Streetwise Professor

Thanks to Translations Online is this translation of an editorial from Nezavisimaya gazeta, which reads in part:

The apotheosis of this extravagance could be the decision, announced on Tuesday, to give Kyrgyzstan a loan of $2 billion and $150 million in nonrefundable aid. For the sake of comparison, the entire budget of this small mountain country is just over $1.1 billion. In exchange, President Kurmanbek Bakiev of Kyrgyzstan promised to close the American military base in Manas, through which the United States delivers supplies to its contingent fighting the Taliban and Al-Qaeda in Afghanistan. This expensive exchange is dubious from the economic and geopolitical standpoints. If the Americans and their allies suddenly leave Afghanistan, Moscow might have to restrain the radical Islamists in that region again.

Even expenditures of that size on allies might be justified in some way if it were not for the financial crisis, which has drastically reduced Russia’s own economic potential. Now this money is needed within the country. The Ministry of Economic Development and Trade expects a decrease of 0.2 per cent in the GNP. The country is in danger of dropping out of the top 10 economies in terms of dollars. The exchange rate of the ruble to the dollar was more than 1.5 times the present figure in July, and gold-backed currency reserves have decreased by more than one-third. The federal budget for this year will be adjusted in line with an income projection of only 6.5 trillion rubles instead of the 10.9 trillion in the current budget. The plans for spending cuts are still unknown, but the projected expenditures in the current budget amount to 9.024 trillion rubles. The number of unemployed might also double and exceed 10 million.

Even the United States, with the largest economy in the world, is tempering its geopolitical ambitions in the atmosphere of crisis. Barack Obama has announced the reduction of the contingent in Iraq and is urging Russia to reduce the nuclear potential of our country by 80 percent. Moscow, on the other hand, is eager to take advantage of the crisis to strengthen our position in the world and to restore and maintain our status as a great power instead of thinking of ways to solve its own socioeconomic problems. Furthermore, price is no object. In this sense, Russia is similar in some respects to the almost penniless Countess de Beauvilliers in Emile Zola’s novel  Money, who was willing to limit her daily diet to nothing but bread as long as she did not have to reduce her lavish banquet menu by a single dish, all for the sake of maintaining her image as a prosperous aristocrat. The sooner Russia gives up the great-power ambitions that are so inconsistent with the present state of its economy, the less the country, its population, and the physical production sector will have lost when the crisis is over. It would be regrettable if Russia were to make the same mistake as the USSR, wasting all of its resources on global confrontation with the West and trying to maintain its status as the world’s second superpower at any cost, to the point of the complete collapse of the economy and the disintegration of the country.

Emphasis mine.  

Politicians’ preferences are revealed by their choices.  Putin and Medvedev et al have made their choice very, very clear.  Theirs is to be Ozymandias, elevating their personal glory and dreams of imperial majesty, at the expense of a prosperous and decent society.  It is sickening, and as Penny suggests, sociopathic.  Why should we enable such behavior by bargaining with them over NATO, or missile defense, or anything else that the Putinists and chekists want?  

Remind me again.  Who is the Russophobe?  Only someone who has identifies the interests of Russians with the Russian state, who believes that Russians are state property only meant to serve the state, can consider such a deluded and inhumane agenda to be Russophilic.  

A couple of remarks re raining money on the ‘Stans, while offering to allow the US and NATO to transport supplies (non-military) to Afghanistan across Russian territory.  First, Ivanov and others in Russia have said–with straight faces–that there is no connection between Kyrgyzstan’s decision to close the Manas airbase to the US, and the financial largesse provided by Russia.  Please.  Don’t insult our intelligence.  Second, the Russians know that we know that they can allow the US supplies to reach Afghanistan via Russia today–but not tomorrow, on their whim.  Denying us use of Manas while providing access to Russian rails keeps their hand on our windpipe (to clean up the metaphor I was originally going to use).  Their grip is loose now, but it could tighten at any time.  There is no way that we can safely plan military operations on such an unreliable logistical foundation.  (Remember that military phrase: “Amateurs talk tactics.  Professionals talk logistics.”)  

This is just laying the trap for Russia to make demands on some other issues (missile defense, Ukraine, Georgia, gas pipelines) and threaten to withdraw the logistics route at a critical point in Afghanistan operations unless we cave to their demands.  And, at the time of such withdrawal, they will again insult our intelligence by claiming that it had nothing to do with negotiations over missile defense, or Ukraine, or whatever.  

Putin revels in playing hardball, being the tough guy, the gangsta.  This is just another one of his Sopranos tricks.  The question is, will we play hardball too?  “Reset relations” my a**.

Postscript.  The Kyrgyzstanis clearly realize that there’s a quid pro quo–Russian money in exchange for kicking out the US:

Kyrgyzstan officials have said they want the base closed, but lawmakers there said Monday that the parliament will delay voting on it until Russia provides $450 million in loans and aid it promised when Kyrgyz President Kurmanbek Bakiyev made the base announcement Feb. 3. “We have decided to wait until the Russians send the money,” Communist Party deputy Absamat Masaliyev, a member of the parliament’s coordinating body, told the Associated Press.

The financial world watched Timothy Geithner’s speech and collectively said: “That’s it?  I mean really, there’s nothing else?”  And then they went out and sold stocks, oil, the Euro, the pound, the Loonie, and the Australian dollar, and bought Treasuries and yen.  In short, the market’s reaction to Geithner’s non-announcement announcement was that observed every time concerns about the financial crisis have ratcheted up–a flight from risk; a flight to perceived quality and safety.  

My reaction is not that much different from the market’s, and the vast majority of economists and finance people who have expressed their opinion.  I do have several specific comments, however.

First, the “Bad Bank” idea is here.  I think.  Hard to say, because it is now dressed up as a “Public-Private Investment Fund,” the motto of which appears to be “If we build it, they [i.e., private investors] will come.”  The Treasury recognizes the difficulties of pricing bad loans, but somehow private investors will magically solve this problem: “[the Investment Fund] allows private sector buyers to determine the price for current troubled and previously illiquid assets.”  Uhm, like, isn’t that possible now?  But, like, nobody’s doing it?  Isn’t the reason that “[m]any proposals designed to [cleanse toxic waste from balance sheets] are complicated by their . . . sole reliance on public purchasing” that no private purchasers are willing to buy them from banks?  So how is slapping a new name on this going to make any difference?  

The discussion of the Bad-Bank-Whose-Name-Shall-Not-Be-Spoken also reveals the political wordsmithing, not to say dishonesty, that pervades the Treasury document.  It says the the Investment Fund will help banks “cleanse their balance sheets of what are often referred to as ‘legacy’ assets.”  Except they’re almost never referred to as “legacy” assets.  The proper name is “toxic assets.”  This Victorian primness is just plain weird.  

The details are maddeningly missing here.  Who decides what assets go into  Bad-Bank-Whose-Name-Shall-Not-Be-Spoken?  Who decides on whether to accept bids (if any are forthcoming)?  Will BBWNSNBS package assets and auction them?  Sell them one off?  The document says–and I quote, because otherwise neither you nor I would believe it–“the new program. . . COULD involve . . . .”  Good grief, it COULD?  What else COULD it involve?  The Treasury has spent how many weeks/months designing this and came up with one COULD?  I mean, the original TARP plan, hurriedly slapped together over a weekend, was a masterpiece of detail compared to this.  This is devolutionary, not evolutionary, let alone revolutionary.

Bad bank precedents (e.g., Resolution Trust, the Swedes) basically seized banks whole, stripped out the bad assets, and put them in a bad bank.  My Humpty Dumpty approach doesn’t go that far because it doesn’t involve the seizure (nationalization) of entire banks.  Instead, it involves the admittedly compulsory exchange of toxic assets for equity in a company that holds these assets.  It’s not really a bad bank, because I don’t envision it being highly leveraged.  It’s more like a Bad Hedge Fund or Bad Private Equity Fund.  It could be funded by revenues from the assets it holds, and perhaps through sale of some equity to the public or the issuance of (limited amounts) of debt.  

