Capitalistic Communism: The time where all financial institutions belong to the state

The Soviet Union Saving Bank book

When the late 2007 crisis was at its initial states, very few voices of worry were heard in world. "Just another slump of the economy" most people thought. "We have seen a lot and this is nothing special." Yet, a few months later, when things began to get more serious many were concerned about the future. Then came the collapse of the Lehman Brothers investment bank, which marked an era of state involvement in the market. The US Congress allowed for a $500 billion cash injection in the market (the Troubled Asset Relief Program), with direct asset purchases through the stock market. The time of nationalizations had began.

The crisis moved to Europe in no time. It was not long before many banks were forced to seek government assistance in order to stay afloat. Her Majesty's Government in the UK acquired an 84% stake in Royal Bank of Scotland (RBS), a 43.5% in Lloyds TSB and a 43.5% in HBOS (Lloyds later acquired HBOS). In Holland stakes in ABN AMRO Bank and Fortis Bank were bought by the government, with ING Groep also assisted later, and SNS Reaal was also bailed-out just yesterday.

Spain's Bankia was another indication of the terrible state of the financial system, requesting a €19 billion bail-out on 25 May 2012. During the same time, in Cyprus, Popular Bank received a €1.8 billion bail-out making it 84% state-owned. Just as more banks are announcing their yearly results, Credit Agricole announced a €2.7 billion write-down yesterday and Germany’s Deutsche Bank posted a loss of €2.2 billion the day before. I do not have any current knowledge concerning the state of recapitalization procession in Greece and by how much the state will be involved in the banks, yet it will not be minimal. When Monte dei Paschi di Siena's audit is finished by the Italian authorities we will also have a clearer view on whether the state will assist it, as it did with Banco Popolare in 2009.

What may have caused this? The simple answer is the housing price crashes which followed housing bubbles in more than 25 countries around the world. With increased exposure to investment banking, most of the banks had severe losses during the first years of the Great Recession. Then, some had to request state assistance. With governments classifying them as "systemic" they had no option but to bail them out. This increased the national debt. Thus, they had to take some austerity measures in order to bring their deficits down. This pushed the economy further into recession and many more financial institutions were brought to their knees.

The issue is what becomes next. Will banks be perpetually in the hands of governments? Although control may not be held by the state (as in the case of British banks where the government received only preferred shares) it appears as if we are moving towards an economy where most banks are controlled by the state. I would not discuss the idea of whether this is good or bad. Yet, it would be very likely that conflicts of interest would rise in the case where governments control financial institutions. Thus, when states decide to bail-out an institution they should be sure that it will be able to pay back the hard-earned taxpayers money.

What I have never understood is why government just hand the bail-out money to the institutions which pose systemic danger instead of doing something about it. Wikipedia defines systemic risk as "the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market."

If we know what systemic risk is and we know which organizations are likely to produce such effects how come we are not doing anything about it? Why don't regulators split the state-owned institution into 2 or 3 (or more) smaller ones which would pose much less strain on the economy if they fail instead of just perpetuating the situation? In addition to less danger to the economy, competition will also be increased, giving more opportunities and lower prices to the consumers and even more jobs will be created. Yet, no government has taken such actions even though they have classified institutions as posing systemic danger. This would have the extra advantage (for the government) of being able to sell the stakes they currently own over an IPO to investors, thus making sure that they will receive their money back, with a profit.

One cannot help wondering what are they waiting for...

P.S. New Eurostat data suggest that the EA17 unemployment has risen by 1% over the past year. Highest increases were noted in Greece, 7%, Cyprus 5% and Spain 3%. Wondering how much time it would take for policymakers to understand that what they are doing is wrong.

Are Privatizations a Good Idea?

The transfer of companies held under the control of the state to private individuals has received great attention over the last months. The latest information from Greece claim that by privatizing 6-7 large corporations the country will receive more than EUR 2.5 billion, money that will undoubtedly be very useful during this current situation.

In economic theory the value of these companies is derived by calculating the discounted value of all future cash flows to be received by the company. In a (very) simple example if a company was expected to bring in EUR200 million per year for the next 10 years and then dissolve, with an interest rate of 0% (a highly unlikely scenario), then the value of this company would be EUR 2 billion. As you may have guessed, the should be no monetary difference between the money received now and the money received as an annuity. Thus, this is what many economists state as "creative accounting": getting more money now, but losing all the future streams of cash; it may look good now, but you will deprive future generations of their cash.

