Why don't we let the government guarantee the stock market?

I think that might be the ultimate end-point of the type of thinking that Interfluidity is pursuing. It's not terribly different from the type of microequity market I was imagining as a capitalist paradise. Of course, I wasn't proposing that the government actually guarantee some minimal price to equity investors as a way of encouraging them to risk their capital. I was propopsing to force them to risk their capital by making it illegal not to. But this is perhaps a minor difference.

The logic of guaranteeing a floor for the stock market is not as crazy as it first seems. First, you have to realize that we are guaranteeing the banks via the FDIC. History has fairly conclusively shown that banking without the FDIC is inherently unstable.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost.

Then you have to acknowledge that the current proposals about public-private partnerships are structure to be more of the same. One way of looking at either of these is to say that the FDIC has been mis-pricing its insurance in the past, and that the proposed "bad bank" structures amount to selling the private sector a put while collecting a very low premium (they are right here that the devil is in the details of how it is structured).

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won't speak for CR, but some of us would disagree with JH's presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH's plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers' put option and its "vega" — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry's quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It's as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

Once you realize that we have always been paying for the public good of having people give their savings to a bank so that it can be invested rather than keep it in their sock (though this is only apparent in crises) you can ask if there is any better way to do encourage this. To wit:

Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms' reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

So maybe all capital should be equity capital. The problem of creating the public good of encouraging people to take this risk could be solved either, as he suggests, by increasing their leverage, or by guaranteeing them some minimal worst case outcome, say by agreeing to buy the equity of any company at $1 and restructure it or shut it down. Either way, we should make explicit that financial markets are a public good that we all pay for equally with out taxes -- the question is just how to engineer the public good of sensible private risk taking.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we'd like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.