Geithner Presents a Rubbish Plan

The asset rescue plan that will be unveiled by this week has already been leaked sufficiently that we can decide whether it is any good.

The answer is, I am afraid, that is a bad plan. Rubbish in fact.

I have mentioned before that it seems the administration has a much more benign view of the financial crisis than I do. they are taking the view that the problems stem not from a surplus of rotten assets, but rather, from poor market understanding of the true value of assets.

This may appear to be a subtle difference, but it is fundamental.

The ‘poorly understood assets’ argument is based on the classic bank run psychological interpretation of facts. In this case a sudden heavy draw down of liabilities at a bank triggers a fire sale of its assets – so it pay the liabilities off – but assets usually are worth less in a fire sale than they would be under normal conditions. This causes the bank to have to liquidate more assets than it normally would. Under extreme circumstances the bank ends up not being able to generate cash fast enough and it fails. This series of events results frequently from depositor panic and is the reason we have FDIC depositor insurance. The key fact to remember in this typical ‘bank run’ scenario is that the bank’s assets may be perfectly sound. they are usually not toxic at all.

The ‘bad assets’ argument is totally different, even though on the surface it shares many similarities with the ‘poorly understood assets’ argument. The difference stems from the way in which a bank can fail. In the ‘poorly understood assets’ argument the bank assets don’t generate sufficient cash because the fire sale gluts the market. In the ‘bad assets’ argument the assets don’t generate the cash because they’re not worth much anyway.

This difference is key. Because the policy response to a normal bank run is simply to provide reassurance to the markets. This can be done by the government simply buying the assets so as to remove the glut. And the existence of FDIC deposit insurance also calms depositor nerves.

These policy responses don’t work in the bad assets case. This is because the banks are still stuck with rotten assets even if the markets are calmed. So the fundamental issue of bank insolvency is not resolved.

So to treat a ‘bad assets’ crisis as a ‘poorly understood assets’ results in insolvent banks being treated as if they were healthy but simply caught in a bank run.

This is what the administration is now doing.

This is a misdiagnosis of epic proportions. It indicates to me that the government, and especially the key economic players like Geithner, Summers, and Romer, are all too wedded to traditional thinking to identify, let alone treat, the problem.

The risk is that we will end up with a set of Japanese style ‘zombie’ banks, with weak lending hampering a return to healthy economic growth.

So this is not a trivial mistake.

It is a major error.

Which is why I think Geithner’s plan is rubbish.

I am losing confidence rapidly in this administration.