But the point is that pussy-footing around with getting the bad assets off the bank balance sheets ain’t gonna work.  It’s long past time for that.  The government can wait for Citi or some others to go into FDIC receivership, and then strip out the bad assets to seed the Bad Whatever, or it can find the will and the way to force these assets into the Bad Whatever without nationalization.  

Second, the plan puts the government in the CDO/asset backed security business.  The “Consumer & Business Lending Initiative” will “support the purchase of loans by providing the financing to private investors.”  But don’t worry, it will “Protect Taxpayer Resources by Limiting Purchases to Newly Packaged AAA Loans.”  That makes me feel so much better!  The government will only purchase the senior tranches! We all know how safe those are!   And how reliable those AAA ratings are!  

Memo to Treasury: a lot of senior tranche, AAA rated paper will–or at least should–end up in the bad bank.  That is, dubious–to put it as kindly as possible–credit ratings provided the cover by which banks loaded the boat on risk, and then saw the boat sink.  Given this history, the bold-faced, italicized hype about “protecting taxpayers” by relying on AAA ratings reminds me of Samuel Johnson’s quip about second marriages being a triumph of hope over experience.  

I mean really.  Did anybody actually read this?  Anybody who’s been conscious since August, I mean.  

Third, guarantees make it, I think, but again in a dishonest, stealthy, cross-dressing kind of way, so I’m not quite sure.  Banks that have undergone a comprehensive “stress test”  will “have access to a Treasury provided ‘capital buffer’ to help absorb losses and serve as a bridge to receiving private capital.”  

The introduction to this section mentions “uncertainty about the real value of distressed assets and the ability of borrowers to repay loans.”  Therefore, it is reasonable to conclude that the losses to be absorbed would include mark-to-market losses on existing toxic assets on bank balance sheets, i.e., it would provide a guarantee on these assets to facilitate the ability of banks to attract private capital.  Reasonable, but it’s not certain that that’s the right interpretation.  Would have it been so hard to make it clear, one way or another?  Why play twenty questions?  And then not answer them.  

Fourth, the document makes it clear that banks that receive government assistance will be required to expand lending.  Although it sets the benchmark for comparison as “what would have been possible without government capital assistance,” this is a nebulous standard.  We can’t run parallel universes, controlled experiments, that permit a precise comparison of what would have been possible in this but-for, no capital assistance world.  Note that the burden of proof is squarely on the lender: the standards “require recipients . . . to show how every dollar of capital” is preserving or generating lending.  Thus, faced with the burden of proof to demonstrate that it is meeting an objectively unproveable standard, it is inevitable that banks will be under tremendous political pressure to expand lending, or to engage in extensive loan forebearance.  This will compromise, and could overturn altogether, the primary objective of returning banks to financial health and stability.  

Fifth, but don’t worry, “Political Interference in Investment Decisions” is “Prohibited”!  Boy, I feel so much better knowing that the Treasury “has announced measures to ensure that lobbyists do not influence applications for, or disbursements of, Financial Stability Plan funds, and will certify that each investment decision is based only on investment criteria and the facts of the case.”  No mention of Congressmen, Senators, political appointees in Treasury, the White House (e.g., David Axlerod), etc.  Put differently, the “lend or else” dictate makes financial institutions acutely vulnerable to political pressure from elected officials and their political appointees.  The decisions made in this environment will almost certainly mean that a large fraction of the loans that banks make under this sword of Damocles will be bad, further deepening the hole that this plan was supposedly intended to get us out of.  

My final judgment, after reading and re-reading the plan (multiple re-reads being required because I couldn’t believe it the first several times through)?  The market was very forgiving in its judgment.  This is a step backwards, not a step forward.  No, it is many steps backwards.  It addresses NONE of the crucial issues in a serious, conclusive way.   To be quite honest, I think that even the REALLY REALLY Bad option I discussed over the weekend–nationalization–would be better than this.  

I should also note that in addition to the errors of commission, by failing to set a clear path forward, this thing (I shouldn’t dignify it with the name “plan”) ramps up the policy uncertainty and political risks in the market to an unacceptable degree.  It also seriously undermines market confidence in the competence of the Treasury–and Obama.  The indecisiveness is incredibly damaging.  Deciding on something–even something I would consider inferior–is better than floating this term paper that decides nothing.  

In a nutshell: a first class FUBAR.

Snarky postscript: I may be dating myself, but when I see Geithner’s picture I think of “Eraserhead” (a 1970s David Lynch cult film.)

He just needs a bit more of an up-do and he’s got it.

Harvard’s Robert Barro calls the stimulus bill the worst legislation since the 1930s.  (I think he is being VERY kind.)  Stanford’s John Taylor is also scathing in his criticism.  (Aren’t both “saltwater economists”?  They certainly aren’t bilgewater economists.)

What I find so troubling is that the intellectual footings of this policy are so shaky, not to say non-existent.  The arguments for the stimulus package are as substantial as the toy in a box of Cracker Jack.  Constant invocations of “increasing aggregate demand.”  Aggregate demand is a metaphor, at best, and far more insubstantial than the other metaphors economists use.  It is a modeling device that is convenient for analyzing some problems, but its connection with the real economy is even more tenuous than our other conventional modeling devices.  

There is no such thing as “aggregate output.”  There are many industries, many goods, many sectors, all of which rely on specialized resources that are not readily redeployable among them.  Directing–via coercion–spending to one sector or another is likely to worsen resource misallocations, rather than mitigate them.  I find it particularly bizarre that some of the stimulus appears to be directed at supporting industries and sectors that resources should leave (e.g., construction, automobiles).  We almost certainly built too many houses (due to perverse monetary policy, as John Taylor explains it), so resources should leave that business.  Why stimulate it?  

Moreover, the arguments don’t even seem to be directed at the right question.  They seem to be answering the question: “How can we best increase current measured output?”  I have problems with both “current” and “measured.”  What is the future cost of an increase in current output?  What is the true value of the “measured” “output”?  Much of the argument seems to ignore costs–when it doesn’t confuse costs for benefits.  

The most grounded Keynesianism relies on the notion of price and wage rigidities to explain how “deficiencies in aggregate demand” can lead to suboptimal outcomes.  But, presumably these rigidities reflect information and contracting problems, and are close to the constrained best in some way; those focusing on these rigidities seem to have fallen for the Nirvana fallacy, and believe that because something is not first best it can be improved upon.  That’s not true.  Bad things can be made worse.  It does not follow, moreover, that a particular “stimulus” package will improve welfare even if such rigidities exist.  If prices and wages do not reflect opportunity costs because of such rigidities, government directed spending can exacerbate distortions in resource allocation.  (To make sense as a measure of welfare, GDP or another measure of aggregate output relies on prices reflecting the appropriate marginal costs and benefits.  But with rigidities, they don’t so reflect these margins.)

I agree with Taylor and others that we should attack the source of the problem–the financial and banking markets.  The unveiling of the Geithner plan has been delayed, but it apparently includes a mix of not so bad and bad.  It may do some good.  I doubt the stimulus bill will; indeed, I believe it will make things worse.  Moreover, it will likely interfere with addressing the banking problem by dramatically increasing federal indebtedness, thereby raising the cost of financing the recapitalization of the financial system.  

Compounding all this is the dishonest agitprop and partisan demonization being used to sell the stimulus.  When walking off a plane this afternoon into Hobby Airport in Houston, my ears were bombarded with Obama’s speech.  My first reaction–an unconscious one, certainly, because I had little time to absorb the content, and based completely on the tone of voice and phraseology–was to have flashbacks to films of a Nuremburg rally.  Reading the details does little to dispel my initial visceral response.   As Mark Steyn wrote, the “Hope, Not Fear” trope of the campaign has been inverted.  In 2001 Bush was flayed for “talking down the economy”–he was a piker compared to Obama.  We are about to be buffaloed into spending huge sums for largely useless purposes by demogogic phrases and comic book economics.  This cannot work out well.

