Firefighter arson is a serious problem.  The U.S. Fire Administration, part of Homeland Security, concluded in 2003, “A very small percentage of otherwise trustworthy firefighters cause the very flames they are dispatched to put out” (p.1). Illustrative and shocking anecdotes are on pp. 9-15 of that report, as well as here and here.

Macroeconomic policy making now has a similar issue to confront.

As the economy begins to stabilize and the financial system shows signs of recovery, accolades start to shower down on various officials, including most recently Ben Bernanke, who was rewarded this week with renomination – and almost certain confirmation – to a second term as chairman of the Federal Reserve Board of Governors.

Bernanke is widely seen as our financial firefighter in chief (BusinessWeek; USA Today)  Similar terms are used to describe Treasury Secretary Tim Geithner and the entire gigantic financial rescue effort.  Larry Summers, head of the White House National Economic Council and administration economic guru-at-large, is applauded as an “experienced crisis manager”, which amounts to the same thing in this context.

If any of this sounds familiar, you’re probably remembering the famous cover of Time magazine from November 1999, which depicted Alan Greenspan, Robert Rubin, and Summers as “The Committee To Save The World.”  The idea then was that crises in Asia, Latin America, and Russia had spilled over to US financial markets, most notably in the near failure of Long Term Capital Management, but disaster had been averted by – essentially – the financial firefighting abilities of this troika.

But what if the financial crises in recent decades – you can add the dotcom bubble, the S&Ls fiasco, and various emerging market debt crises to our recent housing and banking disaster – is not a sequence of random unfortunate events, but rather the product of a dangerous financial system?  Given that today’s firefighters also previously held responsibility for overseeing this system, both recently and as long ago as the early 1990s, this question is relevant – particularly as the very same team, in various combinations, repeatedly pronounced on the system’s fundamental soundness. 

Some of today’s firefighters pushed hard for deregulation of derivatives markets in the 1990s, and this now proves to have been an important cause of the crisis (Summers and others).  Others had responsibility for the solvency of Wall Street over the past half decade, yet disguised all potential warnings in layers of impenetrable opaqueness (e.g., Geithner; see p.91 in David Wessel’s bestselling In Fed We Trust, Crown Business, 2009).  Still others pronounced that there was no housing bubble exactly as things spiraled out of control and the potential costs to taxpayers rose (Bernanke and his colleagues at the Fed; again, pick up Wessel’s book, p.93 is among the most damaging).

No one is suggesting that our illustrious financial firefighters deliberately triggered a crisis.  But, for over two decades, they and their close mentors oversaw the operation and development of a banking and securities system with profound instability hard wired into its DNA.  Don’t take my word for it; review this speech by Summers in April 2009, or – in the light of what we know now – look at his talk on crises to the American Economic Association in 2000.

Perhaps that was all a legitimate mistake on their parts and they have now learned the right lessons.  But how then do you explain their amazing reluctance to reform the financial system today?

President Obama said on Tuesday that Ben Bernanke helped avert a second Great Depression.  That is a considerable achievement, but why then are this administration and the Federal Reserve proposing only minor adjustments in oversight and governance for the financial system that ran amok – producing “financial innovation” that harms consumers and destabilizes everything?

It makes no sense at all.  Unless, of course, they are not afraid of future financial fires – despite the enormous fiscal cost (likely 40% of GDP from this round alone), the unemployment (heading to and lingering at 10%, by the administration’s own revised estimates), and the millions of people hammered hard by lender abuse, house price collapse, and job losses.

You may not like the implications, but keep in mind this advice: “To ignore the problem or suggest that it does not exist will only increase the damage caused by the arson firefighters involved, as well as destroy the morale of the other firefighters in their departments” (Minnesota Fire Chief, March/April 1995 issue, quoted on p.1 of above cited report).

By Simon Johnson

A slightly edited version of this post originally appeared on NYT.com’s Economix, and from that version you can link directly to the referenced pages in David Wessel’s book. 

