Paul Romer, husband of Obama CEA head Christina Romer, starts up where I ended in my rumination A Better Approach?. In his WSJ article, Let's Start Brand New Bank, Romer supports my theme that the first step is getting price discovery in mortgages and other credit instruments. But how? Romer proposes that the remaining $350 billion of TARP money go to starting up new banks. His frame of reference has precedent in the financial sector, except without Government needing to be involved directly with providing capital.
As with every post bubble crisis, whoever was not involved in markets prior to the bubble always has the best opportunity to "clean up" and make money as a function of the prior disaster. I purposely phrase it this way, because it highlights the need to create strong economic incentives for these potential new investors to show up. ("New" investors is a "construct". Providers of capital very likely will have already had investments with banks). Romer is suggesting that with the Government as a co-investor, this will provide the necessary incentive.
One example of this occurring "naturally" was in the property and casualty insurance industry 20 years ago. When the hurricanes Hugo and later, Andrew, wiped out or caused major losses among P&C insurers, insurance premiums rose dramatically. This is analogous to mortgage prices falling (or yields/interest rates rising). New investors started up new insurance companies with the benefit of receiving these higher premiums. This was good, because "prices" acted as a "signal" and drew new capital into a sector of the economy which had run out of capital.
In 1998, when Long Term Capital almost started a global crisis comparable to what we have today, the prices of "equity options" skyrocketed after a "market storm". Similar again to P&C insurance and mortgage prices, prices of equity "options" (options are just another way to provide leverage to investors, similar to lending money) got too low. Demand for them grew (like demand to borrow money to buy houses grew) until there was a collapse in the equity market. Without getting into the arcane details of equity option pricing, the effect was the same as today. Those financial institutions that provided "leverage" to investors to buy stocks lost money as the stock market declined rapidly, just as those institutions who provided leverage to those who were buying houses lost money when housing prices declined. Once again, those who had not participated in "selling options" prior to the market collapse could come in and provide that same leverage for a higher price (like the new insurance companies could charge higher premiums after the hurricanes).
Romer's proposal is ingenious and is "Creative Destruction" literally in action. The destruction part is that his proposal almost certainly would result in some current banks, or what he calls "zombie banks", going under. But his bottom line is we need to attract new capital to the banking sector. The only way this happens is by "making investors an offer they can't refuse" . An offer investors can't refuse is a risk reward so much in their favor that it attracts capital to where it is most desperately needed. When there have been conflagrations in markets, this has been the only way to bring in new capital. That is, when there is no demand, prices need to drop far enough to bring in demand. As my previous two examples demonstrate, this ancient simple concept works to solve the seemingly most intractable problems. The Government's willingness to be a co-investor lessons the risk new investors have to bear, the equivalent of "lowering" the price of investment. FYI, if this were to come with a "cap" on what new investors or employees can be paid, we may as well not even start. Instead, there should be no "cap" on what the Government (i.e., taxpayers) can earn.
Why hasn't this spontaneously already happened? I don't know. Nothing prevents it from happening and this has to give one pause. Maybe the response to the crisis by Government has been so chaotic, it has prevented capital from coming in as we "wait" to see what the Government's final position will be. Or, maybe Romer's idea is not a good one, despite its appeal.
In any case, we are where we are and new capital has not come in and we still have stuck credit markets. What is interesting and unusual about Romer's proposal is that he explicitly stipulates that the endgame is for the private sector to control banking. The intermediary step is for the Government to provide incentives (i.e., capital) to get the process going. If you think about it, this requires the Government to believe the private sector is what is absolutely required to make economies most efficient, but now, in this time and place, Government can help facilitate that.
Under Romer's proposal, we would stop propping up the zombie banks. We would let the current regulatory system function as it functions. We would not fix borrowing rates as Geithner is now proposing, or force banks to not foreclose on homes as is also proposed. If banks go under, they go under. Romer would have the Government announce immediately they have $350 billion to invest in start up banks. This would attract, presumably, matching capital, and these new banks would not be saddled with the old loans of the current banks. This is precisely analogous to what happened, spontaneously, in the insurance industry. Eventually, investors would buy out the Government which would have made money (that is the idea anyway) on its investment.
Is there risk to this proposal? I would think so. It also is not "ideologically" pure. An ideologically pure argument would be to follow the Romer proposal without the $350 billion invested by the Government. This may in fact be the better way, as we do not know if there is natural "demand" for the borrowing that will be "supplied" by the Government capital. This would then be pouring money down another rabbit hole. Romer also points out that the human risk and temptation of Government to stay owners, once it supplied the capital, would be there. But that is already happening now with no forward looking market based principle in mind to get the Government out.
It is an interesting gamble. We have already decided to spend the money. This, of course, is not a good enough reason of itself. But at least it has market based principles at its core and market precedents of it working as mentioned above . For sure, I like it better than the Geithner proposal on the table. Do we have the wrong Romer at CEA? Or, perhaps, we can blow out the tax cheat liar and replace him with Romer number two.
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