business is little different from government purchasing the assets. It is not clear to me that selling default insurance would be more profitable.

House Democrats want a parallel program that would help defaulting mortgage borrowers to avoid foreclosure — to help them "stay in their homes." Such a step might set an undesirable precedent in economic policy. If, after investing in my vocational training, I cannot make it in the line of work I chose — not at the real wage that the market has since established, at any rate — will I be entitled to help from the government to "stay in my work"? Furthermore, many defaulters are housing speculators not families caught up in an adjustable rate mortgage they did not understand. Finally, the overinvestment in houses does not present the systemic risk of economic breakdown that the overextension of credit does.

However, the program to revive the operation of the banks through purchase of the toxic assets faces a sticky wicket. If the government sets the prices too low, the banks will supply little of their assets; they will prefer to hold them to maturity in order to get the price appreciation for themselves. The Treasury will then need to raise the terms. But that may cause the banks to hold off longer, speculating on still better terms ahead.

If, instead, the Treasury sets its prices too high, its funds will go far enough to buy only a portion of the toxic assets offered in response. Thus, it is not certain that such a program would work to clean out the toxic assets at all quickly. Subnormal operation of the banking industry might drag on for a few years.

A program of asset purchases, however needed, is limited in scope. It cannot be counted on to increase the equity capital of the banks — to shore up their solvency. Underpaying for the toxic assets would actually inflict a further loss of capital. Overpaying the banks for their toxic assets could contribute capital, but that may not be politically feasible or attractive.

So it is clear that the main prong of any "rescue" plan must serve to advance the recapitalization of the banks. Cash transfusions in return for warrants are a good way to do it, as it lets taxpayers share in the upside. The rescue of Chrysler used warrants. This past Monday the FDIC got $12 billion in preferred stock and warrants in the deal that saw Citigroup buy Wachovia. The question is which banks are to be thrown a lifeline, which will have to sink or swim. This one-time dose of corporatism is unpleasant, though the banking industry is to blame for its necessity.

But these steps toward making the system operational again will leave it dysfunctional. We don't want to restore the system as it was. And the risk that the industry would cause another round of wreckage is not the only reason.

What has occurred is not just an old-fashioned banking crisis but also a banking scandal. Most of the big banks were shot through with short-termism, deceptive practices and self-dealing. We must institute basic changes in corporate governance and in management practice to restore responsibility and honesty for the sake of the economy and for the self-respect of the country.

We also need to return investment banking to its roots. There is more to the influence of the financial sector than merely its effects when it goes off the rails. The financial system is not a sort of circulatory system that passively carries fresh saving to the places in the economic body that demand the greatest investing — as if guided by some "invisible hand." Judgment and vision — of bankers, fund managers, angel investors and the rest — matter hugely. So do the distortions, the limits and the license created by the regulatory system and the moral climate. To prosper and advance, the American business sector is going to need a financial system oriented toward business, not "home ownership."

Mr. Phelps, the winner of the 2006 Nobel Prize in economics, directs the Center on Capitalism and Society at Columbia University.

This gradualist view is wrong, according to an important new book by Yasheng Huang, a professor at Massachusetts Institute of Technology. Original research on China is rare, largely because statistics, though plentiful, are notoriously unreliable. Mr Huang has gone far beyond the superficial data on gross domestic product (GDP) and foreign direct investment that satisfy most researchers. Instead, he has unearthed thousands of long-forgotten pages of memoranda and policy documents issued by bank chairmen, businessmen and state officials. In the process he has discovered two Chinas: one, from not so long ago, vibrant, entrepreneurial and rural; the other, today’s China, urban and controlled by the state.

In the 1980s rural China was in the ascendancy. Peasants, far from being tied to the land, as has been assumed, were free to set up manufacturing, distribution and service businesses and these were allowed to retain profits, pay dividends, issue share capital and even a form of stock option. State banks rushed to provide the finance. Nian Guangjiu, a farmer from impoverished Anhui province, built up a business selling sunflower seeds (a popular snack), employed over 100 people and made a million yuan (nearly $300,000) in profit in 1986—just a decade after Mao’s death. Because most of this activity was set up under the misleading label of “Township and Village Enterprises”, Western academics largely failed to spot that these ostensibly collective businesses were, in fact, private.

But then, in 1989, came the Tiananmen Square protests. A generation of policymakers who had grown up in the countryside, led by Zhao Ziyang, were swept away by city boys, notably the president, Jiang Zemin, and Zhu Rongji, his premier. Both men hailed from Shanghai and it was the “Shanghai model” that dominated the 1990s: rapid urban development that favoured massive state-owned enterprises and big foreign multinational companies. The countryside suffered. Indigenous entrepreneurs were starved of funds and strangled with red tape. Like many small, private businessmen, Mr Nian was arrested and his firm shut down.

