Well, that didn't take long. Usually disillusionment takes longer. But when it comes to fixing our failing financial system - a prerequisite for any economic recovery - it's only taken three weeks for the Obama administration to embrace the same giveaway-to-Wall Street bankers boondoggle that Bush and Co. patented. And as Joe Biden could tell us, that's not the change we need; that's more of the same. Indeed, as far as there even is a plan, it seems to amount to little more than putting lipstick on a pig: taxpayers guaranteeing the inflated values of dud assets. Whether private investors like hedge funds and private equity buy these items from banks first is irrelevant; taxpayers are still ultimately on the hook for assets no one wants to touch.
And that is why it is time for Geithner to go. The information about the latest bailout is the final straw. Real change - the change we need - is looking out for taxpayers before Wall Street. That means giving the public real upside in any bailout, which at this point means nationalizing the banks. Anything else is merely a poorly disguised subsidy for bankers. So Mr. President, it's time to pull another Daschle: admit you made a mistake, and fire Timothy Geithner.
Is this a liquidity or an insolvency crisis? Or, put more directly, are the so-called "toxic assets" on banks' balance sheets undervalued due to panic in the markets, or are they simply fundamentally worthless? This is the key question policymakers must answer before formulating any plan. If we face a liquidity crisis, simply throwing enough money at the banks should resolve the situation. If the banks are insolvent, however, our best course is a temporary nationalization.
Let's consider two recent examples to illustrate this distinction between liquidity and insolvency crises. In 1998 the hedge fund Long Term Capital Management (LTCM) nearly destroyed the financial system. LTCM had made a fortune by betting that the differences between different types of bonds would narrow. But then in 1998, Russia defaulted on its debt. Stuck holding now worthless Russian bonds, LTCM had to sell other assets to raise cash. But there were two problems. First, LTCM's holdings in each asset were so large that they often couldn't sell the assets without reducing the price substantially; they had illiquid positions. Second, a number of investors who also held Russian bonds had the same holdings as LTCM. So, for example, when LTCM tried to sell Brazilian bonds to raise capital after the Russian default, they found that the Brazilian bonds were only fetching firesale prices, because other investors were selling Brazilian bonds to raise cash as well. Financial investors were the linkage between unrelated assets. This contagion essentially forced LTCM into bankruptcy. But LTCM was highly leveraged, meaning it had borrowed heavily, in this case from Wall Street firms. If LTCM failed, these counterparties would face enormous losses themselves, and likely be forced into bankruptcy as well. LTCM was the first domino. To prevent this destructive cycle from beginning, the Fed organized a private bailout of LTCM by Wall Street. They provided liquidity, i.e. cash, so that they could unwind LTCM's positions over about a year, letting the panic in the markets pass. Because LTCM's positions had more or less been fundamentally sound, the Wall Street firms were actually able to turn a profit as they sold off LTCM's assets. This was a prime example of how to deal with a liquidity crisis.
But what if LTCM's holdings hadn't been undervalued due to panic? What if they had actually just been worthless by the underlying fundamentals? This would be a problem of insolvency. And that was exactly the situation Japan's banks found themselves in the 1990s. After Japan's joint stock and real estate bubbles popped in the late 1980s, Japanese banks were stuck holding now worthless paper. Rather than admit that they held dud loans, Japanese banks kept these "toxic assets" on their balance sheets, refusing to write them down. But when banks face credit losses on this scale, of course they pull back credit; they stop giving out loans. While the government eventually bailed out Japan's financial companies, it became a bit of a black hole: the government propped up so-called "zombie" banks that were de facto insolvent and still refused to lend. Because modern economies need a functioning financial system to grow, the result was a decade of stagnation and deflation, now dubbed Japan's "lost decade".
Sweden offers a better solution to such an insolvency crisis. In the early 1990s, Sweden's financial sector, like Japan's, was de facto insolvent. But rather than dithering, or simply pouring money into a black hole by giving their banks essentially blank checks, the Swedish government took decisive action. They nationalized the banks. They wrote down all losses on bad loans. Then they recapitalized the banks with public funds, before selling off the parts of the firms to private investors. Their economy quickly rebounded.
Now these might seem like academic questions, but they are crucial when it comes to fashioning a bailout that will revive our economy. And indeed, President Obama showed that he is well aware of these precedents in his recent interview with ABC News. So how does Geithner's current plan stack up against what we know works and what doesn't? Not well. While details about Geithner's plan are still relatively sparse, the public-private partnership - the "bad bank" - seems like yet another attempt to prop up dud assets to the inflated values banks continue to mark them at. Without significant government guarantees/financing, it seems very unlikely that hedge funds or private equity firms would want to buy these "toxic" assets. And whether we subsidize hedge funds and private equity to buy these from banks with guarantees, or simply overpay the banks for these assets ourselves doesn't matter; both amount to subsidizing bankers' mistakes. Furthermore, this only continues the misdiagnosis of this crisis as a liquidity problem rather than an insolvency one. For the past year, Bernanke and Paulson flooded the markets with liquidity. They opened the Fed's window to extend financing, taking back dud assets as collateral. They got involved in the commercial paper market. And most notably, they injected $350 billion of TARP money into banks directly. While credit markets have improved from their apocalyptic October levels, we are still in a crisis. Very clearly, this is not a liquidity problem.
The second prong of Geithner's brief outline, the so-called "stress testing" of financial institutions, is more promising. Establishing transparency and trust in banks' balance sheets is vital to repairing the financial sector, and getting our economy growing again. Indeed, Paul Krugman asks:
What happens if, or more likely when, a major money center bank is stress-tested and found to have negative net worth? One possibility is that the auditors are told to come up with a different answer; that’s a big concern. The other is that the bank is effectively nationalized; as I read the language that could be achieved as part of the public capital injection. So what is the plan? I really don’t know, at least based on what we’ve seen today. But maybe, maybe, it’s a Trojan horse that smuggles the right policy into place.
While Krugman may be right - after all, Obama has shown himself to nothing if not a shrewd political operator - Obama's own answer in the aforementioned ABC interview about nationalization a la the Swedish model seems to quash such hope. Obama objected to adopting something along the lines of Sweden's temporary nationalization in part because
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.
Or, as finance blogger Calculated Risktranslates:
We know the correct answer, but we are afraid to do it - because of our "culture" - so we are going to follow the Japanese plan.
Perhaps this is too hysterical a reaction to a single remark from President Obama. But this remark taken in conjunction with the timidity of the Geithner plan seems to indicate an unwillingness to address this crisis head on for fear of the Republicans criticizing them as "socialists". This is nonsense. The public wants results. Period. It's not about bigger or smaller government, but about effective government. And if temporarily nationalizing the banking system is a necessary step towards any recovery, the electorate will reward Obama as the economy improves. Trying to win over the Joe-the-Plumber base of the GOP - or at least not anger them - should not be a concern.
At this point, choosing the wrong policy could doom the Obama presidency. Indeed, Martin Wolf of the FT already asked "has the Obama presidency already failed?" in response to Geithner's proposed bank bailout. The costs of rescuing the financial system will be enormous even if we pursue the best possible policies. If we pour trillions of dollars into Wall Street, and the economy continues to collapse, any chance of getting meaningful health care reform or investment in clean energy will probably be out the door; the GOP will continue to "rediscover" their fiscal conservatism, and obstruct any new spending. But if the economy rebounds, the Democrats will have enough popular support to push through their agenda (along with rising tax revenues from a healthy economy). So Mr. Obama, please save your presidency before it even really begins - and find someone who will bring real change and accountability to Wall Street if Mr. Geithner won't.