Insolvency vs. Liquidity, or Austrians vs. Keynesians
by Michael S. Rozeff
by Michael S. Rozeff
An economics debate of very great importance is surfacing. Is the government's economic rationale for bailing out the banks valid? If it is not, then the entire case for the bank bailouts fails.
On one side of the debate are Austrians using Austrian economics, on the other side are Keynesians using Keynesian economics. Gary North writes "The government, which is running a trillion-dollar deficit this fiscal year, is adding ever more debt to save the favored banks. It is buying the banks' insolvency in the name of future taxpayers." North sees the bank problem as insolvency. Concerning FED and government power to create money and "fix the crisis," Lew Rockwell writes "Good liquidity needs to be based on savings and capital, and it cannot be created by decree. Decrees end up creating money out of thin air, which ends up overriding market preferences and generating inflation. Everything officials do to fix the crisis ends up prolonging it." Rockwell sees the FED's provision of liquidity as impossible to reconcile with preferences, and with the attempt to provide it being counterproductive.
Observing a marked widening of credit spreads for many kinds of bonds, the Keynesians conclude that there is a liquidity problem in bank-held assets. Not accepting or applying either Austrian or finance theory, they fail to appreciate that the re-pricing of bonds from 2007 onwards is due to a higher price of insuring against recession and a correction to prior bubble prices. There is no liquidity problem in the credit markets.
Important new research supports the Austrians and suggests that the government's rationale for bank bailouts is invalid. This research is highly technical, but it uses mainstream, basic, and widely-accepted finance theory. It shows that the higher required returns (or higher spreads) on toxic credit assets are not unusual in light of increased stock market volatility and other financial factors. The authors
"...conclude that the pricing of investment-grade corporate credit has largely been consistent with that of the equity market when viewed through the structural model. In other words, from the context of the structural model, there should be nothing particularly surprising about the severe widening of credit spreads in the investment grade CDX [credit index] and the underlying cash bond credit spreads. Indeed the observed widening of the CDX spread is, if anything, somewhat low relative to what the structural model forecasts conditional on the market declining by 40% and its long-term volatility doubling. The out-of-sample results challenge the commonly advocated view that the pricing of credit securities has become distressed, and instead suggest that spreads on the synthetic securities are unusually low."
The pricing of the toxic assets of the banks is in line with the pricing of other risky assets. There is no evidence that prices of credit instruments are now reflecting fire sales or distress selling. The evidence, if anything, suggests that the prices are actually on the high side. This means that the liquidity rationale of the Keynesians has no basis in fact.
The findings are sure to be contested in the literature, as most research is. In the end, they will prove robust. They will hold up.
The debate on bank bailouts is broader than economics. It goes to a question of justice. Should one group, taxpayers, be forced to pay for the mistakes of another group, bankers? It goes to a question of freedom versus socialism and fascism. Should banks operate in a profit and loss system and bear the losses that they incur, or should they not, in which case the financial system becomes more socialist and fascist? Even before addressing these questions, if the Keynesian policy does not do what it is claimed, then in economic terms the Keynesian case falls.
The government and FED claim that the financial system lacks liquidity. They say that there is a market pricing defect or failure. This, they say, is why the bad loans (toxic assets) held by the banks are worth more than the prices that they are fetching in the market. These prices, they claim, are fire sale prices. The remedy, they call for and implement, is for the Treasury and FED to supply the banks with liquidity, i.e., bail them out. Thus, the government and the FED are directing trillions of taxpayer dollars to shore up weak banks by buying their bad loans rather than overseeing a judicial-like process of re-organizing the banks and cleaning out these loans in established bankruptcy-like procedures.
The Austrian position is that the financial system does not lack liquidity. The bad loans were overpriced to begin with, largely because the FED and government engineered a speculative bubble. The bubble burst. The loans were repriced in the market. The loans are now worth what they are bringing in the market. Thus, the government has no liquidity justification for bailing out the banks. The government's economic rationale has no merit. Many banks are insolvent. On the economic merits, they should be allowed to fail, not bailed out.