Nevertheless, there can be some good derived by privatizing public companies: corrupt officers and state officials cannot appoint whoever they please as an employee of those companies, without caring for what is best for the company and its consumers. This was the case with many organizations in Greece, and I do believe that very few Greeks will deny this fact. Reducing costs may not, however, result to lower prices for consumers as the popular belief may be, although they are in general a good thing as they may be used in funding new projects or distributing profits to shareholders (which is very good as this increases consumption, savings and investment).

The issue here is that privatizations should not happen just for the monetary compensation as the rationale behind it is fallacious. They should occur as a means to promote a better environment for the state companies and to promote investment as well as consumption. This can also occur when the state does not have controlling interest (more than 50%) in a company.

A rally against privatizations in New Zealand, July 2012. It looks like this is
a worldwide phenomenon. Source: Wikimedia Commons

The optimal solution for this problem would be for the Greek state to keep a reduced amount of equity in the companies it will privatize (around 20% but not more than 30%). This would allow both the company to operate without the state forcing officials or policies to them, and the country can still benefit from both the future cash flow as well as from the income it will receive from selling part of the equity they hold. This is one of the very situations in real life when a true win-win situation occurs: both the company and the state benefit. The only drawback is that the state will not receive as much money as by selling its whole share in the companies. This drawback is however very small compared to the benefits such a decision would have both in the medium- as well as the long-run.

P.S. I do really hope that when the Greek state finally sells its share in state companies (whether all of it or just a part) it will choose to do so to more than one investors. Transferring power to just one person was, is, and never will be a good idea.

Privatizations vs Competition or The fallacy of Economists

Having been away for two days, I had that secret fear that something big would occur during the weekend and that I would miss it. Fortunately for me, (and unfortunately for the EU) nothing very exciting has happened.

The first major story I noticed in the news, was that Greece had already pledged on austerity measures worth 11.5 billion euros in order to receive the additional financial aid it requires to avoid bankruptcy. Specifics concerning the measures will be presented in September. The Greeks blame the deeper than expected recession for their failure to meet their targets says Reuters. Expected  by whom might I ask? Is there an economist who thought that enforcing rough austerity measures in an economy in a very short period of time would not have very deep consequences? What were they expecting? A mild 2% contraction of GDP?

In any case, the unreasonable reasoning of Athens (based on the estimates of an unreasonable research?) and their reluctance to impose a new set of austerity measures only indicates that things are worse than anyone expected. In an effort to generate income the Greek government is thinking (after taking Troika's blessing of course) about privatizing some of its state-owned firms like OPAP (the organization responsible for sports betting and other games in Greece) and the Public Power Corporation. This move is expected to generate income as well as boost investment in the country. 

This line of thinking, however, is prone to two caveats:

1. Given the fact that the Greek public sector is thought to be overstaffed, privatizing these two companies (or any others) will most likely result in layoffs, increasing the already high percentage of unemployed workers in the country

2. From my intermediate economics I recall that when privatizing a company the amount of money you should get should (at least in theory) equal the stream of income which that specific company would generate over the years. This would mean that the government's budget constraint would remain unaffected by the sale, creating only a short-time effect, which is eloquently called "creative accounting".

Any economist who is able to think would not agree to the privatizations. However, there are some who are proponents of this strategy. (I really hope they are not the ones who also thought that the Greek recession wouldn't have been so deep) What I think that many are confusing is privatization and competition. (the alternative would be that they either don't think or they forgot what they have learned). 

Most economists are proponents of competition, as in a competitive market, the consumer almost always has more options and cheaper goods (and sometimes less unemployment) than any other market structures. Thus, having a competitive market is good for the people. The more companies enter a market sector the more competitive-like that market will look. For example, a market is more competitive when you have five power companies than one.

Many economists seem to think that privatizing a state-owned company would allow others to enter that specific market. This however that might not be the case. It may be that establishing a company in a sector which was traditionally dominated by one very large player will be much harder than expected if not impossible. This may occur because of the market structure, inability to access consumers or material and many other reasons. If this is the case, then the difference between a private and a public monopoly is that a public monopoly is much better for the consumers. What should be done, is that investors and entrepreneurs should be given incentives to form companies in the same market sector (if this is feasible), something which would increase competitiveness, lower prices, boost investment and even lower unemployment.

Countries should not even consider privatizing their state-owned companies. Instead they should promote an incentive scheme which would induce individuals or other companies to invest in those sectors which are currently under state-owned monopolies, a move which would have both short-run and long-run beneficial consequences.