Public Works Done Right
February 22, 2009
(This article originally appeared in the Daily Reckoning on February 18, 2009. More below.)
In November of 1929, in reaction to the breakdown of the stock market, Herbert Hoover immediately called for a raft of economy-supporting programs including substantial spending on public works projects. This round of public spending resulted in San Francisco’s Bay Bridge, the Los Angeles Aqueduct, Hoover Dam on the Colorado River, and many other such projects.
Hoover Dam is perhaps the most iconic of all of these efforts. Although environmentalists might argue, in terms of its benefits such as electricity generation and water supply for agriculture and eventually urban use, it is about as useful and worthwhile a public work as anyone could ever hope for. When it was completed, it was the world’s largest electric-power generation facility and the world’s largest concrete structure.
Planning for Hoover Dam began in 1922, and was overseen by Herbert Hoover himself. Construction on the project was approved by Congress in December 1928 — long before the economic problems emerged. It was, in contemporary terms, as close to a “shovel-ready” project as you’d find. The initial appropriation for construction was made in July 1930.
The project officially began in September 1930. The contract for construction was awarded to a joint venture of six private companies in March, 1931. The first thing they had to do was to make a small city for the workers who would be working on the project. Boulder City was occupied in the spring of 1932. Roughly 16,000 workers were part of the construction, and many brought their families to live in Boulder City.
Initial construction on the dam project itself began with the upper cofferdam in September 1932. Construction was completed in March 1936. It was considered a great accomplishment to complete such an ambitious project so quickly.
As a result of these spending programs, the Federal budget ballooned enormously. In 1929, the government had $3.862 billion of tax revenue, and spent $3.127 billion, enjoying a surplus of $734 million. In 1932, the government spent $4.659 billion, a 49% increase despite the “deflationary” environment.
In 1931, the government had its first deficit in eleven years, of $462 million. Perhaps this, and the spending commitments upcoming, is why Hoover pushed through an enormous tax hike in April 1932, which was enacted in June of that year. The top income tax rate in the U.S. rose to 63%, from 25% previously. Inheritance taxes were doubled, corporate tax rates rose, and a long list of excise taxes were imposed. It was predicted to raise $1.1 billion in new revenue, in an effort to close the budget deficit.
The tax didn’t help the economy much, however, and revenues remained weak. In 1932, revenue had collapsed to $1.924 billion, and were only $1.997 billion in 1933. The budget deficit exploded to $2.735 billion in 1932 and $2.602 billion in 1933.
John Maynard Keynes once argued that, in a depression, it would be worthwhile to pay workers to dig holes, and to pay other workers to fill them up. But how is this different than paying workers to do absolutely nothing? The main advantages appear to be psychological. “Workers” maintain a better morality and work ethic, and are less likely to revolt, than “welfare recipients.” And, they can be counted as “employed,” while a welfare recipient might remain “unemployed” until they actually found something productive to do in the economy.
We can see that it is not so easy to just “push money into an economy” via public works projects. The more useful they are, the more likely it is that they will take years of planning and construction. If the goal is to supposedly avoid some sort of downward spiral over the next six months, it is more likely that the funds will end up directed into something more like Keynes’ hole-digging exercise.
Thus, we can see that, when short-term “stimulus” becomes the focus, the effect is more likely to be short-term welfare. There is nothing particularly wrong with welfare in a depression. Better than having people dying in the streets. But, increased welfare spending isn’t much of an economic program in itself.
In retrospect, Hoover Dam was probably a worthwhile project. It produced something of value, and kept 16,000 workers busy over the 1931-1935 period, the worst part of the Depression. However, one effect of this aggressive deficit spending was an eventual rise in tax rates, which did additional economic harm. Roosevelt continued along the same path: spending soared up to $9.468 billion in 1940, and tax rates soared higher as well, with the top rate hitting 81% in 1940 (and 94% in 1945).
Politicians always like to spend other peoples’ money, so it is no surprise that they — always and everywhere — flock around those economic advisors that tell them that enormous spending projects are the key to resolving economic difficulties. Nor is it a surprise that economists are quick to tell people what they want to hear. If you’re going to be wrong all the time, you might as well be popular, well-paid, and wrong. Economics being what it is, you can always argue later that you were wrong because “people didn’t do enough.”
These ideas were solidified in a book written by John Maynard Keynes and published in 1936. Since governments had already been hard at work at “stimulus” for a half-decade or more already by that point, you could say that the book was a how-to guide for economists to justify policies that were already popular.