This post is reproduced here with permission.  If you would like to use the entire post, please contact the New York Times.  The usual fair use rules apply to short quotations.

On Monday and Tuesday of this week, Treasury Secretary Geithner – and Secretary of State Clinton - meet with a high-level Chinese delegation.  (Could someone please update the Treasury’s schedule of events? At 7am on Monday it still shows last week’s agenda; update, 9am, this is now fixed – thanks).

According to official previews (i.e., the apparent contents of background briefings given to wire services), the economic topics are China’s concerns about the value of the dollar (i.e., their investments in the U.S.) and the amount of debt that the U.S. will issue this year.

This is absurd.

China decided to accumulate over $2trn worth of reserves, most of which they are presumed to hold in dollars.  No one compelled, suggested, or was even particularly pleased by their massive current account surplus (peaked at 11% of GDP in 2007, but still projected at 9.5% of GDP for 2009).  We can argue about whether this surplus - arguably the largest on modern record for a major country – was intentional or the result of various policy accidents. 

Irrespective of underlying cause, any country that runs such a current account surplus is implicitly taking a great deal of currency risk – China was in effect deciding to take the biggest ever official long-dollar position.  The idea that the US government should spend time reassuring them is somewhere between quaint and not good strategy.

If China decides to now shift out of dollars, what would happen?  Remember that the US left the world of fixed exchange rates and associated rigidities a long time ago – back in the early 1970s.  The dollar would surely depreciate and inflation would likely rise.  But who cares?

A weaker dollar would help our exports.  It’s not honorable for the issuer of a reserve currency to talk down its own exchange rate (hence the Rubinesque “strong dollar” rhetorical trap), but if a third party leads a big sell-off, what can we do about it?

Treasury’s concern is not really the value of the dollar – particularly as they would like a bit of inflation at this point; again, if it’s China’s fault that the real value of our debts falls, that might play (or spin) well in Peoria.  Instead, Treasury’s concern is the large amount of debt that they/we are trying to issue.

If China is worried about the future value of our debt in renminbi, then Treasury will have to pay higher long term interest rates.  But, as Treasury and the White House have been emphasizing, what really matters for our long-term fiscal solvency is bringing Medicare and associated costs under control.  Any strategy that relies instead on indefinitely low long-term interest rates is illusory – and any investor who thinks we will be like Japan in this regard is in for some disappointment.

The real issue for discussion this week should be China’s current account surplus and the pressing actions needed to bring this under control.  The US should put on the table the possibility of more assertively taking China to the World Trade Organization over its fundamentally undervalued exchange rate and associated trade policies (Arvind Subramanian’s idea).  The exchange rate dimension should have been dealt with by the IMF, but unfortunately that organization has (again) ducked its responsibilities on this issue.

The Treasury apparently thinks it should be deferential and on the defensive vis-a-vis China.  This is not only bad economics, this is bad geopolitical strategy.

By Simon Johnson

Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation. 

The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.

1. Their view: Regulation is overly focused on safety and soundness of individual banks.  Reality: There was a complete failure of safety and soundness supervision.  This must be fundamental to any financial system – without this, you’ll get mush every time.
2. Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator.  Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess.  If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up.  The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
3. Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors.  Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage.  What prevents the biggest banks from capturing or manipulating regulators?  There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
4. Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.”  Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued.  We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
5. Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.”  This sounds incredibly vague and may be the worst news today.  It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.

And of course the complete omissions from this document are breathtaking.  No mention of executive compensation or the structure of compenstion within the financial sector.  Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking.  And no notion of regulatory capture-by-crazy-ideas of any kind.

There are a couple of positive notes towards the end.  The administration will seek a resolution authority for dealing with failed banks, but we knew this already.  And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.

Overall, there are no surprises here.  Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09.  But presumably by then the authors will be out of office.

