Successful bank rescue still far away

[Guy Berger]

Successful bank rescue still far awayBy Martin Wolf

Published: March 24 2009 19:24 | Last updated: March 24 2009 19:24

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I am becoming ever more worried. I never expected much from the Europeans or the Japanese. But I did expect the US, under a popular new president, to be more decisive than it has been. Instead, the Congress is indulging in a populist frenzy; and the administration is hoping for the best.

If anybody doubts the dangers, they need only read the latest analysis from the International Monetary Fund.* It expects world output to shrink by between 0.5 per cent and 1 per cent this year and the economies of the advanced countries to shrink by between 3 and 3.5 per cent. This is unquestionably the worst global economic crisis since the 1930s.

One must judge plans for stimulating demand and rescuing banking systems against this grim background. Inevitably, the focus is on the US, epicentre of the crisis and the world’s largest economy. But here explosive hostility to the financial sector has emerged. Congress is discussing penal retrospective taxation of bonuses not just for the sinking insurance giant, AIG, but for all recipients of government money under the troubled assets relief programme (Tarp) and Andrew Cuomo, New York State attorney-general, seeks to name recipients of bonuses at assisted companies. This, of course, is an invitation to a lynching.

Yet it is clear why this is happening: the crisis has broken the American social contract: people were free to succeed and to fail, unassisted. Now, in the name of systemic risk, bail-outs have poured staggering sums into the failed institutions that brought the economy down. The congressional response is a disaster. If enacted these ideas would lead to an exodus of qualified employees from US banks, undermine willingness to expand credit, destroy confidence in deals struck with the government and threaten the rule of law. I presume legislators expect the president to save them from their folly. That such ideas can even be entertained is a clear sign of the rage that exists.

This is also the background for the “public/private partnership investment programme” announced on Monday by the US Treasury secretary, Tim Geithner. In the Treasury’s words, “using $75bn to $100bn in Tarp capital and capital from private investors, the public/private investment programme will generate $500bn in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time”. Under the scheme, the government provides virtually all the finance and bears almost all the risk, but it uses the private sector to price the assets. In return, private investors obtain rewards – perhaps generous rewards – based on their performance, via equity participation, alongside the Treasury.

I think of this as the “vulture fund relief scheme”. But will it work? That depends on what one means by “work”. This is not a true market mechanism, because the government is subsidising the risk-bearing. Prices may not prove low enough to entice buyers or high enough to satisfy sellers. Yet the scheme may improve the dire state of banks’ trading books. This cannot be a bad thing, can it? Well, yes, it can, if it gets in the way of more fundamental solutions, because almost nobody – certainly not the Treasury – thinks this scheme will end the chronic under-capitalisation of US finance. Indeed, it might make clearer how much further the assets held on longer-term banking books need to be written down.

Why might this scheme get in the way of the necessary recapitalisation? There are two reasons: first, Congress may decide this scheme makes recapitalisation less important; second and more important, this scheme is likely to make recapitalisation by government even more unpopular.

If this scheme works, a number of the fund managers are going to make vast returns. I fear this is going to convince ordinary Americans that their government is a racket run for the benefit of Wall Str*eet. Now imagine what happens if, after “stress tests” of the country’s biggest banks are completed, the government concludes – surprise, surprise! – that it needs to provide more capital. How will it persuade Congress to pay up?

The danger is that this scheme will, at best, achieve something not particularly important – making past loans more liquid – at the cost of making harder something that is essential – recapitalising banks.

This matters because the government has ruled out the only way of restructuring the banks’ finances that would not cost any extra government money: debt for equity swaps, or a true bankruptcy. Economists I respect – Willem Buiter, for example – condemn this reluctance out of hand. There is no doubt that the decision to make whole the creditors of all systemically significant financial institutions creates concerns for the future: something will have to be done about the “too important to fail” problem this creates. Against this, the Treasury insists that a wave of bankruptcies now would undermine trust in past government promises and generate huge new uncertainties. Alas, this view is not crazy.

I fear, however, that the alternative – adequate public sector recapitalisation – is also going to prove impossible. Provision of public money to banks is unacceptable to an increasingly enraged public, while government ownership of recapitalised banks is unacceptable to the still influential bankers. This seems to be an impasse. The one way out, on which the success of Monday’s plan might be judged, is if the greater transparency offered by the new funds allowed the big banks to raise enough capital from private markets. If that were achieved on the requisite scale – and we are talking many hundreds of billions of dollars, if not trillions – the new scheme would be a huge success. But I do not believe that pricing legacy assets and loans, even if achieved, is going to be enough to secure this aim. In the context of a global slump, will investors be willing to put up the vast sums required by huge and complex financial institutions, with a proven record of mismanagement? Trust, once destroyed, cannot so swiftly return.

The conclusion, alas, is depressing. Nobody can be confident that the US yet has a workable solution to its banking disaster. On the contrary, with the public enraged, Congress on the war-path, the president timid and a policy that depends on the government’s ability to pour public money into undercapitalised institutions, the US is at an impasse.

