A few weeks ago, Joseph Stiglitz wrote an article (“A Bank Bailout That Works”) for The Nation.
He was highly critical of the policy decisions taken to date by both administrations. Even though he didn’t at the time have the details of Geithner’s latest plan, its core principles are anything but new and his analysis suggests he’d be most unlikely to view it favourably:
Still worse are proposals to try to enlist the private sector to buy the trash. Right now, the prices the private sector is willing to pay are so low that the banks aren’t interested–it would make apparent the size of the hole in banks’ balance sheets. But if the government insures private-sector investors–and even makes loans at favorable terms–they’ll be willing to pay a higher price. With enough insurance and favorable enough loan terms, presto! We can make our banks solvent.
But there is a sleight-of-hand here: go back to the zero-sum principle. The private sector is not going to provide money for nothing. It expects a return for providing capital and bearing risk. But its cost of capital is far higher than that of government. The losses are real, and the private sector won’t bear them without full compensation. This means that the amount the government is likely to have to pay in the end is all the greater.
This proposal, like so many others emanating from the banking community, is based partially on the hope that if banks make things sufficiently complex and nontransparent, no one will notice the gift to the banking sector until it is too late. It appears as if they are at last getting the high market prices that they hoped they would get all along. But it would be a misnomer to call these market prices, since the government has taken away the downside risk.
The markets don’t seem to agree. They put on an uninhibited celebration after Geithner’s announcement last night, with the S&P 500 soaring over 7%. Even normally grouchy commentators like Alan Kohler give it a qualified tick of approval. Perhaps they’ve got it right; then again, perhaps the markets are just sick of being depressed and feel the need to kick up their heels for awhile; they’ve certainly been acting that way for the last few weeks. Not even “great depressions” (assuming that’s what we’ve got on our hands) travel all the way to their destinations in a straight line.
We’ll find out soon enough. Meantime, Stiglitz’s preferred solutions to the banking crisis are fairly traditional:
Firms often get into trouble–accumulating more debt than they can repay. There is a time-honored way of resolving the problem, called “financial reorganization,” or bankruptcy. Bankruptcy scares many people, but it shouldn’t. All that happens is that the financial claims on the firm get restructured. When the firm is in very bad trouble, the shareholders get wiped out, and the bondholders become the new shareholders. When things are less serious, some of the debt is converted into equity.
Banks aren’t airlines, of course, and dealing with their demise is a bit trickier but Stiglitz sees no reason why similar principles can’t be successfully applied. He looks at a few alternatives, including the “good bank” proposal put forward by, amongst others, Willem Buiter at the London School of Economics.
Underlying it all is a conviction that the banks are profoundly crippled as a result of the multiple excesses of recent years. The primary problem is insolvency, not illiquidity, and the underlying economic fundamentals are likely to get a whole lot worse before they get better. Propping banks up by taking toxic assets off their hands at above market prices, all on the taxpayer’s tab, is in his view an exceptionally roundabout, opaque and expensive way to try to deal with the problem.
He’s not alone. In a column on the weekend, Krugman was not happy:
If the reports are correct, Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy – specifically, the “cash for trash” plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.
This is more than disappointing. In fact, it fills me with a sense of despair.
[ . . . . . ]
But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus – for that is what the Geithner plan amounts to – will change that fact.
I enjoy Krugman even when I disagree with him; he just writes so well. In this case, though, it seems to me he’s also spot-on. This is duck and weave stuff, papering over cracks, leaving the utterly discredited status quo in place. Not only is it unlikely to be effective in the long run, it risks (as Krugman and others have pointed out) so depleting Obama’s political capital that his ability to take effective action becomes severely curtailed.
Still, if the market’s in a mood to party then the celebratory fashion in which this plan has been received may carry on for a while; maybe even quite a while. Truth is, nobody knows how this tragedy-cum-farce will play out.
Perhaps the curtain’s only just been rung down on the first act.