The contrast between the monetary situations in Russia and the US is striking.  In the US, money supply has exploded, but demand for money has increased further, leading to a decline in the “velocity” of money.  This graph of US has to be seen to be believed (and perhaps not even then).  As a result of the decline in velocity, inflation has actually abated, and by some measures (e.g., the CPI) we are experiencing a deflation.  

In Russia, in contrast, base money has been declining (about 10 percent in January), but velocity has been increasing, leading to an acceleration in inflation.  

This difference demonstrates that the “financial crisis” is not all the same everywhere.  Its effect and symptoms differ among nations.

In the US, individuals and firms have responded to the increase in the risk in the financial system by wanting to reduce their exposure to private liabilities.  These include, inter alia, the liabilities of banks (e.g., banks don’t want to lend to other banks), corporate debt, and individual debt (e.g., mortgages).  Instead, they want to shift their wealth into liabilities of the US government, including base money, deposits guaranteed by the federal government, and Treasury securities.  Avoiding the mistakes of the Great Depression, the Federal Reserve has accommodated this spike in the demand for its paper by flooding the system with liquidity.  Despite this tsunami of liquidity creation, inflation has abated and the dollar strengthened because the Fed was responding to a dramatic increase in demand, rather than unilaterally raising supply with no corresponding demand increase.  (For now, I should emphasize.  I am very nervous about the medium-to-longer term prospects for inflation and the dollar.)

In Russia something similar has happened.  A loss of confidence in banks led depositors to  reduce dramatically their demand for bank liabilities.  The Russian central bank accommodated this demand for liquidity in a sensible way, by injecting massive amounts of liquidity into the system much like its cousin, the Fed.  Failure to do so would have wrecked the banking system.  This is one of the policy choices that Sergei Guriev praises in the article I linked to earlier.  

But here’s the difference–and the similarity.  In the US, people wanted to substitute holdings of US government liabilities for private liabilities, hence the decline in velocity.  In Russia, people haven’t wanted to substitute holdings of Russian government liabilities for private bank liabilities and corporate liabilities.  Instead, like Americans, they’ve wanted to substitute holdings of US government liabilities for their holdings of Russian bank and corporate and government liabilities.  This requires selling rubles and buying dollars and dollar assets.

Hence, the decline in the ruble.  The Russian central bank has accommodated some of this demand to substitute dollars (and euros) for ruble liabilities (both private and government, e.g., currency) by selling dollars from reserves (contributing to the decline in the ruble money supply).  

So, what Russians and Americans quite clearly agree on is that they want to increase their holdings of US government liabilities, and reduce their holdings of other liabilities.  But that has very different implications, very different costs, and imposes very different constraints on policy makers, for the US and Russia.

By not floating completely, the RCB is encouraging behavior that contributes to inflation, and other inefficient practices observed of late.  In particular, anticipating future declines in the ruble, it is sensible for Russians to convert their ruble holdings into goods as well as dollars.  Hence, the increase in velocity (people spending their rubles faster) and the spurt in inflation observed in January.  The return of barter is another manifestation of the growing unwillingness of Russians to hold their government’s liabilities, specifically its currency.  

This is why, as bad as the policy headaches are in the US, they pale in comparison to those bedeviling Russian policymakers.  In the US, it has been possible to accommodate individuals’ desired changes in their asset holdings by printing something these individuals want (for now, anyways).  In Russia, that isn’t an option.  In the US, private liabilities are unattractive, but dollar government liabilities are (again, for now).  In Russia, both private and government liabilities are unattractive.  We can print money without immediate adverse consequence because people want to hold it (kicking down the road the problem of how to sop it all up down the road when–or is it if?–normalcy returns.)  Russia can’t because people don’t.  It can either accommodate the changed demands of Russians by drawing down on reserves, further devaluing the ruble, or jacking up interest rates.  Is death an option?  Always, and it’s not obviously dominated by these other choices.  

In brief, Russia faces a policy constraint that the US has been able to avoid so far; the unwillingness of its citizens (or anybody else) to hold its government liabilities.  Russians want liquidity, but not in the form of rubles.  The supplying of liquidity to the banks has kept them in business, but has led to the transformation of bank liabilities into dollars and euros, not rubles or Russian government debt.  This translates into a decline in the ruble, and a spike in inflation.  No way around it.  None.  

This is politically charged for Russia.  Past collapses of the ruble, and episodes of inflation, have shaken governments.  The causes of Tsarist collapse in 1917 are many, but certainly one was the explosion in inflation, and the ham-handed response to it (especially price controls that destroyed the market for grain, leading to shortages in the cities where the February Revolution broke out.)  

If you don’t have anything to sell that anybody wants to buy, you are in trouble.  Right now, the markets for oil and rubles are in the dumper (the latter in part because of the former).  Which is probably why Alexi Kudrin is green with envy for Timothy Geithner and Ben Bernanke.  There aren’t many people about whom the same can be said.

Strategy Page ran a piece today with a title that could have come straight from the pixels of SWP: “Homicidal Maniacs With Delusions of Grandeur and Selective Memories.”  Three guesses as to the subject, but two don’t count:

The global recession has hit Russia hard, so now the Russians are eager to have NATO and U.S. supplies (no explosives or weapons, though) shipped to Afghanistan via Russia. That means millions of dollars of much needed business for Russian railroads.Another mutually beneficial financial deal with the West includes retiring more nuclear weapons. Russia wants to proceed with deals made in the last five years, that call for Russia and the U.S. dismantling most of their remaining nukes (each nation has about 6,000). Russia apparently wants the number reduced to a thousand, rather than the current 2,000. This would save hundreds of millions of dollars a year in maintenance and security costs.

The government has again warned neighboring countries (like Estonia and Ukraine) to stop being ungrateful for what Russia did for them during World War II. This is a long standing sore point. The Baltic Countries and Ukraine consider themselves forcibly made a part of the Soviet Union. All four nations contributed troops to the Nazi war effort against the Soviet Union. Although reviled in Russia and the West, these troops are local heroes, for having fought against the hated Russians (not for supporting the Nazis.) The Russians don’t get it, ignoring the fact that Russian secret police and death camps killed millions of people from the Baltic States and Ukraine. Russia considers these dead to be criminals, while the countrymen of the victims consider Russians homicidal maniacs, with delusions of grandeur and selective memories.

Speaking of delusions, hundreds of Russian MiG-29 fighters remain grounded after one of these aircraft crashed last December 5th. The cause was structural failure (the tail separated, in flight, from the rest of the aircraft). The Russian Air Force has been investigating, but has not announced anything yet. It’s believed that poor maintenance and a shortage of spare parts is the main cause.

It’s gets worse. Russian arms exporters see sales to China falling up to 40 percent this year. The reason is partly the poor quality of Russian weapons, and partly Chinese theft of Russian technology to build their own versions of Russian weapons (complete with flaws, but the Chinese don’t seem to mind as long as they save lots of money).

Russia is proposing a new treaty between itself and the West. The main idea is that the West would promise not to invade Russia, or mess with Russian internal affairs (which tend to get messy). Russia, in turn, would stop acting like a paranoid bully.

NATO has told Russia that it is not happy with the way Russia has absorbed two portions (Abkhazia and South Ossetia) of neighboring Georgia, and is building a military base in Abkhazia. Russia ignored the criticism. Meanwhile, Russia continues to have problems governing some of its border areas, that would rather be independent. Mainly, it’s the Caucasus provinces of Chechnya, Ingushetia and Dagestan. Long unstable because of clan and ethnic differences, the situation has been made worse by Russian economic mismanagement, and the appointment of corrupt provincial officials. The national government  has sent in special police units, but that has done nothing for the unemployment and corrupt officials that anger the locals the most. The violence (weekly assassinations and raids on police stations) is spreading to Moscow, where in one recent week, there were four Caucasus related murders. The northern Caucasus has been a headache like this, for centuries. No one has ever come up with a lasting solution.

