As featured on p. 218 of "Bloggers on the Bus," under the name "a MyDD blogger."

Thursday, February 12, 2009

Stress Test Then Nationalization?

I'm a little late to this party, but here's President Obama on nationalization.

There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what’s called “The Lost Decade.” They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn’t see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.

And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.

I appreciate that he's thought through the scenario and is aware of the Swedish solution. I think the "cultural differences" is a cop-out. First of all, for the last 70 years the FDIC has been able and willing to take over banks all the time, and nobosy has really raised their voices in alarm. In fact, they appreciate it. In addition, there's a market-based case for nationalization - banks that are insolvent and have failed shouldn't get propped up but should be subject to the vicissitudes of the market. We don't want consumers to be wiped out in the process, and that's why we have a system of temporarily taking over the banks and selling them back to investors once they get on their feet. If we have to call it "preprivatization" to remove the stigma, fine, but "cultural differences" should never get in the way of sound policy.

The "Sweden had like five banks" isn't really a legitimate claim, either. Nobody's talking about the thousands of community banks and lending concerns; there is a problem with half-a-dozen very large banks and financial companies. The scale in terms of numbers is not so different.

Now, if Obama wanted to make a technical point, he could make this one:

My bottom line: Visit the Nordic countries and you’ll be impressed that their civilian public agencies are much more effective than ours. Arguments which observe that things their institutions can do, our institutions might well screw up are valid. At the same time, there are things that require effective public agencies to do that need to be done. In fields like educating poor children, we’re simply not doing them, and a price is paid. But it’s a price that most middle class Americans don’t see or pay personally. If it turns out that we can’t manage a financial panic adequately, we’ll all be paying the price. I don’t think assuming failure in advance and therefore adopting unlikely-to-work policies makes sense. Abraham Lincoln and FDR both asked the government to do things it didn’t have the ability to do; that meant they had to build the institutions.

Exactly. Cultural or technocratic barriers aren't an option when the clearly preferable policy is a temporary nationalization. We don't have the luxury of messing this part up. If the banks aren't lending properly because they are hording capital, all of the economic multiplier effects of the stimulus are lost. Banks will suck up money from consumers and it will fall into this black hole. We will not have solved the core economic problems. And if the Fed is planning this massive community lending for cars, students, credit cards, small business and nonresidential mortgages, um, why do you need the banks at all? Not to mention that such lending just re-inflates the securitization bubble by guaranteeing the secondary market, which isn't wise.

The case for nationalization is pretty clear. Robert Kuttner and Simon Johnson say it well, but Martin Wolf is perhaps saying it best:

All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency.

Under the first view, the prices of a defined set of “toxic assets” have been driven below their long-run value and in some cases have become impossible to sell. The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses. This was the rationale for the original Tarp and the “super-SIV (special investment vehicle)” proposed by Henry (Hank) Paulson, the previous Treasury secretary, in 2007.

Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities. The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.

Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so. But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a “no brainer”.

The "stress test" portion of the plan holds out some hope. If there is a legitimate independent audit of the books, and the top banks are all seen to be insolvent, the case for nationalization becomes much more clear. That's privileged information and it makes sense to go through a process to find it out. But in the interim, handing over a bunch of money that isn't going to do much of anything is ridiculous.

Obama and his team may think there is no political possibility of nationalization without the data. But there's probably no possibility WITH the data - Republicans won't go for it. Sometimes you just have to rip the band-aid off.

The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new “good banks”, leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new “bad banks”, leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic.

By asking the wrong question, Mr Obama is taking a huge gamble. He should have resolved to cleanse these Augean banking stables. He needs to rethink, if it is not already too late.


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