[Marxism] Obama’s Ersatz Capitalism

[Louis Proyect]

NY Times, April 1, 2009
Op-Ed Contributor
Obama’s Ersatz Capitalism
By JOSEPH E. STIGLITZ

THE Obama administration’s $500 billion or more proposal to deal with 
America’s ailing banks has been described by some in the financial 
markets as a win-win-win proposal. Actually, it is a win-win-lose 
proposal: the banks win, investors win — and taxpayers lose.

Treasury hopes to get us out of the mess by replicating the flawed 
system that the private sector used to bring the world crashing down, 
with a proposal marked by overleveraging in the public sector, excessive 
complexity, poor incentives and a lack of transparency.

Let’s take a moment to remember what caused this mess in the first 
place. Banks got themselves, and our economy, into trouble by 
overleveraging — that is, using relatively little capital of their own, 
they borrowed heavily to buy extremely risky real estate assets. In the 
process, they used overly complex instruments like collateralized debt 
obligations.

The prospect of high compensation gave managers incentives to be 
shortsighted and undertake excessive risk, rather than lend money 
prudently. Banks made all these mistakes without anyone knowing, partly 
because so much of what they were doing was “off balance sheet” financing.

In theory, the administration’s plan is based on letting the market 
determine the prices of the banks’ “toxic assets” — including 
outstanding house loans and securities based on those loans. The 
reality, though, is that the market will not be pricing the toxic assets 
themselves, but options on those assets.

The two have little to do with each other. The government plan in effect 
involves insuring almost all losses. Since the private investors are 
spared most losses, then they primarily “value” their potential gains. 
This is exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or 
$200 in a year’s time. The average “value” of the asset is $100. 
Ignoring interest, this is what the asset would sell for in a 
competitive market. It is what the asset is “worth.” Under the plan by 
Treasury Secretary Timothy Geithner, the government would provide about 
92 percent of the money to buy the asset but would stand to receive only 
50 percent of any gains, and would absorb almost all of the losses. Some 
partnership!

Assume that one of the public-private partnerships the Treasury has 
promised to create is willing to pay $150 for the asset. That’s 50 
percent more than its true value, and the bank is more than happy to 
sell. So the private partner puts up $12, and the government supplies 
the rest — $12 in “equity” plus $126 in the form of a guaranteed loan.

If, in a year’s time, it turns out that the true value of the asset is 
zero, the private partner loses the $12, and the government loses $138. 
If the true value is $200, the government and the private partner split 
the $74 that’s left over after paying back the $126 loan. In that rosy 
scenario, the private partner more than triples his $12 investment. But 
the taxpayer, having risked $138, gains a mere $37.

Even in an imperfect market, one shouldn’t confuse the value of an asset 
with the value of the upside option on that asset.

But Americans are likely to lose even more than these calculations 
suggest, because of an effect called adverse selection. The banks get to 
choose the loans and securities that they want to sell. They will want 
to sell the worst assets, and especially the assets that they think the 
market overestimates (and thus is willing to pay too much for).

But the market is likely to recognize this, which will drive down the 
price that it is willing to pay. Only the government’s picking up enough 
of the losses overcomes this “adverse selection” effect. With the 
government absorbing the losses, the market doesn’t care if the banks 
are “cheating” them by selling their lousiest assets, because the 
government bears the cost.

The main problem is not a lack of liquidity. If it were, then a far 
simpler program would work: just provide the funds without loan 
guarantees. The real issue is that the banks made bad loans in a bubble 
and were highly leveraged. They have lost their capital, and this 
capital has to be replaced.

Paying fair market values for the assets will not work. Only by 
overpaying for the assets will the banks be adequately recapitalized. 
But overpaying for the assets simply shifts the losses to the 
government. In other words, the Geithner plan works only if and when the 
taxpayer loses big time.

Some Americans are afraid that the government might temporarily 
“nationalize” the banks, but that option would be preferable to the 
Geithner plan. After all, the F.D.I.C. has taken control of failing 
banks before, and done it well. It has even nationalized large 
institutions like Continental Illinois (taken over in 1984, back in 
private hands a few years later), and Washington Mutual (seized last 
September, and immediately resold).

What the Obama administration is doing is far worse than 
nationalization: it is ersatz capitalism, the privatizing of gains and 
the socializing of losses. It is a “partnership” in which one partner 
robs the other. And such partnerships — with the private sector in 
control — have perverse incentives, worse even than the ones that got us 
into the mess.

So what is the appeal of a proposal like this? Perhaps it’s the kind of 
Rube Goldberg device that Wall Street loves — clever, complex and 
nontransparent, allowing huge transfers of wealth to the financial 
markets. It has allowed the administration to avoid going back to 
Congress to ask for the money needed to fix our banks, and it provided a 
way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high 
costs of the administration’s plan become apparent, confidence will be 
eroded further. At that point the task of recreating a vibrant financial 
sector, and resuscitating the economy, will be even harder.

Joseph E. Stiglitz, a professor of economics at Columbia who was 
chairman of the Council of Economic Advisers from 1995 to 1997, was 
awarded the Nobel prize in economics in 2001.