http://www.alternet.org/story/124166/
Is the Entire Bailout Strategy Flawed? Let's Rethink This Before It's
Too Late
By Joseph Stiglitz, CNN
America's recession is moving into its second year, with the situation
only worsening.
The hope that President Obama will be able to get us out of the mess is
tempered by the reality that throwing hundreds of billions of dollars at
the banks has failed to restore them to health, or even to resuscitate
the flow of lending.
Every day brings further evidence that the losses are greater than had
been expected and more and more money will be required.
The question is at last being raised: Perhaps the entire strategy is
flawed? Perhaps what is needed is a fundamental rethinking. The
Paulson-Bernanke-Geithner strategy was based on the realization that
maintaining the flow of credit was essential for the economy. But it was
also based on a failure to grasp some of the fundamental changes in our
financial sector since the Great Depression, and even in the last two
decades.
For a while, there was hope that simply lowering interest rates enough,
flooding the economy with money, would suffice; but three quarters of a
century ago, Keynes explained why, in a downturn such as this, monetary
policy is likely to be ineffective. It is like pushing on a string.
Then there was the hope that if the government stood ready to help the
banks with enough money -- and enough was a lot -- confidence would be
restored, and with the restoration of confidence, asset prices would
increase and lending would be restored.
Remarkably, Bush administration Treasury Secretary Henry Paulson and
company simply didn't understand that the banks had made bad loans and
engaged in reckless gambling. There had been a bubble, and the bubble
had broken. No amount of talking would change these realities.
It soon became clear that just saying that we were ready to spend the
money would not suffice. We actually had to get it into the banks. The
question was how. At first, the architects of the bailout argued (with
complete and utter confidence) that the best way to do this was buying
the toxic assets (those in the financial market didn't like the
pejorative term, so they used the term "troubled assets") -- the assets
that no one in the private sector would touch with a 10-foot pole.
It should have been obvious that this could not be done in a quick way;
it took a few weeks for this crushing reality to dawn on them. Besides,
there was a fundamental problem: how to value the assets. And if we
valued them correctly, it was clear that there would still be a big hole
in banks' balance sheets, impeding their ability to lend.
Then came the idea of equity injection, without strings, so that as we
poured money into the banks, they poured out money, to their executives
in the form of bonuses, to their shareholders in the form of dividends.
Some of what they had left over they used to buy other banks -- to
pursue strategic goals for which they could not have found private
finance. The last thing in their mind was to restart lending.
The underlying problem is simple: Even in the heyday of finance, there
was a huge gap between private rewards and social returns. The bank
managers have taken home huge paychecks, even though, over the past five
years, the net profits of many of the banks have (in total) been negative.
And the social returns have even been less -- the financial sector is
supposed to allocate capital and manage risk, and it did neither well.
Our economy is paying the price for these failures -- to the tune of
hundreds of billions of dollars.
But this ever-present problem has now grown worse. In effect, the
American taxpayers are the major provider of finance to the banks. In
some cases, the value of our equity injection, guarantees, and other
forms of assistance dwarf the value of the "private" sector's equity
contribution; yet we have no voice in how the banks are run.
This helps us understand the reason why banks have not started to lend
again. Put yourself in the position of a bank manager, trying to get
through this mess. At this juncture, in spite of the massive government
cash injections, he sees his equity dwindling. The banks -- who prided
themselves on being risk managers -- finally, and a little too late --
seem to have recognized the risk that they have taken on in the past
five years.
Leverage, or borrowing, gives big returns when things are going well,
but when things turn sour, it is a recipe for disaster. It was not
unusual for investment banks to "leverage" themselves by borrowing
amounts equal to 25 or 30 times their equity.
At "just" 25 to 1 leverage, a 4 percent fall in the price of assets
wipes out a bank's net worth -- and we have seen far more precipitous
falls in asset prices. Putting another $20 billion in a bank with $2
trillion of assets will be wiped out with just a 1 percent fall in asset
prices. What's the point?