When you get past the cloud of nonsense surrounding “stimulus spending,” with its output gaps, multipliers and so forth, it seems to me that government spending during a recession accomplishes roughly what it does during any other time. Mostly, it is a big waste of money, but it might keep some people employed and maybe you’ll even be left with something useful afterwards. I would suggest a decent rail system, at least as good as that of France. Since we’re spending trillions anyway, how about as good as the U.S. had in 1910? That would be, I argue, the least bad of all possible boondoggles.
* * *
Eastern Europe: It’s the currency stupid! Lots of worry these days about Eastern Europe, where Western European banks have huge loans. The fix is easy — just fix the currency. Here’s how:
Instead, there is a lot of nonsense out there about “fiscal austerity” and so forth. It’s not a fiscal problem — it’s a currency problem.
What they should have done is just adopt the euro upon entering the eurozone a few years ago. Currency stability is the whole point of the euro! Then, nobody would be having these problems. Well, stupid actions produces stupid results.
It is sometimes hard to imagine that a whole subcontinent can have an economic meltdown, destroying the banking system of another subcontinent, because people can’t figure out these childishly easy principles. But, that’s really the way it works.
* * *
Volcker: Still the One. It’s amazing how Paul Volcker stands completely apart from the legions of prevaricating, spin-farting sycophants common in government today.
He scoffed at the notion that those entities must be free to innovate — stating that financial “innovations” like asset backed securities and credit default swaps have brought few benefits. The most important “innovation” in banking for most people in the last 20 or 30 years, he maintained, is the automatic teller machine.
I agree with this. The basic nuts and bolts of capitalism are mostly unchanged for the last 200 years, and they have worked fine. Equity, preferred equity and debt. The real purpose of the financial system is to finance commercial undertakings. “Finance” means “raise money for.” If you want to invest in something, you might need to raise money. You end up either selling equity or borrowing the money. Thus it has been for probably six hundred years. All the various repackaging and derivatives have served no real purpose in the financing of commerical operations. Mostly, “financial innovation” has been about repackaging equity or debt (mostly debt) into new forms, typically by making it so complex that the repackager can make some unearned money from the deal. If you take a bunch of BBB debt, and repackage it into forms which are (bizarrely) rated AAA, then you can sell the BBB debt for more than it’s worth. The other big form of “financial innovation” is mostly about inventing new casino games. The original casino game, the stock market, is not very profitable for the casino. (Trading commissions are low.) But, if you invent new casino games, mostly via derivatives, you can generate a bigger take for the casino operator. None of this has anything to do with the financing of commercial enterprises, which can function just fine with equity, preferred equity and debt as they have for centuries.
Maybe you noticed that the various banker-bailout packages have followed the same pattern. They are all basically free money for banks, but disguised in all manner of gratuitous complexity. Geithner’s most recent “public/private” approach represents a still-further complication, in a new attempt to hide the basic transaction of free taxpayer money. That’s financial engineering!
However, people are getting wise to the game.
* * *
“Nationalizing Banks” Good and Bad:
This op-ed came out in the Washington Post. My comments are in red.
Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume. Of course, the economy would still stink, but the death spiral we are in would end.
You don’t need to “nationalize.” Some sort of flash-bankruptcy would work fine. That would probably need government oversight, though.
Nationalization — call it “receivership” if that sounds more palatable — won’t be easy, but here is a set of principles for the government to go by:
First — and this is by far the toughest step — determine which banks are insolvent. Geithner’s stress test would be helpful here. The government should start with the big banks that have outside debt, and it should determine which are solvent and which aren’t in one fell swoop, to avoid panic. Otherwise, bringing down one big bank will start an immediate run on the equity and long-term debt of the others. It will be a rough ride, but the regulators must stay strong.
Second, immediately nationalize insolvent institutions. The equity holders will be wiped out, and long-term debt holders will have claims only after the depositors and other short-term creditors are paid off.
Now we come to the problem here. This is a liquidation plan. I think liquidation — of the ten or so largest financial institutions in the U.S. — would be quite risky. Well, maybe not: “risk” implies uncertainly, while I think this would definitely be a disaster. Plus, it is completely unnecessary.
Third, once an institution is taken over, separate its assets into good ones and bad ones. The bad assets would be valued at current (albeit depressed) values. Again, as in Geithner’s plan, private capital could purchase a fraction of those bad assets. As for the good assets, they would go private again, either through an IPO or a sale to a strategic buyer.