The study released by Coval, Jurek, and Stafford, appears here. It entirely supports the Austrian position. Their article examines the pricing of the bank toxic assets using the best available sophisticated financial techniques. It is done by researchers who are not Austrian economists. They unambiguously deny the government's explanation.
Professors Coval and Stafford work at Harvard Business School, both in the area of finance. Professor Jurek is at Princeton in the economics department, where he teaches finance. None of these researchers does research in or associates himself with Austrian economics. None of their 60 references is to Austrian work. Most are to technical finance articles. The article itself makes no mention of Austrian economics.
Are major banks insolvent, or does the financial system lack liquidity? This question is in some ways a no-brainer, because it is obvious that as home prices fall substantially, those banks with very high leverage and lots of mortgage loans made with high loan-to-equity ratios are wiped out. This happens because the equity (home values) behind the loans becomes less than the face value of the loans. Superior and superb analysts like Reggie Middleton recognized this very early and explained it at length (see here.) Furthermore, there are major pools of liquid assets in the economy, such as huge amounts in money-market funds.
Nevertheless, Keynesians argue that the bank assets are being underpriced due to illiquidity. They argue that the bank problem is a liquidity problem, and that this justifies bank bailouts. Austrians view the FED and government as having promoted the bank loans that went bad via inflation and other housing policies. These loans went sour and were revealed as mal-investments when the boom ended and housing prices fell. The problem is not liquidity but bad loans and, in many cases, bank insolvency. This argument then — insolvency vs. liquidity — has emerged as a key difference in the last two years between Austrians and Keynesians.
In the past two years, the Federal Reserve (FED) and two federal government administrations have been disbursing trillions of dollars to banks, insurance companies, other financial institutions, and industrial firms. During this period, officials have again and again insisted that the economy was mal-functioning by not providing liquidity to viable firms. They argued that this lack of liquidity made it necessary to provide government resources to these firms, paid for by taxpayers, and to flood the banking system with Federal Reserve dollars, which, by the way, constitute a very serious inflation of the currency. For example, Ben S. Bernanke, the FED chairman, made the liquidity argument at length on December 1, 2008. A few quotes:
"...to offset to the extent possible the effects of the crisis on credit conditions and the broader economy, the Federal Open Market Committee (FOMC) has aggressively eased monetary policy...The Committee's rapid monetary easing was not without risks. Some observers expressed concern at the time that these policies would stoke inflation... the second component of the Federal Reserve's strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector — that is, by lending cash or its equivalent secured with relatively illiquid assets.
"To ensure that adequate liquidity is available, consistent with the central bank's traditional role as the liquidity provider of last resort, the Federal Reserve has taken a number of extraordinary steps...
"Judging the effectiveness of the Federal Reserve's liquidity programs is difficult. Obviously, they have not yet returned private credit markets to normal functioning. But I am confident that market functioning would have been more seriously impaired in the absence of our actions."
More recently, the U.S. Treasury on March 23, 2009, issued a white paper on the Geithner Public-Private Investment Program (PPIP). It says
"Troubled real estate-related assets, comprised of legacy loans and securities, are at the center of the problems currently impacting the U.S. financial system...The resulting need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. While fundamentals have surely deteriorated over the past 18-24 months, there is evidence that current prices for some legacy assets embed substantial liquidity discounts...This program should facilitate price discovery and should help, over time, to reduce the excessive liquidity discounts embedded in current legacy asset prices."
The notion of fire sales and liquidity discounts on the bad loans (called legacy loans) is firmly embedded in the rhetoric of U.S. policy makers. They are leaning heavily on this idea to sell the merits of their enormous wealth transfers to banks.
