Friday, October 10, 2008

Guest Post: A Non-Socialist Proposal to Help Recapitalize the Financial System 

Guest Post by John A. Spry, Ph.D. Opus College of Business, University of St. Thomas

One of the major problems during the present financial crisis is the need inject capital into the banks. As Professor Greg Mankiw wrote yesterday,
�There is broad agreement among economists that what the financial system needs right now is not only an injection of liquidity but also a recapitalization. The essence of the current financial crisis is that many firms bet that housing prices would not fall; the prices fell nonetheless; and now these firms have too little capital to perform the crucial function of financial intermediation.
How can the government act to get more equity capital into the banking system without the government ownership of at least part of the banks? How can we reduce the debt to equity leverage of banks and thus promote more trust in the banking system? Mankiw proposes that the government match private equity investments into banks with an one hundred percent government match of equity investment in banks that attract new private capital.
The question for the moment is, How can we get capital back into the financial system? Ideally, it would be great if more Warren Buffetts would step up to the plate and recapitalize financial firms with private money. Unfortunately, that might not happen fast enough to prevent a major economic downturn.

Some economists have proposed forcing these firms to go raise more capital from private sources. But how exactly can the government do that? It is not entirely clear how, as a legal matter, that can be accomplished. Perhaps regulators can twist the arms of the financial institutions. Call it the Tony Soprano approach. �Nice bank you have here. I wouldn�t want anything bad to happen to it.�

Other economists have suggested that the government inject capital itself. That raises several questions. First, which firms? The government does not want to put taxpayer money into �zombie� firms that are in fact deeply insolvent but have not yet recognized it. Second, at what price should the government buy in? Third, isn�t this, kind of, like socialism? That is, do we really want the government to start playing a large, continuing role running Wall Street and allocating capital resources? I certainly don't.

Here is an idea that might deal with these problems: The government can stand ready to be a silent partner to future Warren Buffetts.

It could work as follows. Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government�s shares would be nonvoting until the government sold the shares at a later date.

This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control.

Why would an undercapitalized financial firm take advantage of this offer? Because it would need to raise only half as much capital from private sources, that financing should be easier to come by. With Warren Buffetts in scarce supply, the government can in effect replicate them, by piggy backing on what they do.
My proposal: Give new equity investments in banks made over the next 30 days a guaranteed zero percent tax rate for the next 20 years.

Given our relatively high rates of capital taxation, the IRS already is a �silent� partner as it retains a significant fraction of the upside of equity investments. Instead of, or at least before launching Mankiw�s 100% match of new equity investments in banks with government money, while retaining high rate rates on the private equity investments in banks, first eliminates the taxes on new equity issued by banks.

The 30 days limit of the proposal it to encourage banks to raise equity through new stock offerings soon, while allowing the time to issue new stock. I agree with Mankiw that new private equity investments in banks would be just wait the �economics� doctor should prescribe. This plan lets market differential the sound banks from the �zombie banks� like the Mankiw plan, but without the government ownership of private bank stock.

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