Hempton’s Law of the Conservation of Subsidy

By Felix Salmon
April 2, 2009

John Hempton has a nifty piece of logic demonstrating that it doesn’t make sense to bellyache about the implicit subsidy in the Geithner bank bailout plan. It’s worth reading the whole post, but basically he’s saying that the subsidy only really kicks in when the banks are insolvent, and since the government has promised “no more Lehmans”, insolvent banks are going to be receiving generous dollops of government subsidy in one form or another anyway.

Call it Hempton’s Law of the Conservation of Subsidy: Subsidy can neither be created nor destroyed, it can only be changed from one form to another.

I think John might be on to something here, but I still think there’s a strong case to be made for maximizing the transparency of any government subsidy to the banking system. The critics of the subsidy implicit in the Geithner plan aren’t in general critics on the grounds that it constitutes excessive government spending — we’re mostly supporters of the stimulus package, for instance. Rather, my problem with the implicit subsidy is more about the “implicit” part than the “subsidy” part. If you’re going to subsidize the banks, let’s make it very clear which banks you’re subsidizing, and how much you’re subsidizing them by.

This is all connected to the nationalization debate, of course. Every time the government throws a certain amount of cash at a bank, it’s quite easy to calculate the ownership stake that quantity of money could buy, given the prevailing share price. And so you get pro-nationalization rhetoric along the lines of “we could have bought Citigroup X times over for the amount of money we’ve given them”.

If you hide that money in some combination of PPIPs and the FDIC, however, then it’s never possible to calculate how much any given bank has benefitted from the taxpayer plan. You get all the costs of nationalization with none of the upside. So it’s easy to see how a government which doesn’t want to nationalize — like this one — came up with the PPIP scheme. It might not reduce the total subsidy going to the financial sector, but it certainly reduces its transparency.


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What I liked about Hempton’s approach which was that it stated assumptions and examined the PPIP heuristically, because, quite frankly, the details are sketchy. So, assume “No More Lehman’s”, which I do, makes sense as a useful approach for evaluating the PPIP. As well, I assume that we cannot currently, and possibly not in the near future, seize a bank. I used to believe differently:

http://www.nytimes.com/2008/10/10/busine ss/worldbusiness/10global.html?pagewante d=1&hp

“The White House confirmed that the Treasury Department was considering taking ownership positions in banks as part of its $700 billion rescue package. But officials said the idea was less developed than the plan to buy distressed assets from banks through “reverse auctions.”

The goal, Treasury officials said, is a plan that would be broadly available to all banks, rather than through specific rescue packages negotiated on a case-by-case basis. That makes it likely that the government could afford to take only a small stake in any single institution.

The direct injections of cash would be for comparatively healthy banks. If a bank is failing and needs to be rescued or shut down, the Federal Deposit Insurance Corporation would handle it through its own procedures.”

For a long time, I believed that. For one thing, I couldn’t imagine that the FDIC didn’t have a plan to seize any possibly insolvent bank, because I thought that was their job. Silly me. Now I believe differently.

So, I have two assumptions to work from. What I’m having a hard time crediting are “proofs” that begin like this:

“Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time.”

Why would I do that? I don’t know or assume any such thing. One thing that I learned from studying skepticism, beware of arguments that say ” Consider x…” or “Assume x…”. I don’t do any such thing until I’m convinced that it makes sense to do so. If I do follow any such “proof”, I’ll use it if and when the real world seems to approximate it, or show me that it’s useful. As of yet, many of these “proofs” are of little or no use, except, in a few cases, to point to possible problems that we should look for in the PPIP. I say “possible”.

Hempton’s approach also noticed, quite correctly, that there were dueling subsidies and incentives in the PPIP. If you don’t see that, the whole PPIP must seem very strange indeed.

But, if you like these kind of arguments, be my guest and credit them. Just don’t blame me when the skeptic has shown you, beyond doubt, that the real world doesn’t exist.


“One potential criticism of Krugman and his ilk in this case is that they choose outcomes to fit their conclusion. But it is precisely the outliers that create the problem and the risk to the taxpayer. So it’s not clear that even this criticism is warranted.

In any event, they’re being consistent. Therefore, they’re not being illogical.

The use of the terminology “non-recourse” in these discussions is confusing and unnecessary. The fact that both bank debt and Geithner debt are non-recourse at the fundamental level of the equity investor is irrelevant to a comparison of the differences in these funding alternatives. The fact that both bank debt and Geithner debt have puts to the taxpayer similarly adds nothing to the comparison. The comparison rests on the structure of the put. The put structure is aggregate in the case of the bank. It is subdivided in the case of the Geithner plan. This means the collective outcome is different in the two cases, depending on the constituent outcomes. It is the effect of the subdivision of the put that creates all of the extra risk for the taxpayer in the Geithner plan.”

Posted by maynardGkeynes | Report as abusive

I am certainly no expert, but my concern about this plan is that it might serve to prop the zombies up for a few more months, move the day of reckoning forward a year or so, but not fix the underlying problems. If I understand it correctly, the banks will have a choice about whether to sell their “legacy” (aka crap) assets at the offered prices. It’s easy to imagine that this will lead the banks to sell only the least bad of their legacy assets, particularly if selling them all at a fair price would lead to them being obviously insolvent. The existing management and shareholders and employees and bondholders of Citibank, say, seem to have an incentive to try to get their bank propped up for another year or two, in hopes that things will get better or some big bet will pay off or whatever. Because if they become obviously insolvent, they’ll have to be closed down, and all those groups will take a hit.

It seems to me, again as no expert at all in this stuff, like we’ve spent the last year and more trying to put off the day of reckoning for these big financial companies. If this is just another scheme to push the day of reckoning forward another year, then it has big costs–big banks that still aren’t healthy for another year, continuing problems caused by everyone worrying about counterparty risk (because they know that some of the big banks are still sick, but they don’t have a good way of deciding exactly which ones), and both political and budget problems with addressing the problem a year from now, maybe with a resurgent Republican position in congress after the midterm elections and divided government, maybe with much more trouble financing continued deficit spending, maybe just with public outrage at yet another blank check handed to the biggest banks when there’s 14% unemployment.

Is there a reason this can’t happen or isn’t likely?

Posted by albatross | Report as abusive

It’s also hiding the implicit bailout of PIMCO from bondholder hell.

“You get all the costs of nationalization with none of the upside.”

Also, if we can spend how many umpty-bazillion dollars, and we can organize an auction like this, we can nationalize the banks.

['At some point, the adminstrative headache, when combined with the refusal to nationalize, is an admission that we cannot regulate the banks either.']

Posted by max | Report as abusive