There is no need to separate “good” and “bad” assets. Assets are assets. They are all “good” assets at the right price — the price which reflects the discounted present value of the cashflows they are likely to generate. Just ask a distressed-debt fund manager. (In fact, I think that is exactly what some of these people should do.) Due to the extreme forms of metaphor economics that tend to prevail in crises, it seems that people think that “toxic” or “bad” assets are “contagious.” They aren’t. There is no reason why the fact that an institution holds “bad asset” A causes “good asset” B to go bad. Passing ownership of an asset from Bank A to Distressed Debt Fund B has no economic effect, except maybe some profit and loss.
You can see that, once you start calling something “toxic” or “contagious,” it sounds like it needs to be put in a stainless steel drum and buried under a mountain in Nevada. It’s not plutonium, its a mortgage! Unfortunately, most people really do just go by their metaphoric impressions, and thus reach for something that metaphorically sounds right, even though in real life it is completely inappropriate or irrelevant.
Also, as I’ve explained in great detail now, “bad” assets need to be serviced. This is complicated, and takes time and expertise. The institutions with the time and expertise — and the necessary huge trained staffs — are banks. Why would you want to liquidate the organization that exists exactly to solve the problem you have, namely, to service problem loans?
The proceeds from both these bad and good assets would first go to depositors and then to debt-holders, with some possible sharing with the government to cover administrative costs. If the depositors are paid off in full, then the government actually breaks even.
This is the model of the failed S&Ls. They were liquidated. This was possible because they were really very small, there were no debt holders, and they were so bust as to serve no useful economic purpose. Even so, it was a big mess. That won’t work so nicely for the giant banks.
The S&L liquidation was a huge avenue of theft for well-connected insiders (bankers) who were able to purchase assets from the government at super-low prices. Just another way to steal from taxpayers. One reason I would like to leave all the assets in place is to minimize further theft of this nature.
The profits from the S&L liquidation were in the hundreds of billions, so it is perhaps no surprise that bankers are pushing for another giveaway. Even on death’s door, they’re looking for another scam! One of our problems here is that the people who really have the expertise to fix this stuff are, apparently, universally dishonest. They would rather lie, cheat and steal their way to another fat bonus.
Fourth, merge all the remaining bad assets into one enterprise. The assets could be held to maturity or eventually sold off with the gains and risks accruing to the taxpayers.
There is no need to put “bad assets” in one spot. Governments seem to have a fixation with this. You can just have banks hold the assets to maturity. Debt is very simple. It has a value between $1.00 (you get all your money back) or $0.00 (you get nothing). That’s the worst- and best-case scenarios. The really toxic stuff is the derivatives, where there is practically unlimited potential liability. I have thought that what might help is to put the derivatives books of these nationalized/restructured banks into one entity. That might be less messy than just declaring them all null and void. Since several banks would be involved, in many cases the entity will own both sides of the trade and will be able to net them out. There are other advantages too.
The eventual outcome would be a healthy financial system with many new banks capitalized by good assets. Insolvent, too-big-to-fail banks would be broken up into smaller pieces less likely to threaten the whole financial system. Regulatory reforms would also be instituted to reduce the chances of costly future crises.
Assets don’t “capitalize” banks. The assets are on the Asset side of the balance sheet. The capitalization is on the Liabilities side (debt and equity). The asset side isn’t really the problem here. If banks were capitalized at 100% equity — this is known as “asset-based lending” and yes, there are ABL hedge funds out there — then there wouldn’t be a financial problem. The value of the assets would fall by about 15%, and the value of the equity would also fall by about 15%. Big deal. The problem is the capitalization, the liabilities side of the balance sheet. Banks are levered entities (capitalized with lots of debt), and in recent years they have been extremely levered. They have run out of equity. The easiest way to solve this problem — and the normal way in a bankruptcy restructuring — is to convert the debt into equity. Then there is plenty of equity again.
The assets are not only the loans of banks, they are also the business of banks, including the tens of thousands of people who are servicing the assets. You can leave the asset side — the business — alone, and just deal with the liabilities side.
With all that said, it would be nice to break some of the giant banks into smaller sizes.
This probably represents about the best that people can come up with at this time. I think they’ll be able to refine it if they stick with it a bit longer.
* * *
Worse Than the Depression Watch: Soros and Volcker.
NEW YORK (Reuters) – Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.
Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union.
He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system.
“We witnessed the collapse of the financial system,” Soros said at a Columbia University dinner. “It was placed on life support, and it’s still on life support. There’s no sign that we are anywhere near a bottom.”
His comments echoed those made earlier at the same conference by Paul Volcker, a former Federal Reserve chairman who is now a top adviser to President Barack Obama.
Volcker said industrial production around the world was declining even more rapidly than in the United States, which is itself under severe strain.
“I don’t remember any time, maybe even in the Great Depression, when things went down quite so fast, quite so uniformly around the world,” Volcker said.