Wednesday, January 28, 2009

Commentary: How to rescue the bank bailout - CNN.com

Joseph Stiglitz has a thoughtful piece on CNN.com. While I disagree with what appears to be a call for the nationalization of more banks, I do agree that rewarding upside without some real downside risk will only yield more risky behavior which will hurt the economy and lead to future blow-ups. My solution I guess would be to both allow temporary nationalizations (but with a hard fast exit date of no more than five years where the bank is either sold or closed) but also bite the bullet and let some banks fail now. Sure it is painful. Sure some will lose jobs, but what is the alternative?

Some look-ins that might help explain why there is no simple quick fix:

Commentary: How to rescue the bank bailout - CNN.com:
"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:
"...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."

And his version of "Debt makes good times great, bad times horrible" and realization the problem is REALLY big:
"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.... 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?"
Why aren't banks lending?

"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....risks are high in a recession. Having been burned once, many bankers are staying away from the fire...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."

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