It seems that some of our government officials have finally gotten
around to doing some of this elementary arithmetic. So they have come up
with another strategy: We'll "insure" the banks, i.e., take the downside
risk off of them.
The problem is similar to that confronting the original "cash for trash"
initiative: How do we determine the right price for the insurance? And
almost surely, if we charge the right price, these institutions are
bankrupt. They will need massive equity injections and insurance.
There is a slight variant version of this, much like the original
Paulson proposal: Buy the bad assets, but this time, not on a one by one
basis, but in large bundles. Again, the problem is -- how do we value
the bundles of toxic waste we take off the banks? The suspicion is that
the banks have a simple answer: Don't worry about the details. Just give
us a big wad of cash.
This variant adds another twist of the kind of financial alchemy that
got the country into the mess. Somehow, there is a notion that by moving
the assets around, putting the bad assets in an aggregator bank run by
the government, things will get better.
Is the rationale that the government is better at disposing of garbage,
while the private sector is better at making loans? The record of our
financial system in assessing credit worthiness -- evidenced not just by
this bailout, but by the repeated bailouts over the past 25 years --
provides little convincing evidence.
But even were we to do all this -- with uncertain risks to our future
national debt -- there is still no assurance of a resumption of lending.
For the reality is we are in a recession, and risks are high in a
recession. Having been burned once, many bankers are staying away from
the fire.
Besides, many of the problems that afflict the financial sector are more
pervasive. General Motors and GE both got into the finance business, and
both showed that banks had no monopoly on bad risk management.
Many a bank may decide that the better strategy is a conservative one:
Hoard one's cash, wait until things settle down, hope that you are among
the few surviving banks and then start lending. Of course, if all the
banks reason so, the recession will be longer and deeper than it
otherwise would be.
What's the alternative? Sweden (and several other countries) have shown
that there is an alternative -- the government takes over those banks
that cannot assemble enough capital through private sources to survive
without government assistance.
It is standard practice to shut down banks failing to meet basic
requirements on capital, but we almost certainly have been too gentle in
enforcing these requirements. (There has been too little transparency in
this and every other aspect of government intervention in the financial
system.)
To be sure, shareholders and bondholders will lose out, but their gains
under the current regime come at the expense of taxpayers. In the good
years, they were rewarded for their risk taking. Ownership cannot be a
one-sided bet.
Of course, most of the employees will remain, and even much of the
management. What then is the difference? The difference is that now, the
incentives of the banks can be aligned better with those of the country.
And it is in the national interest that prudent lending be restarted.
There are several other marked advantages. One of the problems today is
that the banks potentially owe large amounts to each other (through
complicated derivatives). With government owning many of the banks,
sorting through those obligations ("netting them out," in the jargon)
will be far easier.
Inevitably, American taxpayers are going to pick up much of the tab for
the banks' failures. The question facing us is, to what extent do we
participate in the upside return?
Eventually, America's economy will recover. Eventually, our financial
sector will be functioning -- and profitable -- once again, though
hopefully, it will focus its attention more on doing what it is supposed
to do. When things turn around, we can once again privatize the
now-failed banks, and the returns we get can help write down the massive
increase in the national debt that has been brought upon us by our
financial markets.
We are moving in unchartered waters. No one can be sure what will work.
But long-standing economic principles can help guide us. Incentives
matter. The long-run fiscal position of the U.S. matters. And it is
important to restart prudent lending as fast as possible.
Most of the ways currently being discussed for squaring this circle fail
to do so. There is an alternative. We should begin to consider it.
AlterNet is making this material available in accordance with Title 17
U.S.C. Section 107: This article is distributed without profit to those
who have expressed a prior interest in receiving the included
information for research and educational purposes.
Joseph Stiglitz, a Nobel laureate, is a professor of economics at
Columbia University.
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