It is up to Barack Obama to find a way through. When he meets his group of 20 counterparts in London next week, he will be unable to state he has already done so. If this is not frightening, I do not know what is.

* ‘Global Economic Policies and Prospects’, March 13-14 2009, www.imf.org

martin.wolf@ft.com

Copyright The Financial Times Limited 2009

[robviti]

#1 - Certainly this belongs in the political forum.

#2 - Per Jim: "Please, when posting an article from another website, include a hyperlink to that site. Also, don't quote the full article, but rather the first few paragraphs and then put a link at the bottom for folks who want to read more to do so."

[Jazzmoose]

Provision of public money to banks is unacceptable to an increasingly enraged public, while government ownership of recapitalised banks is unacceptable to the still influential bankers.

What I don't get is why the opinion of these bankers even matter. They have blown it, proven their incompetence and shown that their expertise is deeply flawed. Who cares what is acceptable or unacceptable to them?

[Jazzmoose]

#1 - Certainly this belongs in the political forum.

You mean the political and religion and economics and whatever comes next forum...

[connoisseur series500]

I'm cool with having economics articles in the section. I likely wouldn't have read them otherwise, as I rarely look at the Politics section.

[Chalupa]

Here are two more articles that echo Martin Wolf's thoughts.....

Geithner plan will rob American taxpayers: Stiglitz

Tue Mar 24, 2009 4:11am EDT

By Susan Fenton and Deborah Kan

HONG KONG (Reuters) - The U.S. government plan to rid banks of toxic assets will rob American taxpayers by exposing them to too much risk and is unlikely to work as long as the economy remains weak, Nobel Prize-winning economist Joseph Stiglitz said on Tuesday.

"The Geithner plan is very badly flawed," Stiglitz told Reuters in an interview during a Credit Suisse Asian Investment Conference in Hong Kong.

The rest here.....

and.....

Nobel laureate Krugman slams Geithner bailout plan

Mon Mar 23, 2009 12:24pm EDT

WASHINGTON (Reuters) - Nobel-prize winning economist Paul Krugman said in remarks published on Monday that the latest U.S. Treasury bailout program is nearly certain to fail, triggering a sense of personal despair.

U.S. Treasury Secretary Timothy Geithner on Monday unveiled a plan aimed at persuading private investors to help rid banks up to $1 trillion in toxic assets that that are seen as a roadblock to economic recovery.

"This is more than disappointing," Krugman wrote in The New York Times. ""In fact it fills me with a sense of despair."

More....

It makes you wonder if the White House knows the Geithner plan is going to fail but is putting it forth anyway as a bait and switch that will lead to Plan B - Nationalizing the banks.

[Jazzmoose]

It makes you wonder if the White House knows the Geithner plan is going to fail but is putting it forth anyway as a bait and switch that will lead to Plan B - Nationalizing the banks.

If so, what a horrible disaster for us that they don't have the courage to go with Plan B from the start. If this is the way it plays out, I don't think that cowardice will be forgiven.

[Jazzmoose]

From Glenn Greenwald...

Desmond Lachman -- the former chief strategist for emerging markets at Salomon Smith Barney and a long-time official with the IMF (no raving socialist he) -- argues today that the most apt comparison for the U.S. now is not Japan's "lost decade," but rather, "that the United States is coming to resemble Argentina, Russia and other so-called emerging markets, both in what led us to the crisis, and in how we're trying to fix it." He begins by recounting an IMF trip to Yeltsin-era Russia:

I still recall the shock I felt at a meeting in Russia's dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia's economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia's economic czar at the time.

He then describes the numerous similarities between the U.S. today and those corrupt, collapsing nations he studied in the past:

The parallels between U.S. policymaking and what we see in emerging markets are clearest in how we've mishandled the banking crisis. We delude ourselves that our banks face liquidity problems, rather than deeper solvency problems, and we try to fix it all on the cheap just like any run-of-the-mill emerging market economy would try to do. And after years of lecturing Asian and Latin American leaders about the importance of consistency and transparency in sorting out financial crises, we fail on both counts: . . . .

In visits to Asian capitals during the region's financial crisis in the late 1990s, I often heard Asian reformers such as Singapore's Lee Kuan Yew or Japan's Eisuke Sakakibara complain about how the incestuous relationship between governments and large Asian corporate conglomerates stymied real economic change. How fortunate, I thought then, that the United States was not similarly plagued by crony capitalism! However, watching Goldman Sachs's seeming lock on high-level U.S. Treasury jobs as well as the way that Republicans and Democrats alike tiptoed around reforming Freddie Mac and Fannie Mae -- among the largest campaign contributors to Congress -- made me wonder if the differences between the United States and the Asian economies were only a matter of degree. . . .

In the twilight of my career, when I am hopefully wiser than before, I have come to regret how the IMF and the U.S. Treasury all too often lectured leaders in emerging markets on how to "get their house in order" -- without the slightest thought that the United States might fare no better when facing a major economic crisis. . . . If we insist on improvising and not facing our real problems, we might soon lose our status as a country to be emulated and join the ranks of those nations we have patronized for so long.

more at link!

