Haircuts, Hazards, and Hand-Grenades

I need a haircut. It has been more than six weeks since my last visit to the Crosstown Barber Shop and the little hairs on the back of my neck are looking unsightly.  But the market’s down and I was hoping to get a little more mileage on the last haircut. And there is the odd chance that government, feeling sorry for old people like me, might come to my rescue with a haircut subsidy.

While the above sounds really silly it is not a bad description of what is happening today around the globe.  Today we use the term haircut to describe the ability or willingness of the private sector to share at least part of the credit losses that have occurred in the last several years. A haircut means that a creditor agrees to take less than the promised or expected return on an asset. When it comes to housing in the US, Ireland and a few other places the haircut has to do with financial institutions that hold bad mortgage loans and/or derivatives tied to these loans. When it comes to European and other banks it has to do with banks and other financial institutions that are holding sovereign debt or the official government debt of Greece and other European nations.

We are not used to talking about haircuts in this manner. In the past, banks and financial institutions that held bad investments were seen as poor decision makers and we generally believe they needed to take care of their own business problems.  If they made bad investments and could not stand behind their debts then they should go into bankruptcy or go out of business. One such institution might try to sell its investments and willingly take a price reduction or haircut in order to maintain cash flow. But this decision was a private one – taken by a troubled financial institution to resolve its difficulties. It was not a matter of public policy.

Today things are different. Today we are in a financial crisis in which the proportions of the problem go well beyond a few firms, a few industries and beyond a few countries. The proportions also go well beyond an amount of debt which could easily be paid with government assistance from a single country or even a consortium of countries. Simply put, the financial crisis has most of us in a very deep hole. If it was not such a deep hole, we would have been out of it by now. If it was not such a deep hole, we would not have so much discussion and such little real action. This is not only a deep hole but it is a new one. Financial crises have come and gone. But most of these past financial crises have been limited to one or a few countries. 

These crises came before the age of GLOBALEV. GLOBALEV is a time when leverage became excessive. GLOBALEV is a time of global interconnectedness that turned the financial industry into a highly interdependent organism.  GLOBALEV is a time when housing and financial market bubbles burst and the negative impacts were quickly transmitted to financial institutions in most countries.

In short, we find most countries of the world sharing a very large financial burden. While bankruptcy and debt reneging/renegotiation might have been appropriate in the past, these solutions won’t work in GLOBALEV. There is too much money involved and too many countries that would be part of a downward cycle of default. Asking private investors to assume the whole load of this debt crisis is like asking me to lift a building. A more relevant question, however, is to ask HOW MUCH of the current debt crisis could realistically be carried by the private sector. That is, how much of a haircut are private financial institutions able to take? One might argue that they should take 100% of the burden. This is the way things ought to work in more normal times. But in GLOBALEV it is not possible.  If we asked all financial institutions to clear their nonperforming debt by tomorrow, the world’s financial system would grind to a quick halt.

Many are quick to point out the phenomenon of moral hazard. And they are correct to do that. If you do not make private financial firms assume the full burden of their investments, then they will assume that they will never have to do that in the future. Whatever harmful practices got them into the current problem would surely continue in the future. So the moral hazard issue is real and worth considering when determining the size of the haircut. With the financial crisis so deep and wide, a moral hazard cannot be avoided.

So if the private financial firms cannot withstand full responsibility for their bad investments, then they must be assumed by society.  GLOBALEV implies there must be a shared responsibility. 

This issue reminds me of people who live in flood plains whose property is destroyed by over-flowing rivers and oceans. Whether they were insured or not, it always seems to be the case that society ends up sharing the costs when homes are destroyed by flooding waters. I always gripe that this is unfair to those of us who do not live near water. But it seems to go on and on. After the waters recede people rebuild in the very same places. It sounds crazy but I think about the outpouring of both private and public relief that is mobilized every time there is severe human misery inflicted by Mother Nature. If tax-payers are unable to protect themselves from irrational home location decisions, it seems that we are equally impotent when it comes to deep financial crises.

Some of you are grinding your teeth right now. But I think it is unavoidable that a financial bailout will be part of the solution to our financial crisis. It will send the wrong signal to bailed-out firms and it will not prevent future disasters from happening in the future, but it will be part of a solution that might work.  It might work because the problem is so deep and it requires more assets than the private sector can now provide.  GLOBLEV requires a tax-payer contribution and the only question is HOW MUCH of the total amount is paid through government. Many options are possible. At one extreme the government can shoulder 99%.  At the other tax-payers might fork over 1%. But more than likely, the amount paid by tax-payers will be somewhere in between. 

Unfortunately HOW MUCH the taxpayer pays has become a political/ideological stick of dynamite. Inasmuch we are several years beyond the beginning of the financial crisis and we have little in the way of policy progress. Much has not been legislated and much of what has been legislated has not been put into practice. Stalling, or not deciding HOW MUCH the taxpayer contributes, is the one and only reason why we are staring down the barrel of a double-dip shotgun and why we have made little or no progress in employment.

Right now most of the news is about Europe and the lack of progress on their sovereign crisis. This negative cloud is hanging over all of us. Why? This cloud exists because Germany leads a group of countries that insists on a larger haircut and a small government contribution. France is part of a block that thinks a larger social portion must be paid. In Europe the usual problem of who pays gets even tougher and more political because it not only pits the creditors against the tax-payers but it pits country against country. If most of the debtors are in southern countries and the richer tax payers are in the north, then it is much more difficult to find a sharing solution that seems fair.

What’s happening in Europe is no different than our experience in the US. We continue to have a huge overhang of mortgage debt. We continue to have banks that sit on a razor’s edge of financial stability. We wonder why housing prices keep falling and no clear end to the housing crisis is in sight. But our politicians, like their cousins in Europe, do not want to admit or deal with deciding on the private haircut and the public split. Conservatives want the market to bear the full brunt.  Liberals want the tax-payers to pick-up a larger share of the debt.  Yet nothing will be accomplished until they admit the reality of the situation and get on with a compromise. In the meantime no jobs bill will restore demand or supply to a nation that sees no solution to GLOBLEV. So long as GLOBDEV remains, banks will not lend and houses will not sell.  Firms will continue to have less than sanguine expectations and will see no need to expand employment.

I personally have no frog in this race when it comes to deciding the size of the private haircut. As I said above, the smaller it is the bigger is the problem of moral hazard. Furthermore, the more tax-payers bear the burden the more our national debt increases and the more our financial reputation is a stake. Shifting the burden of finance from the private to the public therefore has its risks. But then the bigger you make the private haircut, the larger the risk you take with respect to the crumbling of global financial markets. This is a deep hole and there is no free lunch. But the more we pretend this is an ideological problem the more we stall a solution and the longer we languish in economic purgatory. We need some experts to decide the proper ratio of public to private responsibility and then we need politicians to bring home the solution. I am not optimistic we will get what we need anytime soon.