True, China’s cities sprouted gleaming skyscrapers, foreign investment exploded and GDP continued to grow. But it was at a huge cost. As the state reversed course, taxing the countryside to finance urban development, growth in average household income and poverty eradication slowed while income differences and social tensions widened. Rural schools and hospitals were closed, with the result that between 2000 and 2005 the number of illiterate adults increased by 30m. According to Mr Huang, the worst weaknesses of China’s state-led capitalism—a reliance on creaking state companies rather than more efficient private ones, a weak financial sector, pollution and rampant corruption—are increasingly distorting the economy.

But what about the growing cohort of Chinese companies starting to strut the world stage? Surely that is evidence of a healthy and expanding private economy. Mr Huang’s evidence shows that, on closer inspection, these firms are either not really Chinese or not really private. Lenovo, a computer group, has succeeded because it was controlled, financed and run not from mainland China but from Hong Kong (a happy legacy of the founder’s family connections there—not something enjoyed by most Chinese businessmen). The subsidiaries of Haier, a white-goods maker, were also put out of reach of mainland bureaucrats early on. Wahaha, a food producer, Galanz, a maker of microwave ovens, and many others all depended on foreign protection and capital to grow and escape state strictures.

Indeed one of the main, and underappreciated, functions of foreign investment in China has been to play venture capitalist to domestic entrepreneurs. As for Huawei, a telecoms group and one of China’s much vaunted “global” companies, its structure and links to the state are so convoluted that the most diligent China-watchers have little idea if it is a private or state firm. They do, however, agree that Huawei’s opacity is a microcosm of China’s distorted economy.

Could China genuinely embrace entrepreneurial capitalism again, as it did in the 1980s? Its current leaders under President Hu Jintao, who cut his teeth in Guizhou and Tibet, two of the poorest and most rural provinces, talk about supporting the countryside and reducing social inequality. But nothing much has been done. China’s deep problems demand institutional and political reform. Sadly, as Beijing’s heavy-handed control of the Olympics suggests, there is scant hope of that.

Many believe that wild greed and market failure led us into this sorry mess. According to that narrative, investors in search of higher yields bought novel securities that bundled loans made to high-risk borrowers. Banks issued these loans because they could sell them to hungry investors. It was a giant Ponzi scheme that only worked as long as housing prices were on the rise. But housing prices were the result of a speculative mania. Once the bubble burst, too many borrowers had negative equity, and the system collapsed.

David Klein

Part of this story is true. The fall in housing prices did lead to a sudden increase in defaults that reduced the value of mortgage-backed securities. What's missing is the role politicians and policy makers played in creating artificially high housing prices, and artificially reducing the danger of extremely risky assets.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target — 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area's median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

Fannie and Freddie also purchased hundreds of billions of subprime securities for their own portfolios to make money and to help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities.

Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor people allowed Congress and the White House to subsidize low-income housing outside of the budget, at least in the short run. It was a political free lunch.

The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters — their bottom line and the so-called common good. First passed in 1977, the CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story, too. In 1997, Bear Stearns did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages.

By pressuring banks to serve poor borrowers and poor regions of the country, politicians could push for increases in home ownership and urban development without having to commit budgetary dollars. Another political free lunch.

Fannie and Freddie and the banks opposed these policy changes at first through both lobbying and intransigence. But when they found out that following these policies could be profitable — which they were as long as rising housing prices kept default rates unusually low — their complaints disappeared. Maybe they could serve two masters. They turned out to be wrong. And when Fannie and Freddie went into conservatorship, politicians found out that budgetary dollars were on the line after all.

While Fannie and Freddie and the CRA were pushing up the demand for relatively low-priced property, the Taxpayer Relief Act of 1997 increased the demand for higher valued property by expanding the availability and size of the capital-gains exclusion to $500,000 from $125,000. It also made it easier to exclude capital gains from rental property, further pushing up the demand for housing.

The Fed did its part, too. In 2003, the federal-funds rate hit 40-year lows of 1.25%. That pushed the rates on adjustable loans to historic lows as well, helping to fuel the housing boom.

The Taxpayer Relief Act of 1997 and low interest rates — along with the regulatory push for more low-income homeowners — dramatically increased the demand for housing. Between 1997 and 2005, the average price of a house in the U.S. more than doubled. It wasn't simply a speculative bubble. Much of the rise in housing prices was the result of public policies that increased the demand for housing. Without the surge in housing prices, the subprime market would have never taken off.