Russia has restored aid to Cuba, but at only a tenth of the Soviet era largess (which amounted to over a billion dollars a year), which ended in the early 1990s (and had been declining through the 1980s).  Russia is doing this mainly to annoy the United States.

SP’s discussion of the battle over the past strikes a nerve.   I’ve written before on the outrageous revisionism in Russian history schoolbooks, and I found Medvedev’s recent lecturing of neighboring nations on their treatment of WWII history particularly grating.   This is particularly true coming from the president of a nation that has yet to deal in a full, honest way with its own historical legacy.  

Now, there is always some ambiguity in connecting the USSR with the Russian Federation, but it is pretty clear that the current Russian leadership, and much of the Russian populace, views the RF as the successor to the Soviet Union.  Moreover, the same leadership and same elements of the population clearly harbor more than a little nostalgia for the USSR; resent its dismemberment in 1991; and would like to see the restoration of its territory under the Russian aegis (if not with all of its social, political, and economic elements.)   And, the USSR was primarily a Russian project.

It is painfully obvious that the USSR, the history of which is obscured (at best) or celebrated (at worst) in today’s Russia, has a legacy that is fully comparable to that of the Nazism that Medvedev accuses the Balts, etc., of celebrating.  Just a few of the horrific events that cost millions of lives which have not been adequately recognized, let alone addressed, by post-Soviet Russia:

• Russian Civil War (millions of dead)
• The Peasant Wars, primarily in Ukraine and other agricultural regions of the USSR (millions dead–probably more than in the Civil War proper)
• Mass Collectivization, “de-Kulakization” (millions deported; millions dead)
• The obliteration of Kazakhstan’s nomadic culture (as part of the collectivization)
• The “Terror Famine” (Robert Conquest’s term), primarily against Ukraine (post-collectivization) (millions dead; a war against Ukrainian culture)
• 1937 Terror (the only thing for which Putin has expressed regret–because it was directed at the party elite, presumably)
• The imprisonment of eastern Europe, with accompanying purges.

I would hope that hectoring and lecturing others about the proper way to remember painful historical episodes would occur only after a serious remembrance and appraisal of the foregoing episodes.  But I would–and do–hope in vain.

I remember seeing the very modest memorial to victims of the KGB kitty-corner to the Lubyanka on a visit to Moscow in 2005.  I also remember thinking that it was a first step, but a very small one.  Since then, there has been retrogression, as the official attitude has been to celebrate a history that produced the events listed above.  And even worse, this retrogression has been accompanied by the badgering of neighbors who have (a) been the victims of many of these atrocities, and (b) have the temerity to remember them as such.  

Remember nothing.  Forget nothing.  A recipe for further pain.  

Sergei Guriev is a friend, and an excellent economist.   (Both also hold true for his wife, Katja Zhuravskaya.)    Along with Yale’s Aleh Tsyvinski, Sergei has written a very even handed appraisal of Russia’s policy mistakes—and successes—in dealing with the financial/economic crisis:

 Russia’s government has, in fact, made serious mistakes in dealing with the crisis. Taxpayers’ money was spent to purchase corporate stocks in a failed attempt to support collapsing stock prices. The government is unlikely to recover its investment anytime soon.

The government was also too slow in depreciating the ruble. While one can argue that one-off devaluation was risky – as it could have triggered a panic – gradual depreciation should have started earlier than it did. In the last two months of 2008, the central bank allowed the ruble to weaken at a rate of one per cent per week, then at two to three per cent per week. It probably still needs to fall another 10 per cent. In the meantime, the central bank haemorrhaged reserves defending this slow correction, while commercial banks have been holding on to dollars in anticipation of the ruble’s further decline.

The third mistake was to raise import duties, especially for imported cars. This was not only economically foolish (as with many other import-competing sectors, the automotive industry will certainly be protected by the weakening ruble), but also politically dangerous. Car owners are an affluent, socially active, and easily organised group. Street protests against the import duties became the first serious popular uprising that Russia has seen in many years. Yet these mistakes are relatively minor and reversible. Indeed, Russia’s government, unexpectedly, has taken resolute and mostly correct economic decisions. First, it prevented the collapse of the banking system. Many Russian banks were heavily exposed in foreign markets, and therefore faced severe financial problems once the crisis hit. A massive liquidity injection by the government ensured that no major bank collapsed, and minor bank failures were administered in a surprisingly orderly fashion.

Moreover, the crisis has – so far – not resulted in major nationalisations of private companies. The government could have used the crisis to nationalise all banks and companies in financial distress. It has not, despite its still awesome foreign reserves, which give it the wherewithal to buy out a significant portion of the economy at fire-sale prices. Instead, up to now at least, the government has mostly been providing (high-interest) loans rather than engaging in massive equity buyouts.

Nor have the oligarchs been bailed out. Of $50 billion in external debt owed by Russian banks and firms in 2008, the government refinanced only $10 billion. Apparently, the terms offered by the government (LIBOR+5 per cent and collateral) have turned out to be right on target. How did reasonable economic policies prevail in this crisis? The key factor is that, for the first time since Putin came to power, the Kremlin perceives a genuine threat. The years of easy popularity are over. All the ugly facts that Russians ignored during the years of fast growth are surfacing.

The regime knows that its survival depends on preventing economic collapse. The crisis energised the system and shifted decision-making power to those who know about and can do something for the economy.

But did these policy changes come too late? The ossified, corrupt, inefficient economy built in during the oil boom may be impossible to save. So the central question that Russia confronts is whether even competent economic policy can prevent economic and political collapse.

Sergei seems less convinced than I that the current Russian system is brittle, and hence vulnerable to collapse, although the last paragraph does suggest that he is open to that view.   He is a serious man, on the ground, with excellent connections in and out of government, so I take his views seriously, and adjust my opinion accordingly, in a good, Bayesian way.  

The major piece of evidence that Sergei cites in favor of his opinion that (a) the Russian government has not done badly in handling the crisis, and (b) is not excessively centralized and brittle, is the absence of major nationalizations.  

A fair characterization of what has happened in the last 8/9 months, but it is still somewhat of an open question as to whether this will hold going forward.   Today’s Bloomberg contains a report that expresses the concerns of a Russian think tank that is allegedly close to Dmitri Medvedev:

Russia’s reaction to the world economic crisis threatens to increase state control over the economy and reduce national competitiveness, according to a research institute close to President  Dmitry Medvedev.

“Ballooning state involvement in the economy, the propping up of ineffective businesses and the atrophy of market institutions present major risks both now and in the future,”  Igor Yurgens, head of the Moscow-based Institute of Contemporary Development, said at a presentation today.

The “fundamental balance” between government and business may be harmed if state ownership of companies’ stock rises another 10 percentage points from the 45 percent held at the end of 2008, according to a 73-page report published by the institute.

Prime Minister Vladimir Putin said in December the state may buy stakes in key companies on “a large scale” to help them survive the crisis. The government has set aside $50 billion to help businesses pay foreign borrowings in exchange for putting up part of their stock as collateral.

. . . .

‘Systemic Crisis’

Yurgens rejected suggestions by the country’s leadership that the domestic situation was caused by problems in western economies. Russia is facing a “systemic crisis” resulting from structural weaknesses particular to its economy and financial system, he said.

The state will only find a way out of the crisis with a “full-fledged” dialogue with society, including civil groups, Yurgens said.

“There are a lot of pragmatic people in the government,” he said in an interview with Bloomberg Television today. “Since they don’t have to mess around with parliament, as in a classical democratic government, they are even more effective in a tactical sense. But we need strategy.”

New import duties on cars and trucks, which sparked demonstrations in cities across Siberia and the Russian Far East, are typical of protectionist measures “popular in many ministerial offices,” the report said.

‘Blind Faith’

The tariffs were “categorically misdirected,” supporting an outmoded industry and running counter to a declaration signed by Russia at November’s G-20 summit in Washington opposing protectionism, the authors said.

