When dealing with a big, awful problem, it’s usually never enough simply to deal with the symptoms we can see. For a fix to be effective, at some point it must address the root causes responsible for those visible blights, lest the symptoms continue to manifest themselves. Of course, the small cosmetic fixes that just cover up the symptoms are easier than the structural ones that address the causes. And it’s exactly this challenge that President Obama is facing with the economy.
The stimulus package, which finally cleared Congress after some legislative back-and-forth, could be effective at dealing with the symptoms of our economic crisis. But a large decline in GDP and skyrocketing unemployment, which the stimulus is supposed to ameliorate, aren’t the causes of the economic crisis. The cause is that banks are floundering and so are unable to do the job they’re supposed to: loan money. Without loans between financial institutions, or to business and individuals, the engine of the economy will simply cease to function.
For example, Japan experienced a “lost decade” in the 1990s with next to no economic growth because they never figured out how to get their banking sector back in shape. And since no one wants ten years of no economic growth and high unemployment, we need a way of dealing with the non-functioning financial sector.
Major banks have been decimated since the massive decline in housing values and the subsequent unraveling of the mortgage-backed securities mess. As Andy Kessler, a former hedge fund manager, explained in the Wall Street Journal, “Despite over a trillion in assets, Citigroup is worth a meager $18 billion, Bank of America only $28 billion.”
Basically, everyone knows banks’ assets are worthless, but no one wants to deal with the consequences of what normally happens when companies are worth nothing: bankruptcy and liquidation.
Treasury Secretary Timothy Geithner, the regulatory whiz kid formerly of the New York Federal Reserve, has stepped in with his new plan. The plan, as explained by the Treasury Department, has five parts.
The first is a “stress test” of the banks and their toxic assets. This means that all U.S. banks with over $100 billion in assets would have to submit to some sort of test to see if they have the “capital necessary to continue lending and to absorb the potential losses” that they could suffer if the economy gets even worse.
So, what happens after the “stress test”? This is where the “capital assistance” program comes in. According to the Treasury, a financial institution that has undergone a comprehensive stress test will have “access to a Treasury provided capital buffer to help absorb losses and serve as a bridge to receiving increased private capital.”
While Geithner and President Obama’s lead financial adviser Larry Summers, as well as Obama himself, have come out against completely nationalizing the banks — a process when the government takes over the insolvent banks, wipes out the shareholders and runs the banks for a short time until they can lend again, then eventually reprivatizes them — this provision of the plan does leave open the possibility of the government actually owning large banks, or at least large shares of them. However, nationalization will not happen immediately, and then only as a possible last resort.
The second part of the plan, and the element on which the entire plan hinges, is the “Public-Private Investment Fund.” The Treasury plan revolves around getting the private sector to invest in banks so they can start lending again. But that’s only if they can get government backing, which means that the Treasury will start by loaning private actors $500 billion, and maybe up to $1 trillion to give them an incentive to invest in banks.
The government will also provide $100 billion for “purchase of loans by providing the financing to private investors to help unfreeze and lower interest rates.” This is where, to understate things, the fate of the economy rests. If businesses can’t get access to credit, it means they can’t make investments, hire new people or expand. And without a fairly constant expansion in business activity, the economy as a whole will grind to a halt.
The rest of the proposed package is made up of provisions relating to executive compensation, an unspecified program to deal with home foreclosures and a variety of oversight and transparency provisions.
Are we supposed to be happy with this plan?
It’s easy to be infuriated by it. After all, we’ve spent some $170 billion on these banks already. Just look at Bank of America, which is worth around $25.5 billion, but has received $158 billion in government support. So, wouldn’t it better for the government to wipe out the shareholders, take over the bank for a while, clean out its bad assets, start loaning again and then privatize it, so that the taxpayers can at least get something for their massive investment? We’re already on the hook for their losses and their crappy assets, so we might as well get something for it. This isn’t some crank idea. Plenty of serious economists and commentators, including Nouriel Roubini, the NYU professor who successfully predicted the current crisis, support it.
The other reason to support nationalization is that it has worked before. In 1992, Sweden faced a similar crisis when its major banks were insolvent. So, after securing individual deposits in every bank (like we do with the F.D.I.C.), the government only recapitalized the banks after the stockholders accepted major losses on all their worthless assets. And the government didn’t give the banks money; instead, the government bought up the shares and resold them later. The entire operation cost 4 percent of Sweden’s GDP, or, translating for America in 2009, just less than 700 billion dollars. Moreover, the banks were profitable within the following two years, and after reprivatizing them, the Swedish government got half of its investment back.
Why isn’t this option on the table, or at least not on the table yet?
President Obama explained in an interview that he doesn’t see it as feasible or desirable for the government to take over and run the banks because the American political culture would be unlikely to tolerate it and because past nationalizations, like Sweden’s, were dealing with fewer banks and smaller financial sectors.
Also, there would be concerns that due to the massive amount of political rigmarole that goes into every piece of legislation, any government-owned bank would behave more like a patronage machine than a bank. For instance, if Chris Dodd, the chairman of the Senate Banking Committee, demanded that a government owned Citigroup lend to flailing business in Connecticut, his home state, could they refuse? Also, there is a concern that once the government started nationalizing firms, it couldn’t stop. The reason is that nationalization entails wiping out stockholders of the nationalized firms; so, after the first few firms were nationalized, stockholders of relatively healthy banks might panic and since those banks would lose all their value, they would have to go through bankruptcy or be nationalized.
If nationalization isn’t an option, could this plan, which Martin Wolf of the Financial Times describes as “optimistic and indecisive” actually work? Brad DeLong, former Treasury official during the Clinton administration and current professor of economics at UC Berkeley, thinks that the plan might work by effectively putting the government on the hook for the most toxic assets, which would then raise the price for the leftover assets, which could then increase the value of the banks and induce them to loan again.
At the same time, private actors would be able to get money to invest in the banks at the same rate the federal government does (because the government is loaning them money), and since the yields on Treasury bonds are at a historical low, they may jump at this opportunity. So, as these private actors pour money into banks with government lending, the asset prices go up and the banks approach solvency and liquidity.
On the other hand, the banks could fail the stress tests, and as discussed above, the government would then have no choice but to find a way to deal with financial institutions that are no longer functioning. This would probably mean the government investing heavily in healthy banks, and finding a way to liquidate the unhealthy ones, probably by taking them over and buying up their bad assets.
So, after trying everything else, a crisis of a magnitude not seen since the Great Depression may end up in the biggest government intervention in the financial system in history. Tim Geithner is trying to prevent that from happening. We’ll see if he can.