Wednesday, January 28, 2009

Treasury Secretary Geithner's Aggregator Bank: Learning from China

China succeeded in fixing its banks through a lengthy recapitalization process that took seven years. China began to dismantle its central-plan economy in 1978 with agricultural reforms, followed by manufacturing. China’s 10 percent annual real growth since 1978 led to a massive increase in bank lending, resulting in many bad non-performing loans (NPLs). China forcefully addressed this problem. The goal was to enable the big four state-owned commercial banks—the Bank of China (BoC), China Construction Bank (CCB), the Industrial and Commercial Bank of China (ICBC), and the Agricultural Bank of China (ABC)—to sell stock and operate as public companies. This required cleaning up their balance sheets. As recently as the fourth quarter of 2003, NPLs in the four banks were estimated at 20 percent of total loans, with skeptics putting NPLs even higher.

The process of fixing China’s banks began in the midst of the Asian financial crisis in 1998. The Chinese government doubled the banks’ capital bases by giving them $32.5 billion through complex swap agreements, in which bad assets were exchanged for government bonds. In 2001 and 2002 China established four asset management companies that bought $169 billion worth of NPLs from the four banks at face value, thereby taking them off the banks’ balance sheets. Despite these measures, NPLs continued to erode the capital bases of the banks. In early January 2004 China transferred $45 billion from its foreign exchange reserves to BoC and CCB, equally split between them.

At the end of 2004, China announced plans to inject capital into ICBC and ABC to enable them to spin off NPLs and build a new corporate governance structure as publicly-listed companies. The government injected $15 billion into ICBC in April 2005. Three of the banks went public. CCB raised $8 billion in its IPO of October 21, 2005, BoC raised $9.7 billion in May 24, 2006, and ICBC raised $21.6 billion in the largest IPO in history on October 20, 2006. Some of the world’s biggest banks and financial institutions invested billions of dollars to acquire minority stakes in the three banks. ABC’s IPO will likely transpire in the next few years. Altogether, the Chinese government spent more than $400 billion to fix China’s banks.

At current market prices, ICBC's capitalized value is seven times that of Citicorp. China's success, albeit over seven long years, suggests that bank recapitalization through an aggregator bank that takes bad assets off the books of distressed banks can work.

Tuesday, January 27, 2009

Patience and Prudence: Resolving the Financial Crisis

The current financial and economic crises were years in the making. But round-the-clock coverage of the crisis and its hoped-for prompt resolution has the public on edge waiting to hear that the worst is over and the country is on the road to recovery. Sadly, President Obama has dashed these hopes with candid, realistic statements that it could take several years to clean up the mess and restore the economy to sustainable growth.

Economists are in sharp disagreement about how to resolve the crisis. Some want large immediate government spending and targeted tax cuts to stimulate the economy. Others prefer to let the market resolve the crisis. Leading economists including Nobel Prize winners are all over the map. Larry Summers, the president’s top economist, claims that a dollar in government stimulus will generate a dollar fifty in economic activity. Others claim little to no benefit. Others say the stimulus package needs to be much bigger than $825 billion. There is no consensus among economists on what to do and how much money is required. There is wide disagreement on how to get maximum bang from the remaining $350 billion in TARP funds and the $825 billion stimulus package that will be signed into law in February.

History has recorded that financial crises often take a long time to dissipate. A worldwide financial crisis in 1857 which occurred in the simpler global monetary system of the gold standard took seven months to resolve. Other crises lasted longer and some shorter. There is no “scientific” basis on which to forecast an end to the current crisis. The country needs a good dose of patience and prudence.

Wednesday, January 21, 2009

Confirming Timothy Geithner as Treasury Secretary

Timothy Geithner, President Obama’s pick to head the Treasury, has acknowledged his failure to pay, in a timely manner, four years of taxes that he owed on Social Security and Medicare. He failed to pay the required taxes despite receiving documents from the International Monetary Fund where he worked that advised him of his responsibility to do so. Moreover, he requested funds from the IMF for that purpose. It took an IRS audit and vetting by the Obama transition team to identify the failure and secure remittance of all back taxes with interest. The issue would not have received so much attention were it not for the fact that the Treasury Secretary oversees the Internal Revenue Service.

In his own words, Geithner stated that his mistake was “careless but unintentional.” Some commentators blame his “honest” mistake on the complexity of the tax code, suggesting the need for serious tax reform.

One can’t help but wonder how many individuals who have failed to pay lawfully due taxes on time are also guilty of nothing more than “careless but unintentional” mistakes The IRS claims that the federal tax gap, the gap between what is owed and what is paid, exceeds $300 billion. How much of that is due to “careless but unintional mistakes?” If charged with failure to pay taxes, how many individuals are likely to plead what could become known as “the Geithner defense?” Could unintentional carelessness in application of tax law become a valid excuse. Not only has it been excused to confirm Geithner, it should be noted that the Treasury Secretary is fifth in the presidential succession list after the Vice-President, Speaker of the House, President pro tempore of the Senate, and Secretary of State.

Friday, January 16, 2009

Simplify the Tax Code? Who’s Kidding Who!