Speaking at the opening session of the World Economic Forum in Davos, Switzerland last month Putin warned of the dangers of “unrestrained state interference” in the economy and of protectionism. “Blind faith in the omnipotence of the state” is a mistake, as proved by the Soviet Union’s collapse, he said.

The Institute of Contemporary Development was founded last year on the initiative of Medvedev, who was elected president in March. He is the chairman of the institute’s board of trustees.

Note the report’s association of the nationalization (and protectionist) threat with Putin.   Coming from putative Medvedev allies (and Medvedev’s people apparently have no love lost for Putin’s although the principals apparently get on well), this is another indication of a growing difference of opinion within the Russian ruling elite.   As the economic crisis deepens, and its affect on ordinary Russians intensifies, this rift—and the potential for rifts within rifts, e.g., among different clans in the Putin circle—will almost certainly widen.  

This is where I think the true brittleness comes from: divergent interests and opinions among a ruling elite under stress, compounded by struggles over a shrinking pool of rents, in a system with weak institutions, and hence few mechanisms (other than repression) to deal with popular discontent, to remove failing governments, or to adjust failing policies.    

Sergei’s argument is that faced with an existential crisis, the government has raised its game and made some good policy choices.   He points to some specific examples where immediate disaster has been avoided (e.g., avoiding a full-blown banking collapse.)   I still think there is considerable uncertainty about the course in future months as the crisis in the real economy intensifies.   That will be harder to deal with than the banking situation, and pose greater challenges to the government.   In my view, it will, moreover, stress the system at its weakest points.   That said, Sergei’s analysis does provide room for optimism, although his cautionary note in the last paragraph makes it clear that his optimism is not unbounded, and that he understands perfectly well the structural weaknesses of the Russian system.  

Paul Gobel summarizes a more pessimistic view from Dimitry Tayevsky:

Because the economic system adopted under Vladimir Putin is no longer working, the political system the former president and current prime minister put in place is rapidly approaching its end, according to a leading Siberian political analyst. But what will replace it and equally how it will be replaced remain very open questions.

In a lengthy commentary posted on the Irkutsk portal Babr.ru, Dmitry Tayevsky argues that because Moscow is running out of money as a result of the declines in the price of oil and gas, the Russian political system is no longer in a position to sustain itself or act as it has both at home and abroad (babr.ru/?pt=news&event=v1&IDE=506710).  

Barring a miracle – and Tayevsky says there won’t be one – Moscow will not be able to meet the commitments it has made to foreigners – including its efforts to purchase friends in the CIS – or to Russians – such as promises to increase pensions – and consequently, Russians won’t be able to continue to live at the level they thought was theirs after the troubled 1990s.
It is worth recalling, Tayevsky says, how “92 years ago, a much less serious situation led to some very serious consequences” and thus to think about what may happen as a result. He thus devotes the remainder of his article to a discussion of six possible “variants” of Russia’s future development.

The first variant, he says, which might be called “the New Perestroika,” would be one in which the regime would blame Vladimir Putin for all the country’s problems and move in a new and more democratic direction. Such a step would be “logical,” but it would almost certainly lead many Russian regions to seek independence rather than be “deceived” a second time.
The second variant, which could be labeled Foros 2,” would be based on exactly the opposite diagnosis. Putin would blame Medvedev for all the problems Russia now faces and demand his removal. By taking such a step, the prime minister might guarantee Russia “a long and stable development like Chile in the 1970s, Cuba, Libya and North Korea taken together.”

But if the first variant could be triggered by the stroke of the pen, the second would be more difficult to pull off, Tayevsky insists. Medvedev, unlike Gorbachev before him, simply hasn’t taken enough “energetic steps in any direction” to have alienated the population and led it to be willing to support anyone else.

The third variant, which Tayevsky calls “Iron Curtain 2,” would rest on an idea the regime has long sought to promote. “Its essence is simply – in fact, in Russia everything is wonderful … but the enemies surround it – from Wahhabis to Georgians, Ukrainians, Americans, the British, or the Estonians — are doing everything” to destroy Russia.

Thus, Russia must cut itself off from the world in order to protect “the young Russian democracy, Orthodoxy, and nationality.” But that would alienate not only many non-Russians but also many Russians in the regions who remember how things played out the last time Moscow adopted this strategy.  

The fourth variant would be a subset of the third. It would involve cutting Russia off in order to justify authoritarianism in order to modernize the country. While not that different from what some around Putin appear currently to aspire to, an effort to realize this variant could lead to the disintegration of Russia as well or to a political explosion.

Such an explosion or “bunt” is the fifth variant of Russia’s future that Tayevsky describes. That would be perhaps the worst, and yet it is the one the Russian government seems to be pushing the country toward. On the one hand, it is impoverishing the people without giving them a chance to express their anger within the system.

And on the other, the current regime lacks both the resources and the leadership to prevent such an explosion or to “redirect” in a positive way. There are, Tayevsky says, no “pretenders”now to the role of Lenin, Trotsky or Stalin, and consequently such an explosion could lead to “a complete national catastrophe.”  

But it is the sixth variant, one that Soviet writers at the time of Gorbachev sometimes called “the Latin American option,” that Tayevsky suggests is “the most probable although far from the most welcome” not only in the way that it would be introduced but also for the situation it would create.

There are many people who don’t like the current regime and have the military capacity to change it, he notes. They might set up “a military dictatorship,” although it is not clear that they could run the country after taking over except by killing people in large numbers not only immediately but for a long time, just like Chile in the 1970s.

There would be only “one welcome aspect of this variant,” Tayevsky concludes his article by saying, and that would be that “none of those who have power [in Moscow at the present time would remain at large.” They would be punished, but so too unfortunately would all the peoples of the Russian Federation.

While it is tempting to dismiss such feelings as those of an isolated individual, that would be a mistake. The notion that Moscow is living beyond its means to promote its own idea of “greatness” or to distract attention from its failures is far more widely held. For another example, this time from a Moscow analyst, see www.gazeta.ru/column/oss/2937043.shtml.
But perhaps the most convincing evidence that many have exactly the same fears Tayevsky points to is that only a few hours after his article was put online, it was removed, perhaps because of pressure from above or hacked by supporters of the regime, so that at the time of this writing it is not accessible, even though Babr.ru remains functional.

Tayevsky’s analysis raises several important considerations, one of which is the centrifugal forces in Russia.   That Medvedev is trying to do to mayors what Putin did for governors is one indication that the ruling elite in Moscow considers this a serious concern.   It is a major problem that US and European (and most Asian) policymakers don’t have to deal with.   (China may face something similar, especially as reflected in the urban-rural divide.)  

In the end, I think it will come down to the resilience of Russia’s institutions in the face of incredible stress.   Inasmuch as institutional robustness is not one of Russia’s strengths, I am less sanguine than Sergei.   But his views definitely deserve to be taken very seriously.   I do.  

Russia is attempting to stem the decline in the ruble (which breached by a hair’s breadth the 41-to-the-basket floor set by the central bank) by means other than selling dollars/euros from reserves.  In particular, it is limiting loans to banks, trying to loan directly to corporations, and trying to use the security services to monitor banks to make sure they are not converting the ruble loans into dollars and euros.  

Limiting loans to banks makes it harder to short the currency; one way to short is to borrow something, and then sell it.  

The dilemma is that Russia is facing a liquidity shortage and a weak (and arguably weakening) banking system.  Raising interest rates and rationing liquidity may stall the ruble’s decline, but exacerbate these other problems.  

Trying to disintermediate the banks, and direct loans directly to corporate borrowings, is likely futile.  Believe me, Russian corporate borrowers certainly know how to work the system to convert rubles into dollars.  