[GA Russell]

I talk about the Austrian economists not because I agree with everything they suggest, but because nobody else around here talks about them.

Moose, your article reminds me that one of the things I have always (since 1974 in my case) liked about the Austrians is their total rejection of the "It can't happen here" syndrome.

[papsrus]

I talk about the Austrian economists not because I agree with everything they suggest, but because nobody else around here talks about them.

Moose, your article reminds me that one of the things I have always (since 1974 in my case) liked about the Austrians is their total rejection of the "It can't happen here" syndrome.

The Austrians are also hardcore limited government types, aren't they? That school of thought that says the markets will take care of themselves if we just eliminate government from the equation. Which is true, I suppose, as far as it goes. It might leave large swaths of us in ruin, but oh well.

[GA Russell]

I talk about the Austrian economists not because I agree with everything they suggest, but because nobody else around here talks about them.

Moose, your article reminds me that one of the things I have always (since 1974 in my case) liked about the Austrians is their total rejection of the "It can't happen here" syndrome.

The Austrians are also hardcore limited government types, aren't they? That school of thought that says the markets will take care of themselves if we just eliminate government from the equation. Which is true, I suppose, as far as it goes. It might leave large swaths of us in ruin, but oh well.

paps, Austiran economics does not consider justice (which to me as a Catholic is a fatal flaw), unless you want to believe that whatever the market decides is just.

What the Austrians are correct about, in my view, is analyzing and predicting: If you do ABC, then XYZ will result. For example, I believe that the public should be aware of the interviews on CNN and Fox with Ron Paul and Peter Schiff because I believe their predictions are the best available. You can see them on YouTube.

In their analyses, the Austrians don't tweek the proposals of the Keynesians, they say that the Keynesians' proposals are going in the wrong direction and will make things worse. They also say that it was the Keynesians who got us into this mess in the first place. That is why they want to abolish the Fed, not change Fed policy. (I know, the Fed was established in 1913 and Keynes came along later, so Keynesianism and private central banking are not identical.)

By the way, in response to your original point, it's good that you agree that the Austrian analysis is, as you say, "true". I believe that the govt should start with Austrian economics and then make exceptions to the policy to ensure justice. (At present [and for many decades] the govt has based its policies on erroneous thinking, Keynesianism.)

For example, slavery exists in the Sudan and I believe Uganda. Suppose a Sudanese capitalist suggests to Nike that with slave labor he can make shoes just as good the ones currently made for paltry wages by the Chinese for less and pass the savings on to Nike. The Austrians would analyze the proposal and tell you if it is correct. The Austrians would not deny its accuracy because of the repugnance of slavery. It would be for the govt to (in my view) place an embargo on goods made by slaves. But that would be a justice decision, not an economic one.

For another example closer to home, the Pope in the Gay Nineties was Pope Leo. He wrote an encyclical in 1891 called Rerum Novarum which is the basis for Catholic social teaching. He details three wages:

1) the living wage - what a young bachelor right out of school needs to support himself, with expenses such as a very small apartment, transportation to work, food and clothing, etc.

2) the family wage - what the husband and father needs to support himself, his wife and his children, including buying a home.

3) the just wage - the family wage plus a little more to enjoy life and save up for a better life.

Now in America today, there are many people who make less than a living wage. I haven't seen a figure on it. The federal govt used to keep track of what a living wage was in various parts of the country, but that practice was stopped during the Reagan administration. But we know that the govt said a couple of weeks ago that 31 million are now on food stamps, and the food stamp program is for people with jobs who don't make enough to feed themselves.

Now in my opinion, this is an unjust situation. I believe that the minimum wage should be the living wage. I believe that if a businessman cannot afford to pay his employees enough to live on, he shouldn't be in that business. For example, in this area of North Carolina, a McDonald's franchise (just the franchise, not the building) costs $2.5 million. So having borrowed to purchase the franchise at that price, the franchise owners hire Mexicans and blacks and occassionally teenagers at less than a living wage. I believe that if the minimum wage were a living wage, the franchisee could still successfully operate a McDonald's, but the franchise would probably be worth less than $2.5 million.

Ot to put it another way, if the antebellum plantation owners had said that they couldn't grow cotton without slaves and still make ends meet, they were told, in effect, "Then get out of the cotton business".

All this is to say that in my view the current situation in America is grossly unjust, but this unjustice is a result of govt policy allowing for the concentration of wealth in the hands of a few capitalists rather than a result of Austrian economic analysis. (By the way, we Americans are given only two choices - capitalism, which is the concentration of wealth and the means of production in the hands of the few capitalists [in America today, one percent of the people own more wealth than ninety percent combined.]; and socialism, which is the concentration of wealth and the means of production in the hands of the govt and its few leaders. The more I read about distributism, which was an idea promoted during the Depression by GK Chesterton and Hillaire Belloc, the more I like it. Distributism calls for widespread ownership of land in particular, and corporations/factories so that we do not have the concentration of ownership.)