By Simon Johnson

France in the 1960s and 1970s was the source of a tremendous amount of new philosophical, literary, and critical thinking – Foucault, Derrida, Lévi-Strauss, Baudrillard, Barthes, etc. But in my opinion, the most important member of that intellectual generation was the sociologist Pierre Bourdieu. In Distinction, Bourdieu’s best-known work, he described how economic class is reinforced by cultural capital: economic elites create cultural distinctions, and pass on to their children the ability to make those distinctions, in order to use cultural sophistication as a means of perpetuating class dominance. This may sound abstract, but think about the example that is the subject of Bourdieu’s The Love of Art: museums. Upper-class parents take their children to fine art museums and teach them how to talk about Rembrandt, Monet, and Picasso; later in college, job interviews, and cocktail parties, the ability to talk about Rembrandt, Monet, and Picasso is one of the markers that people use, consciously or unconsciously, to identify people as being from their own tribe. (Note that democratizing museums – making them open to anyone – doesn’t undermine cultural capital, because the key is not looking at paintings, but learning how to talk about them.)

We used the term “cultural capital” in our Atlantic article as a way of describing the influence of Wall Street over Washington. By this, we meant that one of the primary means by which Wall Street got its way in Washington was by creating and propagating the understanding – among sophisticated, educated, cultured people, as opposed to “populists” or the “rabble” that showed up at anti-globalization protests – that what was good for Wall Street was good for the country as a whole. We didn’t mean to say that old-fashioned campaign contributions and lobbying did not play an important role. (We did, however, say that we thought out-and-out corruption of the Jack Abramoff variety was probably a minor factor – not because we have any insider knowledge one way or the other, but simply because such criminal behavior was simply unnecessary given the other levers available.) But I don’t think that implicit quid pro quo bargaining is a sufficient explanation, because I believe it entirely possible that there are honest politicians and civil servants who really, truly believe that they are acting in the public interest when they come to the aid of the largest banks.

Tim Geithner may very well be such a man.

The New York Times ran a long article today about Geithner’s close connections to the New York financial elite during his years as president of the Federal Reserve Bank of New York, a curious public-private entity that plays a crucial role in the operation of the Federal Reserve, yet is governed by a board a majority of which is elected by the private sector banks themselves. The general thrust of the article is that Geithner had close relationships with many of the people whose banks it was his job to supervise, and that many of his proposals and policies have been generally friendly to those banks. But it should be noted that even after reviewing Geithner’s calendar for all of 2007 and 2008, with all its tantalizing mentions of posh meals and get-togethers (the Four Seasons is mentioned seven times), the Times did not find a smoking gun. Geithner was approached as a candidate to be CEO of Citigroup (an offer he quickly rejected), but nowhere is there any evidence that he traded favors for any kind of personal gain.

Instead, what the article portrays is a continuing series of close contacts – breakfast, lunch, dinner, coffee, charity board meetings, etc. – with a set of very rich, very powerful, very impressive people who all believed in the importance of Wall Street, and the importance of lighter regulation of Wall Street, and the importance of making sure that Tim Geithner believed in it too. It’s doubtful that there was anything close to a countervailing influence from people who thought that Wall Street was taking excessive risks and needed to be reined in; the first meeting with Nouriel Roubini was on August 28, 2008. I don’t mean to imply that Geithner was an impressionable youngster when he arrived at the New York Fed. He was 42 (older than I am now), and he had grown up in the Treasury Department in the Clinton administration. But that was a Treasury Department headed by Robert Rubin (former head of Goldman Sachs, later head of the executive committee at Citigroup) and his disciple Larry Summers, both of whom were strong believers – at the time, at least – in the importance of Wall Street and free financial markets.