As to oversight, my friend Sergei Guriev, an excellent economist, says it best:

Pressure from the government on banks wasn’t working, he said. “You can send a KGB officer to ensure that the bank which borrows from the central bank lends the money instead of buying dollars, but then the firm it lends to will buy the dollars. You would have to appoint a KGB officer to oversee each transaction in the economy. That is not going to work, so we need to wait for the rouble to find a new equilibrium.”

The last sentence hits the nail on the head.  Why are banks sitting on dollars?  Why are they trying to convert rubles into dollars?  Because the currency has not reached its correct, equilibrium, level.  As long as it is above its equilibrium level, bankers, businessmen, and average Ivans and Natashas will try to circumvent the central bank’s–and FSB’s–efforts to keep it levitating.  

Policy makers around the world face extreme challenges.  Nowhere are these challenges more acute than in Russia.  The currency issue is just one example of these dilemmas.  Inflation is another.  Kudrin announced that the inflation rate for January was at least 2.2 percent–a 30 percent annual rate!   This is all the more remarkable given that the base money supply has been decreasing–10 percent in the 29 December-26 January period.  (Contrast this to the US which has seen falling price levels at the same time base money has skyrocketed.)  This means that the demand for rubles has been plummeting (supply down + inflation up can occur only if demand falls dramatically).  This is no surprise, since the ruble is overvalued.

How can Russia respond?  Raising interest rates and/or letting the currency fall further.  The former will inflict more pain on already reeling manufacturers and other businesses.   Keeping the currency too high is already having that effect .  

Whatever way Kudrin (and Putin and Medvedev) turn, they face a distasteful choice.  I understand their reluctance to let the ruble fall further–for Putin, especially, every decline is a signal of failure–but this policy has already wreaked considerable damage, and continuing it will wreak yet more.  Trying to command the currency is as futile as commanding the tides.  Russia will not be able to work through its other economic problems until the currency reaches its equilibrium level.

At the onset of the financial crisis, I conjectured that this would jeopardize the South Stream and NordStream pipeline projects.  Bloomberg reports that South Stream is indeed in trouble:  

OAO Gazprom  plans to delay natural- gas deliveries to Europe through its South Stream pipeline as Russia’s largest energy producer cuts investment amid slowing global economic growth and declining energy demand.

Gazprom, which originally said it would start shipping gas through South Stream in 2013, expects a start date at the end of 2014 or 2015, according to a presentation to investors today in Moscow. Gazprom spokesman  Sergei Kupriyanov  couldn’t be reached for comment.

The cost of the project, which will bypass Ukraine by traveling under the Black Sea to Bulgaria, may reach more than 24 billion euros ($31 billion), the company told investors. Russian Energy Minister  Sergei Shmatko  said in July that the project may cost $20 billion.

Russia, which supplies a quarter of Europe’s gas, is seeking new routes to Europe after a price dispute with Ukraine led to a two-week cut in exports via the former Soviet republic. South Stream is the twin of Nord Stream, designed to link Russia directly to Germany under the Baltic Sea.

State-run Gazprom may cut investments by 14 percent this year as the credit crunch squeezes resources and revenue drops because of falling prices and demand, according to today’s presentation. The world’s largest gas producer will invest $29 billion this year, down from $33.6 billion in 2008, according to company estimates.

‘Generally Positive’

“Our takeaways were generally positive, including surprisingly large declines in expected capex outlays,” Moscow- based Alfa Bank wrote in a note to investors after the presentation. “Gazprom is adapting to the new economic reality.”

Gazprom’s  budget  is based on a $50 a barrel price for Urals crude, Russia’s export blend. Other scenarios under consideration assume barrel prices of $40, $30 and $25, according to the presentation. Chief Executive Officer  Alexei Miller  said in June, when the price per barrel hovered at more than $120, that the price may “soon” hit $250.

The 14 percent (“surprisingly large”) reduction in capital expenditure is perhaps a more important fact than the South Stream delay.  It is well known that Gazprom’s existing fields are in decline, and that it is desperate to find new sources of supply.  It has massive reserves, but getting at them is a daunting task, almost certainly beyond the company’s capabilities.  A 14 percent drop in capex will seriously impede the company’s development of new supplies.  This will further increase its dependence on Central Asian sources (esp. Turkmenistan).  This, in turn will intensify the bargaining, bribery, and conflict currently swirling around that region.  

The delay in South Stream may also give the ill-starred Nabucco project a much needed boost, but other difficulties must be overcome.  Given the gas war, however, one hopes that Europe finds the will to make the way.  Sadly, however, I have my serious, serious, doubts.  This means that Ukraine will continue to play a pivotal role in gas transshipment for the foreseeable future.  This, in turn, means that future gas wars are more likely than not.

I have a good friend from Yekaterinburg.  One time I expressed surprise at some aspect of Russian life she had mentioned, and she responded: “Craig, you live in a different world.  And be glad that you do.”

Much of the debate that rages on SWP relates to those differences, and their meaning.  Today “Russianwitness” contributed a very passionate comment that deserves the attention from those interested in this debate.  Here’s the comment in full:

Hey, Da Russophile, are you saying something about civilized manner? Are you civilized enough daring to say so cynically about doubling of pensions in Russia? You are a trouble free American getting your salary in USA dollars. It is the same like to say: The retired people were paid 1 dollars and now, how greatly positive, they are paid 2 dollars 30 cents. You are such a “great” expert of Russian life – compare at least the milk and bread price in 1998 and today. To enlighten you properly I inform you that bread was 2-3 rubles and milk was 4-5 rubles in 1998 and in 2009 bread is 20-30 rubles and milk is 25-35 rubles. And now compare the same in the US.
Do not speculate about Russian people as population of animals or guinea pigs! Russians are the same human beings like you who deserve to live not worse than you.
Do not even dare to say about sweet life and better changes of seniors and children in Russia. What do you know about it? When did you come to Russia for the last time? Come over today! Get your own statistics – go to typical Russian towns, villages, rural areas in the Urals, Siberia, Far East, somewhere father from Moscow and Sochi (the best, subtropical, climate in Russia). Talk to ordinary people in the territory of Russia not the USA: teachers, budget doctors, engineers, workers farmers and peasants and especially with seniors. Smell for at least one month the air of such industrial towns and cities like Nijniy Tagil, Novokooznetsk, Argoyash, Ekaterinburg! Wash your body with the yellow stinking water which flows from water supply system pipes all over Russia in the eastern areas and in the most western areas in Russia! Live for a few day in the apartment without hot water when the temperature is +8 degrees C inside and -20 degrees C outside! When your wife gets pregnant and the term of this pregnancy is less than one month, rush to the local Children Defense Board and register in a huge line for your future child in the age of 3 years to be cared in kinder garden! Stay in so called budget Russian hospital far from being free and pay for every pill and every polite phrase from a nurse or doctor! Start your own business without any connections in state authorities and without lots of money on the base of bank loans with the annual rate 26 percent! I would like to meet with you in six months of your peacocky business efforts. If you kept your house you would be blessed!
What do you know about Russia having the US citizenship and residing in a warm American state?
Russia is not Moscow and a few more big megacities. The visibility of the better life of some people of a very fragile middle class of Russia happened to a huge extent because Bush was left a president of the USA in 2004 and provided Russia with this horrible chance to fill in the country with heaps of priceless oil and gas money not supported by the real economical growth. A typical representative of middle class who used to have a salary $1000-23000 rubles with the rate 23 rubles per $1 in May of 2008(oil barrel was $145) and now because of crisis his/her salary has been reduced to 10000-15000 rubles with the rate 36 rubles per $1(oil barrel is $40). How much is 10000-15000 in USA dollars now? Would you like me to tell you the level of foodstuff prices while such a horrible devaluation of rubles? Do you know this type of statistics?
What do you know about adoption in Russia? It has been zero for more than 5 months by Russians. Even earlier it was really rare. Russian people have never been sure in their future to deliver children not saying about adoption. A Russian mentality is not ready for adoption and for more than one or in better cases two biological children in the family. Foster care in Russia is the only way to survive for foster parents because they are not able to find jobs other than foster parenting. Russian foster parents are far from genuine love to children. What do you know about the life of children in foster families when they are always under the threat to be thrown off back to orphanages because the state may stop paying foster salaries any time? What have you done for these Russian orphans without any successful prospects in Russia? Have you adopted anybody to rescue at least one? Shut up in your primitive attacks against Americans who really help Russian children.
By the way, when did you throw trash in Russia last time? In 1998, in 2004, 2008? I do it every day and is aware pretty well how scrap-heaps looked in 1998 and how they do now. Never in 1998 the garbage containers were empty and all trash was thrown nearby. Today every morning trash containers are empty and all area around is covered with this garbage because there is much more starving people now (than it used to be in 1998) who scraped out the garbage to find something to eat.
I am questioning you again and again when did you come to Russia for the last time to learn anything of it not saying about proportion of the good and the bad in Russia?

