Reply #46: A Bank Bailout That Works By Joseph E. Stiglitz

[Demeter]

http://www.thenation.com/doc/20090323/stiglitz/single?rel=nofollow

The news that even Alan Greenspan and Senator Chris Dodd suggest that bank nationalization may be necessary shows how desperate the situation has become. It has been obvious for some time that a government takeover of our banking system--perhaps along the lines of what Norway and Sweden did in the '90s--is the only solution. It should be done, and done quickly, before even more bailout money is wasted.

The problem with America's banks is not just one of liquidity. Years of reckless behavior, including bad lending and gambling with derivatives, have left them, in effect, bankrupt. If our government were playing by the rules--which require shutting down banks with inadequate capital--many, if not most, banks would go out of business. But because faulty accounting practices don't force banks to mark down all their assets to current market prices, they may nominally meet capital requirements--at least for a while....


There is a basic principle in environmental economics called "the polluter pays": polluters must pay for the cost of cleaning up their pollution. American banks have polluted the global economy with toxic waste; it is a matter of equity and efficiency that they must be forced, now or later, to pay the price of cleaning it up. As long as the banking sector feels that it will be bailed out of disasters--even ones it created--we will continue to have a moral hazard. Only by making sure that the sector pays the costs of its actions will efficiency be restored.

The full costs of those mistakes include not just the $700 billion bailout but the almost $3 trillion shortfall between the economy's potential output and its actual output resulting from the crisis. Since we are not forcing banks to pay these full costs imposed on society, we should hear no complaints from them about paying for the much smaller direct costs of the bailout.

The politicians responsible for the bailout keep saying, "We had no choice. We had a gun pointed at our heads. Without the bailout, things would have been even worse." This may or may not be true, but in any case the argument misses a critical distinction between saving the banks and saving the bankers and shareholders. We could have saved the banks but let the bankers and shareholders go. The more we leave in the pockets of the shareholders and the bankers, the more that has to come out of the taxpayers' pockets.

Principles and Goals

There are a few basic principles that should guide our bank bailout. The plan needs to be transparent, cost the taxpayer as little as possible and focus on getting the banks to start lending again to sectors that create jobs. It goes without saying that any solution should make it less likely, not more likely, that we will have problems in the future.

By these standards, the TARP bailout has so far been a dismal failure. Unbelievably expensive, it has failed to rekindle lending. Former Treasury Secretary Henry Paulson gave the banks a big handout; what taxpayers got in return was worth less than two-thirds of what we gave the big banks--and the value of what we got has dropped precipitously since.

Since TARP facilitated the consolidation of banks, the problem of "too big to fail" has become worse, and therefore the excessive risk-taking that it engenders has grown worse. The banks carried on paying out dividends and bonuses and didn't even pretend to resume lending. "Make more loans?" John Hope III, chair of Whitney National Bank in New Orleans, said to a room full of Wall Street analysts in November. The taxpayers put out $350 billion and didn't even get the right to find out what the money was being spent on, let alone have a say in what the banks did with it.

TARP's failure comes as no surprise: incentives matter. Bankers won't restart lending unless they have a reason to do so or are forced. Receiving billions of dollars in bonus pay for racking up record losses is a peculiar "incentive" structure. Bankers have been accused of unbounded greed using hard-earned taxpayer dollars for bonuses and dividends, but economists more calmly observe: they were simply responding rationally to the incentives and constraints they faced.

Even if the banks had not poured out the money in bonuses as we were pouring it in, they might not have restarted lending; they might have just hoarded it. Recapitalization enables them to lend. But there is a difference between the ability to lend and the willingness to lend. With the economy plunging into deep recession, the risks of lending are enormous. TARP did nothing to require or create incentives for new lending, focusing instead on cleaning up past mistakes. We need to be forward-looking, reducing the risk of new lending. Just think of what new lending $700 billion could have financed. Leveraged on a modest ten-to-one basis, it could have supported $7 trillion of new lending--more than enough to meet business's requirements.

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Is There an Alternative?

Firms often get into trouble--accumulating more debt than they can repay. There is a time-honored way of resolving the problem, called "financial reorganization," or bankruptcy. Bankruptcy scares many people, but it shouldn't. All that happens is that the financial claims on the firm get restructured. When the firm is in very bad trouble, the shareholders get wiped out, and the bondholders become the new shareholders. When things are less serious, some of the debt is converted into equity. In any case, without the burden of monthly debt payments, the firm can return to profitability. America is lucky in having a particularly effective way of giving firms a fresh start--Chapter 11 of our bankruptcy code, which has been used repeatedly, for example, by the airlines. Airplanes keep flying; jobs and assets are preserved. Under new management, and without the burden of debt, the airline can go on making a contribution to our society.

Banks differ in only one respect. The failure of a bank results in particular hardship to depositors and can lead to broader problems in the economy. These are among the reasons that the government has provided deposit insurance. But this means that when banks fail, the government comes in to pick up the pieces--and this is different from when the local pizza parlor fails. Worse still, long experience has taught us that when banks are at risk of failure, their managers engage in behaviors that risk losing even more taxpayer money. They may, for instance, undertake big bets: if they win, they keep the proceeds; if they lose, so what?--they would have died anyway. That's why we have laws that say when a bank's capital is low, it should be shut down. We don't wait for the till to be empty. Because the government is on the hook for so much money, it has to take an active role in managing the restructuring; even in the case of airline bankruptcy, courts typically appoint someone to oversee the restructuring to make sure that the claimants' interests are served.

Usually, the process is done smoothly. The government finds a healthy bank to take over the failed bank. To get the healthy bank to do this, it often has to "fill in the hole," making up for the difference between the value of what the bank owes depositors and the value of the bank's assets. It's no different from an ordinary takeover or merger, except the government facilitates the process. Typically, in the process, shareholders get wiped out, and often the government and/or private investors may put in additional money.

Occasionally, the government can't find a healthy bank to take over the failed bank. Then it has to take over the failed bank itself. Usually, it restructures the bank, shutting down many of the branches and lending departments with particularly bad track records. Then it sells the bank. We can call this "temporary nationalization" if we want. But whatever we call it, it's no big deal. Not surprisingly, the banks are trying to scare us into believing that it would be the end of the world as we know it. Of course, it can be done badly (Lehman Brothers, for example). But there are far more examples of it being done well.

The current situation is only slightly different. There are few healthy banks to take over the very many unhealthy banks, and the banks are in such a mess--and the economy is in such a downturn--that we don't really know how much money would be needed. We don't know if claims by depositors are greater than the value of assets, and if so, by how much. The banks may claim, If we hold the assets long enough, and if the real estate market recovers, and if our recession isn't too deep or long, then we can meet all our obligations. We are "solvent." We just can't get the cash we need.

Those are big ifs. That's why governments typically make judgments based on market values. Right now, the suspicion is that the banks don't meet their capital requirements with current market values, let alone the market values in the future, as real estate prices continue to fall and the downturn gets worse. (If banks don't have enough capital, we would give them short notice: either come up with additional capital, or you can't continue to operate as you are. We either find someone to take you over, or we run you, restructure and sell.)

The banks obviously don't want the government to play by the rules. They want to delay the day of reckoning. They want what is called forbearance. They say, Allow us a little slack now, because we are fundamentally sound. Of course they would say that. Of course banks claim that market prices underestimate true values. We learned the hard way in the S&L crisis, however, that delay is very costly. We are on track to learn that lesson again.

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About Joseph E.Stiglitz
Joseph E. Stiglitz is University Professor at Columbia University. He received the Nobel Prize in Economics in 2001 for research on the economics of information.