State as grand speculator
There is a nice article in The Economist about history lessons regarding crises. A quote:
“In today’s unholy tangle of short-term funding and long-term derivatives contracts, more banks may well fall into the liquidity traps that snared Bear and Britain’s Northern Rock. If so, central banks may find they have to go further than ever and provide a floor for asset prices in illiquid markets. Since banks are unwilling to trade in mortgage assets, because they do not have the capital or cannot risk marking losses to market, there may be an opportunity for governments to buy assets at big discounts. Judicious intervention could in principle improve liquidity, bolster confidence and may in the end even make money for taxpayers if asset prices recover. But supporting badly run investment banks should also come with strings attached: regulatory control to reduce the chance that public support will be needed again.”
Think for a while what The Economist seems to suggest. One post below there is a story from Financial Times suggesting that excellent results achieved by Chinese state owned companies may call for rethinking of 21th century economic mantras, that state ownership is always bad (with exception to public goods).
The Economist article goes even further. It says that governments should use the current crisis as an opportunity to buy assets at silly prices. The current economic set up is ideal for this type of transactions. Credit risk is dirt cheap, while yields of government securities are way to low to be treated as forecasts of central bank interest rates in the future. So The Economist implicitly suggests the following. Because bankers of the world want government bonds, lets offer lots of them in safe heaven places (Switzerland and Japan, US tresuries, German bunds). This will make bankers happy, they will finally have LIQUID ASSETS, no bank runs, trust will be back, repo market will be in goos shape again. Governments should then use raised funds to buy cheap assets (bank shares, bank bonds, bank and insurance companies owned collateralized loan portfolios, credit derivatives portfolios, you name it). Becasue state cannot go belly up (assume that recent Russia and Argentina are exceptions rather than rule) government can hold these portfolios until panic goes away, and make tons of money.
I have argued long time ago, that Sovereign Wealth Funds should be doing this. While Fed horror dance is creating huge moral hazard, SWFs bid would be seen as long-term smart investemnt strategy. Now The Economist suggest that governments in many countries should turn themselves into leveraged buyers of mortgage linked securities. Imagine weekly cabinet starting with a PM address “I have a great pleasure to inform you, my cabinet ministers, that iTraxx fell by 67 bps last week which means a mark-to-whatever gain for our government leveraged position by 27 billion XYZ. That is great, healthcare minister would scream, we can finally implement long overdue plan to modernize hospitals. Yeah, yeah, infrastructure minister would add, and build new highway or modernize railway.
Most prime ministers would have no clue what MBS stands for, My Big Support may come to their mind. So it is risky to ask them to become grand speculators. But Economist may have a point here, it may be a clever way to reduce banking sector exposure to liquidity/systemic fallout risk then pumping trillions of dollars/euros into the system by central banks. It will also punish those who should be punished, as banks would get treasuries yielding negative real rates, their earnings will return to long-term averages, and CEO bonuses too. In the long term governments net asset positions will improve, which will make it easier to balance budgets.
This is no free lunch, and it is not Pareto improvement, as imprudent banks will suffer, as they should, no pain no gain my karate sensei used to say. But it may be better than running Greenspan put policy for the third decade in a row.
It is high time, that for the first time in the history of financial markets, that low paid ministry clerks outsmart overpaid investment bankers.
This is my interpretation of The Economist recommended policy adjustment. Does it make sense?