Wow.  (The comment originated from an IP address in the Urals, BTW.)  A very personal, immediate, and intense appraisal of life in today’s Russia.  And not one submitted by “the Other.”  

I should say that I’m pleased, honored, and humbled by the many comments posted on SWP, even (especially?) from those with whom I usually disagree.  I am especially appreciative of comments such as Russianwitness’s, and hope to receive more such first-person correspondence as time goes on.

“Stimulus” package or no, the economy will not resuscitate until the financial markets, and especially the banking system, are stabilized and recapitalized.  Several alternative approaches are on the table.  In this post, I’ll give my appraisal of each.  Sad to say, the leading candidates are the least attractive, in my view, and the most appealing ones have received little traction.  

The four alternatives are (in order from most awful to least bad):

• Nationalization
• Government guarantees
• Bad bank (with a SWP twist–call it “Humpty Dumpty Light”)
• Bad bank on steroids (“Full Monty Humpty Dumpty”)

Nationalization would involve a government takeover, for some indefinite period, of banks.  Equity holders and bondholders would be zeroed out.  When this option is proposed, it is often said, in a soothing fashion, that the seized institutions will eventually be privatized.

The government (in the US) already has a regime for nationalization: the FDIC can seize banks under certain conditions.  The nationalization proposals being mooted would go beyond this.

Nationalization has one advantage–no bailout of shareholders of the seized institutions (and the bondholders as well).  But it has two major disadvantages, namely: the likely politicization of resource allocation decisions, and soft budget constraints.  Together, this combination is quite dangerous.

Nationalized banks would certainly be under pressure to make lending decisions based on political criteria.  Like FNMA and FHLMC?  Like the CRA?  You’ll love nationalized banks!  Want Barney Frank and Chris Dodd exerted disproportionate influence over how capital is allocated in the US?  Nationalization is for you!

I don’t believe that Fannie and Freddie and the Community Reinvestment Act were the sole, or even the primary causes of the financial crisis.  But they were definitely major contributory factors.  Pressures on financial institutions to achieve political objectives, primarily in housing, contributed to the perverse lending practices that culminated in the subprime meltdown.  

With nationalized banks, these pressures would be felt in all aspects of lending, not just housing.  The banks would become levers that politicians pull to favor influential constituents, and to engage in industrial policy.  

The resulting loans would, almost certainly, be far likelier to default than loans issued based on economic criteria by profit maximizing banks.  That’s where the “soft budget constraint” comes in.  Nationalized banks in financial difficulty would almost certainly receive government financial support, further eroding market discipline and enabling continued extension of credit to bad, but politically favored, risks.

And here’s where soothing promises that nationalized banks will be privatized “as soon as possible” become meaningless.  It may never be possible, as bad loans multiply on nationalized banks’ balance sheets.  Nationalized banks will become the financial equivalent of roach motels–we can get in, but we can’t get out.  

My verdict: nationalizing is Really REALLY Bad.  

As to guarantees: an improvement, but not much of one.  Government guarantees on (some) of the assets on bank balance sheets is equivalent to the Feds writing a massive put.  There are many details to be worked out: What is the maturity of the put?  Who has the right to “put” the assets to the guarantor, and under what conditions?  Is the put on the entire portfolio, or are there multiple puts on multiple portions of each bank’s portfolio?

I’ll put those non-trivial, but secondary, issues aside to focus on other more problematic ones.  Most notably, what is (are) the “strike price” of the put(s)?, and what consideration will the guarantor (the government) receive in return?  

If the guarantee on is something approaching the par (or even book) value of toxic assets on bank balance sheets, the “put” is deep in the money.  That is, it is likely that the market value of the assets is far below the guaranteed level, and therefore it is almost inevitable at some point the bad assets will be “put” to the government, in exchange for the government writing a check for an amount far exceeding the value of the assets.  

If the guarantee is set at a level approximating the current market value of the assets, however imprecisely determined, the option will be at-the-money.  Short options create a short volatility exposure to the option writer, and this exposure is greatest when the option is approximately at the money.  Therefore, making the guarantee approximately at-the-money creates a substantial volatility exposure to taxpayers.  If volatility goes up, the value of the guarantee goes up as well–costing taxpayers money.

If the government receives no consideration for the guarantee, it is a huge subsidy to the financial institution receiving it.  Puts are valuable.  A government guarantee extended gratis to the financial institution is therefore a subsidy to the bank’s shareholders and bondholders.  This value can come from the “moneyness” of the option or the “time value.”  If the guarantee is deep in the money (i.e., the guarantee is at a level far above the market value of the assets), the intrinsic value of the option is large; this intrinsic value will flow to the bank’s current shareholders and creditors.  Even if the strike price of the option the government provides is approximately equal to the market value of the guaranteed assets, the time value is large.  With an at the money option, the guaranteed bank has a “heads I win, tails I don’t lose” position.  If the assets tank further, the government bears the cost as guarantor; if the assets rise in value, the bank can pocket the gain.  This one sided exposure is also valuable, and this value flows to the bank’s current shareholders and lenders.  This value is highly sensitive, moreover, to the volatility of the underlying assets.  

Recognizing this, in recent interventions the government has received consideration in exchange for the guarantee.  For instance, it has received stock.

Receiving the upside on the guaranteed assets is equivalent to buying them outright.  Receiving the upside is equivalent to having a call on these assets.  Writing a put and buying a call is equivalent to a forward contract–a commitment–to buy the assets at the guaranteed value.

Receiving stock gives the government an upside not just on the covered assets, but on the bank’s other assets as well.  But it also gives the government–that is, the taxpayers–an exposure to the downside on the non-guaranteed assets.  

The idea behind the guarantee, presumably, is to shift the uncertainty about the value of toxic assets to the government.  This, in theory, should make it easier for banks to recapitalize; if the government bears the losses on the toxic assets, private investors in the banks need not fear nasty surprises if the value of these assets turns out to be lower than anticipated.  

I don’t like the guarantee approach for a variety of reasons.  

First, there is a high likelihood that it will serve as a stealth bailout of the existing stock and bondholders of the troubled banks.  That is, the value of the put will far exceed the value of the consideration received.  This will represent a transfer from the taxpayers, to the current shareholders and bondholders.  It may facilitate the attraction of new private capital, but there are ways to do this without bailing out the incumbent suppliers of capital.  

The fact that this approach can facilitate a “stealthy” bailout probably explains its political attractiveness. When announcing the guarantee, politicians can say “we didn’t bail out the banks and their shareholders because we didn’t write a check.”  The honest statement would be “we didn’t write a check today, but we promise to write one sometime in the future.”  If the value of the put is greater than the value of the consideration, shareholders and bondholders are happy, because they receive a windfall.  Put differently, the more popular a guarantee is, the more skeptical I become.  It will be most popular when it (a) provides a large stealth subsidy, and (b) allows politicians to escape accountability for the subsidy.   So, if politicians and bankers unite in enthusiasm for guarantees, be afraid.  Be very afraid.  

