Does Obama Have a Plan B?

Op-ed in the Daily Beast

March 29, 2009

It is so much harder when the financial crisis is in your own country.

Timothy Geithner, Larry Summers, and a host of other economists-myself among them-spent the late 1990s yelling at Japanese and other Asian officials to clean up their banking crises. A typical conversation would end with the American adviser bursting with frustration: "Don't you understand? The money is gone. If you just wish for the banks' asset values to come back, any recovery will be short-lived and you will only get more losses in the end. We all know this from long experience."

Then we would go to conferences and discuss what it was about Japanese (or Korean or Indonesian) political economy that prevented resolute action.

So it is with some irony if not humility that we should approach Treasury Secretary Geithner's Public Private Investment Plan presented on March 23. A number of major American banks have lost huge amounts of money, and clearly have insufficient capital if they are not literally insolvent. Why else would they be pushing so hard to change the accounting rules to avoid showing what they really have on their books instead of raising private capital? Why else is the US government taking so long to perform "stress tests" and trying to get expectations of overpayment for some of the bad assets on the banks' books before the test results are out? In short, the US government is looking to shovel capital into the banks without sufficient conditions, hiding rather than confronting the actual situation.

That is just like the Japanese government in their lost decade, or the US officials during the 1980s before they really tackled the savings-and-loan crisis. In those cases, the delay simply made the problem worse over time and in the end the government had to put more money into the troubled banks directly, taking over or shutting down the weakest of them. Whatever the political culture, it would seem we have not learned from experience. Or perhaps we cannot act on our learning. The universal barrier would appear to be the political difficulty of recapitalizing banks. That seems obvious, but the constraint it puts on good policy is enormous.

That is why the Geithner plan is so complex and jury-rigged, to avoid the need for public requests for more money for banks. Unfortunately, it is unlikely to succeed absent additional public money and more-intrusive government action. The plan will buy some time and certainly some appreciation in bank share prices. Current shareholders will be getting a new lease on life with subsidies from taxpayers. For that reason alone, the plan certainly will cost the taxpayer more in the end than a more direct recapitalization with public control would have.

A year or two down the road, we will know for certain whether it worked. By then the banks will either return to normal pre-crisis lending or they will be both too distrusted and too distrustful even to borrow from each other again. As we have seen over the last 18 months, the latter is what near-insolvent banks do. When I was working with the US Council of Economic Advisers and the Japanese business federation Keidanren in 2001-02 encouraging the Japanese government to do finally what was needed, it was the commitment of public money with tough conditions on the banks that we pushed for, and it was the normalization of the interbank market and then of lending behavior that showed success.

In essence, the U.S. Treasury's plan to subsidize private investors' purchases of the banks' toxic assets is a too-clever-by-half mechanism to fix the banks while avoiding going to Congress for more upfront on-budget expenditures. One can imagine the discussions at the White House: We have a budget to pass, and cannot give up those goals to give the bankers still more. Figure out some way to do this off-budget. And so the Geithner plan hugely bribes private investors with taxpayer money, as Simon Johnson, Paul Krugman, Jeffrey Sachs, and I have all described, with one-way government insured bets. Yet the bets are contingent, they only pay when the taxpayer loses-and those losses first appear on the Fed or FDIC balance sheet, not subject to congressional approval.

I know that the very same self-limiting discussions took place at Okurasho, the Japanese Ministry of Finance circa 1995-1998. And they ended with the same result, a series of bank-recapitalization plans that tried to mobilize private-sector monies and overpay for distressed bank assets without forcing the banks to truly write off the losses. Even though the top Japanese technocrats at the ministry were even more insulated from a weak Diet than the congressionally unconfirmed advisers currently running economic policy for the Obama administration, they did worse. Whatever the political context, countries usually try to end banking crises on the cheap, with a limited public role at first, overpaying for distressed assets and failing to change banks' behavior, only to have to go back in a couple of years later.

I hope the Geithner plan, combined with the other financial measures under way, proves to be an exception to the rule and succeeds in stabilizing the U.S. banking system. It could remove some of the bad assets from the banks' balance sheets and put some capital into the banks. Even in that best case, though, it is clear that the avoidance of on-budget costs makes it penny-wise, pound-foolish, for the U.S. taxpayer. It will likely cost the taxpayer more on net, between the subsidies given and the transfer of most upside gains to the private investors, and the overpayments to current bank shareholders for toxic assets. If the U.S. government steps in more aggressively to take full ownership and pays a low price for these assets, the taxpayer would stand to get the full upside, even though it would require more cash up front. That would still be better than the Japanese experience.

But the pattern of these crises-Japan in the 1990s or the U.S. in the 1980s, and elsewhere around the world-leads me to believe that this partial fix will be temporary at best. The banks will still have the worst toxic assets on their books; their managers and shareholders' incentives will not have changed. The banks will be playing with a fresh stack of public money with insufficient strings and probably insufficient capital. Then, 18 months or so down the road, the U.S. government will still have to put capital into the banks, because credit markets will break down again, with many banks again under water. But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out.

Part of the problem is that some of these distressed assets are genuinely toxic. They cannot be consistently valued and priced by anyone because they are part of larger securitized packages and so purchasers cannot disentangle the underlying investments behind them. Under the Treasury plan, those toxic assets are not restructured, but sold as-is just because of the federal guarantee offered against losses. Restructuring these assets would require government supermajority ownership, which so far seems to be politically unpalatable. In which case, the FDIC will end up paying out on the insurance for overpriced assets.

What the Obama team is proposing is disconcertingly similar to the actions of Japanese Prime Ministers Hashimoti, Obuchi, and Mori in 1995 and 1998: Rather than ask the legislature for straightforward recapitalization money, you have the political leadership preferring to risk overpaying current owners of toxic assets rather than forcing sales. For all of Japan's supposed intervention in markets, its government still lacked the stomach for taking over banks, let alone closing them.

In 1998, Japan did get a reformer, Hakuo Yanagisawa, the first financial-services minister independent of the Ministry of Finance. He got a bank recapitalization under way-but did so without putting enough conditions on the capital, hoping to mobilize private investment and limit the number of bank nationalizations. I remember a dinner with him in Tokyo shortly thereafter, where he spoke with conviction about the need to be tough with the irresponsible banks, and how he was politically independent enough to be tougher than the bureaucrats had been, since he was an elected official running a new agency. Three years later, the Japanese banking system failed again, imperiling the economy, while having accumulated billions more in non-performing loans.

Only when Heizo Takenaka became the responsible minister in 2002 were Japanese banks forced to write down the value of the distressed assets before getting recapitalized. From that point forward, the Japanese economy began growing again, and within months, the worst of the Japanese banking crisis was resolved. In the meantime, a couple of Japanese governments had lost power, Yanagisawa had been replaced three times, and Japan suffered three more years of recession.

Takenaka was a brave academic economist unafraid to cite lessons from the U.S. and abroad and took strength from the personal support of the new reformist Prime Minister Junichiro Koizumi. At least as importantly, though, the failure of the Japanese banking system had become so evident and imminent that politicians had no choice but to do the right thing with public capital injections and some bank closings. It is as easy to imagine the candidates for the Takenaka role in the U.S. today as it is tempting to hope that Geithner's current plan will work, albeit at excessive taxpayer expense. But I fear that until Congress gets the message, a lasting resolution of the U.S. banking crisis will not occur-and it may take the failure of the current plan to get that message across, as it did in Japan and elsewhere.