By contrast, the Austrians, as well as other financial analysts, have argued from the outset that the basic problem is not liquidity of the financial system. The argument on the Austrian side is that the banks and other financial institutions have not been in trouble because there is not enough liquidity to buy their loans. They are in trouble because they made bad loans that are worth far less than their values as carried on the banks' books. The banks are often insolvent. Furthermore, these banks do not want to and refuse to sell these loans at the low values to get the liquid funds they want. They are playing politics. They are getting a better deal (a) by shifting some of these loans to the FED in return for Treasury securities, and (b) getting bailed out by taxpayer funds.
In the Austrian interpretation, the banks have waited while the government came up with various devices to bail them out with other people's money. The latest is the Geithner PPIP that uses an FDIC guarantee to private parties to buy the bank loans at prices above market value. In the same vein, the accounting regulatory authority known as FASB has just allowed the banks leeway not to carry these bad loans at their market value by voiding the mark-to-market rule.
In April of 2008, Austrian economist Bill Anderson wrote:
"The Fed's latest move — permitting reeling financial institutions to use near-worthless mortgage securities as collateral for about $200 billion in loans — is yet another example of Bernanke's promise to ‘provide liquidity' at every step, as though the real crisis here is the lack of play money in the nation's financial system...The simple issue is not lack of liquidity. It is the fact that billions — make that trillions — of dollars were malinvested in markets where the increasing values could not be sustained."
In October of 2008, I explained that the FED could not create liquidity in a market without destroying that market. For months, I have referred to the banking system as insolvent, such as here. More recently, I wrote that
"The entire thrust of FED policy as geared to liquidity is questionable. The banking problems center on bad bank loans and the reluctance of lenders to roll over short-term loans to banks whose assets are questionable. Like the TARP loans, the FED loans cannot resolve these problems. They have prolonged them by removing the incentive for banks, which otherwise would have been under greater market pressure, to resolve them. These loans have simply replaced private market capital that might have been supplied under more stringent conditions that would have forced the banks to face the problems and deal with them."
The government and FED story, which parrots the bankers' story, is that the banks do not really have such bad loans. As their story goes, the loans are really worth more than what they are fetching in the market. The market pricing reflects distress sales or fire sales. The loans should not be marked to market, because the market doesn't know what it's doing. The banks were not badly managed in making these loans. If only these loans are given time to work out, their true worth will be discovered. It behooves the taxpayers to tide the banks over. It behooves the FED to take on these loans even if it means inflating the currency.
Coval et al. frame the dispute as follows:
"The government's view is that a disappearance of liquidity has caused credit market prices to no longer reflect fundamentals...The main objective of this paper is to determine whether fire sales are required to explain prices currently observed in credit markets...A key distinction between the fire sale view and the other possibilities is that only the fire sale view requires that current prices are incorrect."
Their findings are as follows:
"The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing."
Bank loan assets were overpriced during the boom. The risk premiums were too low. The overpricing of these long-term assets during the boom is consistent with the Austrian view of a speculative bubble. The market break in 2008 corrected the prices to levels consistent with the pricing of other risky assets. Coval et al. write
"In contrast to the main argument in favor of using government funds to help purchase structured credit securities, we find little evidence that suggests these markets are experiencing fire sales."
This implies that
"...many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities."
In turn, this means that propping up the prices of toxic assets by flooding the banking system and the banks with money (inflation) serves no economic purpose. But, importantly, it transfers massive wealth from taxpayers to banks:
"...any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities."
The readable and non-mathematical discussion that begins on p. 16 of their paper pulls no punches. They end up with a conclusion made many times by those adhering to the Austrian analysis:
"...policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay — and perhaps even worsen — the day of reckoning."
It is good to see mainstream support for the Austrian position. While it is late in the day to stop these bailouts and reverse them, it is not too late to put an end to the myth that the government is saving the banks by improving market liquidity. If the banks end up being saved by taxpayer dollars, we should know that it is because of an enormous wealth transfer to banks, bank stockholders, and bank creditors. We should know that it is at the cost of inflation and the costs of debt and taxes imposed on American taxpayers now and into the far future.
April 6, 2009
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
Copyright © 2009 by LewRockwell.com. Permission to reprint in whole or in part is gladly granted, provided full credit is given.