Bailouts Still a Necessary Evil

Dean Baker [1] is not an admirer of the stress tests or the administration’s financial market interventions, I think it’s safe to say. Rather than devote time to bashing both, however, he has cleverly opted to accept the administration’s stress test findings – a 100% pass rate – and argue that government support is clearly no longer needed. It’s a nifty (and satisfying) approach, but I don’t think it’s the best way to understand the current situation.

While many observers have focused on the pass/pass nature of the stress tests, that’s undoubtedly the least informative part of the published results. The real news is the scores – the estimated capital buffer the banks need to add to weather the crisis. These numbers should not be read as absolutes. Obviously, the figures are subject to change based on how successful banks are at raising private capital through equity offerings and sales of various subsidiary operations. They’re also dependent on macroeconomic conditions; as Dean notes, the adverse scenario doesn’t seem all that adverse in some respects, but by revealing the conditions against which it tested the banks, the Fed has made it possible for private investors (and, indeed, everyone) to use their own judgment in evaluating the results.

[2]

Should We Bail Out This Bailout?

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What the government has given us, in other words, is a pretty good picture of where the banks stand, subject to movements in a few observable variables. This can’t be interpreted as a license to begin a wholesale pullback of the government’s interventions; the test results explicitly take into account government backstops and equity injections. Take those away and the results change. But the publication of the results does give us an opportunity to revisit the strategy behind the interventions.

I am in agreement with several of Dean’s proposed strategic adjustments. I think it’s time to bury the Public-Private Investment Partnerships (PPIP), for instance. The PPIP plan was conceived in a much different climate, when capital markets were closed to nearly all banks, and when an extremely dire macroeconomic outlook promised no end to bank losses. The situation now looks less grim. Banks are having success raising private capital, and the promise of a return to growth (albeit extremely weak) within a few quarters suggests that most banks may be able to earn their way out of the crisis.

In other words, the government needn’t put together a complicated scheme to cajole private money into the financial system, and it certainly need not aid all banks equally. Instead, most of the large banks should be weaned off direct government aid over the next year. In the meantime, the government should move forward on a strategy to deal with large, complex institutions that are unable to recapitalize themselves. Bank of America and Citigroup should be given six months to shrink themselves to manageable size and raise capital, during which time a regulatory reform bill that includes explicit nationalization authority should be moved through Congress. The credible threat of receivership will focus minds at the country’s sickest banks and will provide an exit strategy if targeted equity injections and forbearance prove insufficient to save them.

I also agree with Dean that it’s time to address AIG’s status once and for all. And while I think the government should not yet wind down its guarantees or special lending facilities, I do believe it should put in place specific procedures for doing so, so it is clearly understood that these are not to become permanent features of the financial landscape.

All of this takes as a given that intervention continues to be the right path, which is not a position shared by all progressives. I am sympathetic to this view. No one wants to save a banking system that failed so spectacularly, just as no one wants to save car companies that ran themselves into the ground or homeowners who took out irresponsible loans to buy far too much house. All of this insults our natural sense of what is fair and right.

But it’s important to understand that the government’s first priority has to be to minimize the cost of this financial and economic crisis to us all. There will be time to revisit the failures of regulatory policy later, when conditions have stabilized. I don’t think Americans will have lapsed into complacency so much by autumn that real reform will be difficult to pass.

Many progressives want to use the actual process of crisis resolution to reshape the financial system, but this is like trying to install a sprinkler system while one’s home is on fire. It’s now time to have patience. If in a year’s time the Congress and the administration are no closer to a substantial regulatory overhaul, then it will be time to break out the pitchforks.