Fannie and Freddie played a significant role in the explosion of subprime mortgages and subprime mortgage-backed securities. Without Fannie and Freddie's implicit guarantee of government support (which turned out to be all too real), would the mortgage-backed securities market and the subprime part of it have expanded the way they did?

Perhaps. But before we conclude that markets failed, we need a careful analysis of public policy's role in creating this mess. Greedy investors obviously played a part, but investors have always been greedy, and some inevitably overreach and destroy themselves. Why did they take so many down with them this time?

Part of the answer is a political class greedy to push home-ownership rates to historic highs — from 64% in 1994 to 69% in 2004. This was mostly the result of loans to low-income, higher-risk borrowers. Both Bill Clinton and George W. Bush, abetted by Congress, trumpeted that rise as it occurred. The consequence? On top of putting the entire financial system at risk, the hidden cost has been hundreds of billions of dollars funneled into the housing market instead of more productive assets.

Beware of trying to do good with other people's money. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis.

Mr. Roberts is a professor of economics at George Mason University and a scholar at the Mercatus Center. His latest book is a novel on how markets work, "The Price of Everything: A Parable of Possibility and Prosperity" (Princeton University Press, 2008).

Development Doesn't Require Big Government

Poor countries are learning the wrong lessons from the crisis.

Financial meltdown will not cause the U.S. to abandon democratic capitalism, but the outcome is less clear for countries deciding whether capitalism is the best system. In many of these countries the choice is not between light and heavy financial regulation, but between relying on creative individuals or government planners to escape poverty.

Some countries are already taking the wrong prescriptions from recent events. Honduran President Manuel Zelaya told the U.N. General Assembly last month that the lesson of the crash was "the market's laws were demonic, satisfying only the few." Paraguayan President Fernando Lugo said the "market mechanism" and "immoral speculation" were a mistake. Brazilian President Luiz Inácio Lula da Silva Lula added that speculators have "spawned the anguish of entire peoples" and Brazilians needed "indispensable interventions by state authorities."

We have been here before. Development economics — the study of how poor countries can become rich — was forever cursed by the timing of its birth after the Great Depression. That gave development economics a bias toward relying on governments, rather than markets, to create growth. The early development economists ignored a century and a half of European and North American development through individual enterprise, remembering only that their governments forcefully intervened to stimulate output during the 1930s.

What is widely agreed to be the seminal article in development economics appeared in 1943, calling poor countries "depressed areas." The Economic Journal article by Paul Rosenstein-Rodan, "Problems of Industrialization of Eastern and South-Eastern Europe," concluded that a fourth of the population of these countries was unemployed, and the solution rested in ceding development to the state. Development comes from state-planned investment in all sectors at once, the "Big Push," not reliance on private investors: "An individual entrepreneur's knowledge of the market is . . . insufficient," because he cannot have all the data "available to the planning board."

Similarly, the U.N.'s Depression mindset prompted them to ask an expert commission led by Sir Arthur Lewis in 1950 to prepare a report on unemployment in underdeveloped countries. Its report concluded that "economic progress depends to a large extent upon the adoption by governments of appropriate . . . action," and that political leaders must have a strategy for such growth, reflecting "the facts of each particular case."

Few at the time disagreed. Oxford economics professor S. Herbert Frankel wrote a rare protest in 1952. He believed poor, ordinary people had "peculiar aptitudes for solving the problems of their own time and place," a confidence later vindicated by homegrown success in Botswana, the East Asian tigers, India, Chile, Turkey and China.

Lewis later received a Nobel Prize in Economics. Poor Frankel was basically forgotten.

Development economics still bears the scars of the Depression. A prominent World Bank Growth Commission concluded in May that "fast, sustained growth does not happen spontaneously. It requires a long-term commitment by a country's political leaders," and "each country has specific characteristics and historical experiences that must be reflected" in the leaders' "growth strategy." Some at the U.N. still recommend the discredited Big Push strategy of state-planned investment.

How much poverty has endured because individual entrepreneurs were shunned in favor of the likes of the $5 billion state-owned Ajaokuta Steel Mill in Nigeria, which never produced a bar of steel? Or because African governments spend their time preparing World Bank-required national Poverty Reduction Strategy Reports instead of freeing space for innovators?

We will never know. But we do know that the free market has a long-run track record of creating prosperity — even with the occasional crash. The Depression's deceptive intellectual legacy is that development flows from all-knowing states rather than creative individuals. Here's hoping that the backlash to today's crash will not spawn another round of bad economics for the poor.

Mr. Easterly is professor of economics at New York University, and author of "The White Man's Burden," (Penguin USA, 2006).