Finance, TARP, and the Great Recession
At the unpleasant session yesterday, I did learn something interesting from Doyne Farmer of the Santa Fe Institute, while he was ranting against the state of the art in macroeconomic models. He said that in 2006, the Fed simulated a 20 percent decline in home prices in its model, and the effect was minor.
That sounds highly plausible, of course. But it just adds to my frustration about the infamous Blinder-Zandi black-box simulations purporting to show that the economy would have been much worse without TARP. Such an exercise assumes that we have precise quantitative knowledge of the feedback between real and financial variables. But the exercise that Farmer referred to illustrates just how weak an assumption that is.
These days, we are hearing that TARP is ending, that it will cost less than expected, and that it worked. In an interview at the main event yesterday, Treasury Secretary Geithner says that by injecting capital into large banks, policy makers did something unpopular that would benefit the country. They took one for the team, so to speak.
This may be the true narrative. But there are many unknowns.
Relative to what I expected in 2008, more large banks survived and more small banks failed. That could very well reflect that my impressions were wrong. Alternatively, it could be that TARP raised the franchise value of large banks relative to that of small banks, shifting the government’s losses from TARP to the FDIC.
Relative to what I would have liked to see, the process of getting people out of homes they cannot afford and allowing home prices to reach their natural level has been dragged out. This may have redistributed losses across institutions and over time. Perhaps FHA, Freddie Mac, and Fannie Mae are taking losses that otherwise would have been incurred by private banks.
We do not know what is going on with the Fed’s portfolio of mortgage securities. Have they appreciated in value, or has the Fed absorbed losses that otherwise would have been taken by the banks?
If AIG survives as a going concern, is that because (a) the losses on its credit default swaps were much lower than people feared two years ago or (b) the value of the lines of business that it sold off since then was high enough to cover large losses?
The insider narrative has always emphasized panic and illiquidity. The outsider narrative has always emphasized bad investments and insolvency. In the insider narrative, the TARP halted the panic and restored confidence. The apparently large declines in bank asset values were due to temporary market malfunction, Now that the market is functioning again, the assets are being restored to reasonable values. In the outsider narrative, the losses were genuine. The dodgy assets did not recover their values. They just got shifted around.
The outsiders ask, if TARP worked, why did the real economy take such a huge hit? The insiders insist that without TARP, the hit would have been even worse.
There are some facts out there that make it difficult to argue for the outsider narrative. There are facts out there that make it difficult to argue for the insider narrative. I recommend trying to keep an open mind.