Geithner Plan On Reflection

The infamous Geithner Plan is not sitting well with me. I hope it works, but something keeps gnawing away at me and prevents me from endorsing it. The problem is that even if the plan works we are still left looking at a financial system littered with undercapitalized banks. Geithner’s Plan doesn’t address this lack of capital so there will have to be a ‘next step’ sometime, and the longer that next step is postponed the further off is a full recovery for the economy.

The administration has adopted a ‘go slow’ approach to the financial crisis. I don’t know why, but the evidence all supports the view that they think a little tinkering here and there is sufficient to restore our banks to health.

It won’t.

As of the moment the banking system is chronically short of capital. This is why the cash from the TARP program never found its way out as loans. The banks stashed their TARP money in order to rebuild capital. Until they get more, either from private or public sources, they just won’t lend.

The business of banking is to borrow short, e.g. your bank deposit accounts, and lend long, e.g. your mortgage. Any organization that enters into this monetary ‘intermediation’ can be called a bank. In order to survive the inevitable periodic disconnects between the cash flows on the two sides of their balance sheets banks keep cash – mostly stored away as ‘reserves’ at the Federal Reserve Board – and capital. They also use capital as a buffer to absorb losses when loans are not repaid in full. In a time of uncertainty such as our current economy, banks typically loan less in order to avoid taking on board riskier loans. In recessions even well managed and organized customers can have difficulty paying that bank back, so there is a natural reticence on the part of banks to lend much during a downturn. So capital preservation becomes a major concern to all banks when the economy is bad. What makes this crisis so difficult is that it was caused by the collapse of the real estate bubble, which in turn destroyed vast swathes of bank capital. So just as banks would normally retreat and wait out the economic cycle they found themselves so diminished that capital preservation was not enough to keep them healthy. They needed to augment their capital accounts. But the usual sources of capital in the private markets all failed to step up. Worse: the markets were so scared of potential bank failures that it became impossible even to price the assets on bank balance sheets. No one, literally in some asset classes, was buying.

Geithenr seems to think that he can free up the market for bank assets by offering substantial subsidies. His plan is an attempt to get the market to determine prices for toxic assets, some of which may turn out to be non-toxic. In theory this would allow trading of these assets to begin again and, presumably, let the assets flow to investors who have both the capital and the appetite for risk to deal with them. That would relieve some banks of some of their ‘legacy’ assets so they wouldn’t have to worry about future losses from them..

But this is not a recapitalization program: we would be left several banks unable or unwilling to lend because they would, even then, have insufficient capital. Their capital ratios mat have improved, but they would still not be strong enough to take on new risks. So the credit market crisis would still remain to be solved.

More to the point: the enormous political backlash that has swept through Congress, and the country at large, against anything Wall Street now represents a threat to successful resolution of the problem. The Geithner Plan is in danger of consuming what vestiges of tolerance there is in Congress for further support for the banking system.

It was abundantly clear to me as I watched Geithner and Bernanke being questioned by the House of Representatives Finance Committee that most of its members are clueless when it comes to finance. That’s not their fault, banking can appear arcane, but it is a problem in moments of crisis when decisive leadership is needed. There is practically no understanding of the dire straits that our system is in. And, frankly, Wall Street is simply not a sympathetic victim. The lavish lifestyles of the now defunct investment banking industry and the ridiculous bonus payments that some of its employees received have created such a national dislike that bailing out banks is sliding further from the realms of political reality.

So the administration’s decision to push through the Geithner Plan is a huge gamble: it uses up what little reserve of good will there is and runs the risk of making the really hard work even more difficult.

And therein lies the source of my unease.

I have advocated stronger and more direct action from the beginning precisely because of the potential for ‘bailout fatigue’ to set in. Taking the big banks into government ownership early on would have created a huge political problem. But it would also have started the necessary healing process. Instead we are slogging our way through months and perhaps years of ‘patches’ and ‘fixes’ while the public’s tolerance ebbs away. With each new program appearing expensive and complex I think the public is entitled to think that enough has been done. There has to come a time when the votes just won’t be there for the next program: the assumption will be that if all the effort up until then has not worked, then no government action is likely to work. If we arrive at that moment before the banks are fully recapitalized then we have deservedly consigned ourselves to years of poor growth and underperformance.

All of which could have been avoided had we been led with vigor earlier and had we confronted the problems aggressively up front.

So that’s why the Geithner Plan still gnaws away at me. I just can’t get myself to like it. Its lame.

Addendum:

I am not alone in this view. Martin Wolf at the Financial Times says the same thing: Successful Bank Rescue Still Far Away

Addendum 2: This comment at the blog Baseline Scenario continues the discussion: Plan “B”? The interesting point made here is in reference to Brad DeLong’s argument that, perhaps, the whole game being played by Obama is to exhaust everything else so that when he asks for the powers to nationalize failing banks he can get sufficient support in the Senate. This may be true. If it is, then the US has certainly dug itself a huge ideological hole out of which to climb. When the best solution is prohibited by political objections that can only be overcome at extraordinary cost and after calamitous failure of all other options, then a nation deserves the fate that its obstinancy brings. Let’s hope the Great Recession doesn’t morph into the Second Great Depression just because we didn’t have the guts to confront a failed ideology.