A second problem with the guarantee is that I am skeptical that it will markedly improve the ability of banks to recapitalize.   Potential investors will reasonably fear that any commitments that the government makes today are not credible.  As guarantor, and as part owner, the government will potentially find it very tempting to expropriate new investors sometime in the future, perhaps by reneging on the guarantee in whole or in part, or imposing additional conditions or restrictions, or by using the threat of such actions to force the banks to engage in politicized (but uneconomic) loans.  Just as a guarantee can be a stealth bailout, it can be a stealth quasi-nationalization.  The government as guarantor and owner will have a major influence on a bank’s operations going forward, and can use that to harm the interests of new investors.  This means that although the guarantee may reduce one kind of risk–the risk of fluctuations in the value of toxic assets–it adds another–political/expropriation risk.  

For instance, let’s say that performing on the guarantee turns out to be very expensive, because the strike price on the assets is far above their eventual value (either because that value is over-estimated today, or because their value falls further.)  The political pressure to scale back on the guarantee, or change its terms, will be immense.  You can just envision the political posturing.   New investors in banks would lose if this were to happen.  Foreseeing this possibility, they may be very reluctant to invest today.

A potential investor in an institution guaranteed and partially owned by the government would not be likely to take the promise that “we’re from the government and we’re here to help you” to the bank, as it were, and invest in it.  

Given all this, in my view the guarantee approach could both subsidize existing shareholders and scare off new shareholders.  As a result, it is highly likely to be just an extremely expensive waystation on the road to nationalization.

So, color that one really bad.

Another proposal on offer is the bad bank.  Strip out the bad assets, and put them in a separate institution.  Again, many devilish details.  

Most bad bank proposals envision that the government would pay for the bad assets.  This raises all of the difficulties associated with determining the price.  Too high prices, and there is a transfer of wealth from taxpayers to existing shareholders and bondholders.  Too low prices, and the reverse occurs, and the already weak capital position of the banks is eroded further.

My twist on this is to adapt something from my Humpty-Dumpty proposals.  Put all the bad assets in a separate corporation, and rather than giving the contributing banks cash, give them stock in the new company.

The valuation issue still exists–since the assets are heterogeneous and hard to value, it will be impossible to make sure that every bank receives stock in the new company that is worth exactly the same amount as the assets it gives it.  Here, however, the valuation errors are shared in the banking system.  Some banks win, some banks lose, but there is no possibility of systematic transfers (one way or another) between taxpayers and the banks’ owners and lenders.  

Moreover, as I argued in my Humpty Dumpty proposal, the equity in the new company would be marketable, and almost certainly more valuable than the sum of the current values of the individual assets.  This is true partially because some of the toxic assets would be various CDOs and other claims with various offsetting optionalities that make them very hard to value.  These offsetting options positions would be eliminated, leaving the simpler, easier to value (not easy–easier) assets underlying the CDOs.  The equity would be more liquid than the underlying assets, and liquidity can enhance value.  Thus, it is highly likely that this mechanism alone will mitigate the capital problems that banks face because the equity that they receive will typically be higher than the value of the assets that they give up.  

Perhaps most importantly, the equity in the bad asset repository could trade in the market and produce a transparent, relatively informative price.  Exchanging a dog’s breakfast of assets that cannot be valued for a homogeneous claim (equity in the bad asset repository) with a transparent price makes it much easier to value the banks, and to determine which are insolvent and which are not.  This will facilitate the resolution of the problems in the banking industry by the FDIC, for instance.  It will also make it easier for potential new investors to appraise their value, and thus they will be more willing to invest, and to pay more, for new equity stakes in the banks.  

So, my verdict is: Bad bank without the issuance of publicly tradeable equity in the firm holding the bad assets–not a good idea because of the daunting valuation issues.  Bad bank with issuance of such equity–a definite improvement over either nationalization or a guarantee.  

But, it is possible to go further, and do the full Humpty Dumpty.  The proposal I’ve just sketched out gets the bad assets off US bank balance sheets, but the bad assets are also held by hedge funds, foreign banks, and others.  If the bad bank option is limited to US banks, the ability to undo complex structures such as CDOs, CDOs squared, etc., will be incomplete.  Since a major benefit of hiving off the bad assets is the ability to compress hard to value derivatives with complex embedded optionality back into less complex, more easily valued underlying securities, this limitation to US banks will also limit the scope of these compression benefits.  

As I argued in the original Humpty Dumpty posts, obtaining the maximum benefit would require putting all of the toxic assets, including all of the outstanding CDOs, etc., in the single bad bank.  This would require participation by hedge funds, foreign banks, and other investors.  

You might think that it would also be legally impossible–how can you make a foreign bank exchange its holdings of CDOs on US subprime mortgages for equity in the bad bank?  I think that there’s a (draconian) legal way around this.  To the extent that the cash flows on the bad assets originate in this country, the US could require that the cash flows from all of the assets underlying the toxic assets that would go into the bad bank be directed to that bank, and that the bad bank would retain all such cash flows, but would also exchange equity to those presenting bona fide claims on those cash flows.  In essence, by holding the cash flows hostage, the government/bad bank would provide a very strong incentive for anyone, hedge fund, foreign bank, whoever, to exchange their claims on these cash flows for equity in the bad bank.  Any valuation errors in determining how many shares would be received for each asset would be shared within the world financial markets, would not lead to a direct transfer between financial institutions and taxpayers (in either direction), and could be structured so as not to favor one set of asset owners over another.    

Draconian, yes.  But nationalizing a set of bad assets (or the cash flows on these assets) is less draconian than nationalizing the banks in their entirety or extending guarantees.  The government would also not obtain an ownership stake in financial institutions, or such a huge financial stake that it could more extensively politicize the financial markets. Nationalization and guarantees also would not enhance price discovery and liquidity–Humpty Dumpty would.  

It’s likely that even if this approach were implemented, some banks would be found to be insolvent.  But that’s a feature, not a bug.  First, by improving the transparency of bank balance sheets through the exchange of untraded and untradeable assets for the tradeable equity in the bad bank, Humpty Dumpty would help identify which banks are insolvent, and by how much.  This will reduce the potential for type I and type II regulatory errors (failing to intervene when the bank is insolvent, intervening when it is not).  Also, if (as is almost certainly the case) the traded equity in the bad bank is worth more than the sum of the value of the assets if they remain on the bank balance sheets, on average bank capitalization will rise.

To sum up a very long post: Some variant on the bad bank is, in my view, the best way to go.  People have soured on the bad bank idea because of the belief that it requires exchanging the bad assets for cash, thereby raising difficult valuation issues that will inevitably transfer wealth between taxpayers and bank stock and bond holders.  This problem can be avoided if the bad assets are paid for with equity in the bad bank.  Valuation problems will occur, but the transfers will be contained within the group of firms contributing the bad assets.  Moreover, exchanging heterogenous, hard to value assets for a homogeneous claim on a super-portfolio of these assets will produce a variety of benefits.   This approach will be more efficacious, the more complete the participation in the program.  Achieving more complete participation will require more draconian, and hence politically difficult, measures.

Nationalization and guarantees present far more acute problems, in my view.  Both will politicize the process of capital allocation.  That will destroy value, and transfer wealth.  Guarantees can serve as subsidies.  Moreover, I doubt that any system of guarantees can be made credible against political reneging or renegotiation in the future.  In anticipation of this, private investors will be reluctant to recapitalize guaranteed banks, perceiving them to be nationalized banks in waiting.

So, create a Big Bad Bank by exchanging bad assets for its stock.  A Big Bad Private Bank.  The bigger, the better.  Clean out the Augean Stables.  Create a market for the unmarketable, and minimize the government’s role in the operation of these financial institutions and the financial markets.  The greater and more enduring the direct government involvement in this process, the worse the outcome, in terms of politicized capital allocation and massive transfers of wealth.   Once all the King’s horses and all the King’s men put Humpty Dumpty back together, they should get the hell out of the way and let him do his thing.  It ain’t perfect, but it’s a damn sight better than the other appalling alternatives on offer.