Ifo Viewpoint No. 104: Stuffing the Goose Strategy
Munich, 01 April 2009
The US banking system is bankrupt and is to be rescued with state money. Western Europe’s banks are limping. In Eastern Europe a time bomb is ticking. And all this just because banks, hedge funds, special purpose vehicles, investment funds and real-estate financers were allowed to conduct their business with only tiny amounts of equity capital. Without equity there is no liability, and without liability people gamble. They hunt for risks wherever they can find them because they can privatise profits and socialise the losses. Now the jungle is burning and no one knows how to put out the fire.
Even Chicago-school economists must understand that markets can only function within a strong regulatory framework. This applies especially to financial markets, where the losses can exceed capital reserves many times over. Strict banking regulation acts as a barrier against opportunism. Only strict regulations can create the confidence in the markets that capitalism needs to continue to increase the prosperity of the masses. America needs Walter Eucken, the father of ordoliberalism.
But before Eucken lands in America, Keynes must save the banks and the economy. To do this the state needs to have ownership rights in the banks that are afflicted. The banks cannot be allowed to shrink themselves back to health instead of accepting money from the state because then the economy itself would shrink to death. My proposal: Any bank that does not find enough capital from the market to shore up its balance sheet with at least 4 percent equity capital and a tier-one ratio of 8 percent (core capital relative to risk weighted assets), on average for the past three years, must let the state supply the required capital and become a partner. I call this the stuffing-of-the-goose strategy.
Long-term and short-run goals coincide here, because only with fresh capital will the banks begin to trust each other again. Since as things now stand the capital can only come from the state, there is no alternative to partial nationalisation. Partial nationalisation is not expropriation but a forced issue of new shares to increase the bank’s capital. There is no objection to the old stockholders remaining on board. But the bank must sell the state so many new shares, at prevailing market rates, until the required equity ratios are reached. The old shareholders should not have the right to block this if the conditions do not suit them. What their investment is still worth will be seen in the stock market and not in the balance sheet. And before the state is awarded its share, the new stocks should be offered on the stock market at the planned price. Then no one can claim to have been treated unfairly.
Of course banks should not become government agencies. The state has deeper pockets, to be sure, but it is a bad banker. The private legal form must be maintained because the state will have to sell back its shares when the crisis is over, hopefully at some profit.
The bad bank, however, is a bad idea. It only makes sense if the state pays more money than the market is willing to, but then the state would be giving away the taxpayers’ money. To prevent taxpayers from being cheated, nationalisation must precede the creation of a bad bank. That was the Swedish remedy, and it worked. President Obama’s plan also amounts to giving money to the stockholders. The one trillion dollars that is to be paid as a “scrapping” bonus for toxic assets is about as high as the capital reserves of the entire US banking system. Hedge funds will receive a sizeable portion. No wonder the stock market rallied. Wall Street has managed to prevail again.
When the banks are saved, Eucken can take over. The most important ordoliberal rule is to require considerably higher capital reserves. This is the key strategy for the recovery of the banks, because it increases the liability of the stockholders. Higher capital reserve requirements are better able to cushion shocks and create a more cautious approach to risk taking. This will also bring about a change in management compensation systems. Accordingly, Basel II also needs to be overhauled. Today the banks’ assets are reduced computationally to a fraction of the balance-sheet total, and the core capital ratio leads us to believe that the equity asset ratio is up to five times larger than it actually is. This institutional monkey business has to stop. Basel III must mandate fair weights for risk-weighted assets that make the banks’ risk weighted assets on average as large as the balance-sheet total. Only then will we again have a sound banking system. And we need not fear that capital will be lacking if more capital reserves must be held. The savings in an economy are always sufficient to finance investments, whether they be transferred to the firms in the form of owner’s equity or loan capital.
All of the regulations for the new banking system must be harmonised internationally, because otherwise the countries will relax their regulations to undercut each other. Without harmonisation there would again be a competition of laxity relating to where banks decide to do business. Then we would be right back where we started. In Europe the European Central Bank must take over banking supervision. In Germany, BaFin, the Federal Financial Supervisory Authority, must be subject to the Bundesbank and not the Finance Ministry. This is the only alternative. The necessary international umbrella organisation can be formed by the International Monetary Fund or the United Nations. This is a solution that the Anglo-Americans should also be able to accept at the World Financial Summit, since both organisations are headquartered in America.
Professor for Economics and Public Finance
President of the Ifo Institute
Published as “Stragegie der Stopfgans”, WirtschaftsWoche, No.14, 30 March 2009, p. 40.