Tuesday, 3 March 2009
Last year Myron Scholes predicted the credit crisis would be over on 7th March 2009.
That's coming up this Saturday, so how's the prediction looking?
Well, AIG has lost $60bn and received a further capital injection; the US government has just converted a bunch of debt into 30-odd percent of Citigroup; Martin Wolf has written another article with some nasty-sounding predictions. We're running short of time to fix the system if Myron is to be proved right.
To be clear, this is not about the recession. I don't think we expect economic growth to start in the next four days. It's about fixing the problems in the financial system so that money can start flowing and the recovery can properly begin.
The debate in the US over nationalisation is growing louder. Unusually, the argument is getting simpler rather than more complicated: the losses are there, shareholders have been (as close as makes no difference) wiped out, so do the remaining losses go to creditors or taxpayers?
If no government action is taken, and banks go under, creditors will lose substantially (in the short term). The argument against this (made by Justin Fox at Time) is that if creditors take a loss, they will immediately stop lending to all financial institutions. This would be disastrous for economic efficiency and make the recession much worse. Another argument which he doesn't mention is that even the possibility of this happening will cause a series of bank runs as creditors try to take their money out. However, sufficient government guarantees have been given already to probably prevent this from happening in the short term.
On this argument, taxpayers need to take the hit. But there is at least one counterargument.
Lending is, in theory, based on the returns people expect in future and not those they have received in the past. Therefore, if bank creditors take a haircut in a way that is credibly not going to happen again in the future, their lending behaviour should - in theory - be unaffected.
For example, if this policy were instituted in the US, simultaneously with a constitutional amendment saying that it could never be done again, owners of wealth might have the confidence to keep lending. In theory. Note that the amendment would probably need to be backed up with substantial regulatory legislation to protect taxpayers from the unlimited future losses that might result from the moral hazard created.
Or if the system were credibly recapitalised and regulated in such a way that creditors felt a financial bubble could never happen again, it might work. In theory.
But in reality, creditors who have just lost 10% - or 40% - of their money are unlikely to trust in such promises. Even in the unlikely event that they behave with perfect rationality, it's probably rational to wait a while before reinvesting to protect yourself against legislative instability. And they're not likely to be rational; they're likely to, frankly, fly into a tantrum and start pulling their money out of all sorts of places.
If only there were a way for governments to invisibly reduce creditors' claims without openly confiscating their assets - and without destroying future confidence in property rights. A way for creditors and taxpayers to wink at each other; colluding in sharing the pain, without losing the faith in credit that has built our economic system. Game theory suggests that rational players can lose a round or two if they believe the game will be played enough times in the future to make it worthwhile to keep playing.
There is, of course, such a way - inflation. 10-15% inflation over the next three years would probably haircut creditors sufficiently to eliminate the banking system's deficits. A number of respectable people (Scott Sumner for example) are arguing for an official, pre-announced inflation target (or alternatively a 3 or 5-year target for nominal prices) which would presumably give the banks enough breathing room to sort themselves out within that timeframe.
In rational terms, this is no different than chopping off 3% off creditors' assets each year; but it's within the rules of the 'con game' that is the world monetary system and economy (and I use that term with affection). And thus, it won't have the same destructive effect on confidence.
Of course it is a bit unfair; it forces creditors everywhere to subsidise the creditors who lent to insolvent banks; and it will take some time to work. It creates its own moral hazard problems too. But maybe we have to be utilitarian, let the kids threaten their temper tantrum and give in because it's just easier.
If President Obama and the IMF could just announce it all by Friday, Myron Scholes will have been right and I'll buy him a bottle of champagne. Let me know if you want to claim it, Professor Scholes.