Treasury Secretary-designate Timothy Geithner will not be confirmed in time to take office once President-elect Obama is inaugurated. Failure to pay certain taxes on time along with taking several unlawful deductions have slowed Senate proceedings. But Obama is standing by his man. Geithner is expected to be confirmed within a few days of the new administration. Indeed, failure to meet all his federal tax obligations on time is being characterized as “honest mistakes,” and have led to renewed calls to simplify the federal tax code.

Politicians, business associations, citizens’ groups, and the media have been urging tax simplification for many years. Numerous commissions have recommended simplification measures. Nonetheless, since passage of the 1986 Tax Reform Act, the tax code has steadily grown in length and complexity.

Now comes a 2009 stimulus package with proposals for $275-300 billion in tax cuts. On January 15, 2009, House Ways and Means Committee chairman Charles Rangel outlined the economic recovery program that would be considered next week in the full committee. It included several dozen tax items, some new, with other provisions expanded or modified. The full committee, along with the Senate and the White House, will likely add more provisions. The regulations that will accompany the final legislation will run hundreds of pages. Tax forms will get longer and more complicated.

Promises to simplify the federal tax code are no match for the economic and ideological pressures that result in complexity. Politicians who call for simplification turn right around and further complicate the code with new credits, exemptions, adjustments, preferences, and deductions.

Monday, January 12, 2009

Save—But Not Yet

Many economists have been wringing their hands for years over the lack of domestic saving in the United States, which has increased our financial dependence on foreigners. Finally, Americans have begun to listen and save a portion of their income, especially as their homes and investments have fallen in value.

Are Americans being praised for saving? No! In fact, they are being bemoaned. Economists of all stripes fear that a rise in saving which reduces consumer spending over the next year could lengthen and deepen the current recession. Hold off saving, they urge, until the economy shows signs of recovery. Meanwhile, keep spending, using your credit card if necessary.

How will consumers know when it’s time to rein in spending and begin saving without damaging the economy? Surely not before the end of 2010 since any premature rush to save that slows a recovery could harm Democrats at the polls. Perhaps in 2011? Or perhaps many are sufficiently frightened about the future that they will disregard the pleas to spend and save instead.

Friday, January 9, 2009

I Have a Fiscal Dream

Genesis, Chapter 41, tells the story of Joseph and Pharaoh’s dream. In his dream, seven fat cows emerged from the Nile River which were eaten by seven gaunt cows that later came up out of the Nile. Then Pharaoh woke up.

Pharaoh sent for Joseph, then in jail, to interpret his dream. Joseph told Pharaoh that Egypt would enjoy seven years of bountiful harvests, followed by seven years of famine. The solution? Pharaoh appointed Joseph to oversee the collection of a portion of the grain during the seven years of abundance to be held in reserve for the seven years of famine. And so it was done.

Fast forward several millenniums. Joseph advised Clinton to run budget surpluses in his second term, which were years of abundance. During fiscal years 1998-2001 the budget was consecutively in surplus $69.3 billion, $125.6 billion, $236.2 billion, and $128.2 billion, a total of $559.3 billion (Economic Report of the President, Table B-78).

Federal deficits resumed immediately in the first Bush administration. A portion was due to the Iraq and Afghanistan military operations, but most was due to a combination of higher domestic spending and revenue cuts. For the eight fiscal years overlapping two Bush terms, cumulative deficits will exceed $3 trillion. Four fat cows were barely an appetizer for eight gaunt cows.

As if that were not bad enough, there is no grain (money) stored in the government’s granaries (vaults) to offset any of these deficits. Rather, the new debt will have to be underwritten with much larger borrowing from the private granaries of Americans and foreigners. Sadly, one day this debt will have to be repaid. The upshot will be higher taxes and lower living standards.

Unless, that is, President Obama can find a better interpreter of dreams.

Thursday, January 8, 2009

Big Stimulus, Small Savings. Obama’s “American Recovery and Reinvestment Plan.”

Upon taking office, President-elect Obama hopes to sign a big stimulus package as soon as possible, The amount under consideration is in the neighborhood of $800 billion or so over the next two years, consisting of a mixture of tax cuts and spending measures. The federal budget deficit for the current fiscal year (October 1, 2008-September 30, 2009) is currently estimated at $1.2 trillion. Adding Obama’s stimulus package and perhaps some congressional add-ons could increase the deficit to as much as $2 trillion. Depending on the length and severity of the recession, the deficit could exceed $1 trillion in the next fiscal year. Forecasting deficits over the next few years will be a tricky business, a combination of science, art, and luck.

Obama has also stated his desire to begin the process of bringing long-term deficits under control. To that end he has established a new office in the White House, Chief Performance Officer, filling it with Nancy Killefer, a high profile appointment. He has also encouraged his head of the Office of Management and Budget, Peter Orszag, to comb through the federal budget line-by-line to get rid of inefficient and bloated programs. He has promised that the stimulus package will not include any earmarks: “Read my lips. No earmarks.”

Giving Obama the benefit of the doubt, assume he keeps earmarks out of the stimulus. Depending on the precise definition of an earmark, the savings amount to $20-30 billion, a large sum of money. But it pales against a $2 trillion deficit, offsetting a mere 1-1.5% of the additional borrowing the deficit requires.

How Obama will bring long-term deficits under control will likely to have to wait until 2010 or 2011, when, hopefully, the stimulus succeeds in ending the recession and restoring growth.