The Geithner presidency seems to have represented the high point of a long tradition of cozy relationships between the head of the New York Fed and the banks it supervised. The Times article points out that Geithner’s two predecessors ended up as executives at investment banks, and his successor came from Goldman Sachs. But under Geithner, the relationships may have been their coziest:

Other chief financial regulators at the Federal Deposit Insurance Company and the Securities and Exchange Commission say they keep officials from institutions they supervise at arm’s length, to avoid even the appearance of a conflict. While the New York Fed’s rules do not prevent its president from holding such one-on-one meetings, that was not the general practice of Mr. Geithner’s recent predecessors, said Ernest T. Patrikis, a former general counsel and chief operating officer at the New York Fed.

“Typically, there would be senior staff there to protect against disputes in the future as to the nature of the conversations,” he said.

And at the same time, Geithner seems to have been an especially able advocate for Wall Street, both while at the New York Fed and as Secretary of the Treasury. The Times focuses on a few incidents where he took the banks’ side against other regulators, such as the debate over adopting Basel II, which essentially allowed banks to use their own risk models to determine how much capital they needed. And it should be undisputed that since taking over Treasury Geithner has taken positions that are generally friendly to the large banks (Public-Private Investment Program) or reflect a Wall Street-centered worldview that misreads public and political sentiment (AIG bonus fiasco). He has also continued to surround himself with people from Wall Street, including his chief of staff, the law firm that drafted the proposed legislation giving Treasury resolution authority for non-bank institutions, and the asset management firm handling Treasury’s troubled assets. None of this is new, of course; Treasury has been hiring people from Wall Street for years. And that’s precisely the point.

I don’t know Tim Geithner. But I have no reason to believe he is corrupt. Instead, the simplest explanation of the Times article is that he has internalized a worldview in which Wall Street is the central pillar of the American economy, the health of the economy depends on the health of a few major Wall Street banks, the importance of those banks justifies virtually any measures to protect them in their current form, large taxpayer subsidies to banks (and to bankers) are a necessary cost of those measures – and anyone who doesn’t understand these principles is a simple populist who just doesn’t understand the way the world really works.

Returning to my initial theme, he got the cultural education that rich people get, except instead of just going to the Metropolitan Museum of Art and the Museum of Modern Art, he was educated in the culture of Wall Street. Just like an education in art history is a marker of class distinction that is used to perpetuate class distinction, an education in modern finance is a marker of distinction that sets off those who understand the true importance of Wall Street for the American economy. As long the powerful people in Washington, including the regulators who oversee the financial industry, share that worldview, Wall Street’s power and ability to make money will be secure.

That is the importance of cultural capital.

Update: I’d like to recommend this comment by former young Fed-er, which inexplicably got caught in the spam filter for the last eighteen hours. Here are some excerpts:

I don’t know Tim Geithner either, but I did used to work at the Fed at a very low level, but a level sufficient to grant access to those weekly briefings you see on his calendar, during which he would be briefed by the Fed’s research economists. His thinking was definitely steeped in Wall Street kool-aid. He would often pose opinions generated by Wall Street economists and executives to the Fed’s economists as a way of challenging their thinking and getting them to explain themselves. One got the sense that he spent an awful lot of time talking to Wall Street executives, but that was, after all, a big part of his job.

What is so shocking is that now, when the mess that is the current system has been exposed to him and everyone else, that his thinking doesn’t seem to have changed at all. We were all surprised to varying degrees by the financial crisis (Roubini least, I guess) and many are now trying to rethink the system; Geithner still seems wedded to Wall Street’s way, which is to say, “innovation”, lending determined by the vagaries of the trading floor, big bonuses, and the whole misbegotten quantitative finance approach (i.e. everything, from incentives to risk and all the complexity of human relations, can be written on a napkin using greek letters and equals signs). . . .

The other thing I got from witnessing these meetings is that, in support of the cognitive capture theory (as opposed to the corruption theory), given that he was such a careful and deliberative thinker, he seemed to have a good deal of integrity. He respected people’s opinions and considered them carefully, and he gave credit where it was due. He seemed to follow a Gandhian leadership philosophy: lead by walking behind.

By James Kwak

This morning, by coincidence, there are parallel hearings on Capitol Hill dealing with the nature of our banking system and attempts to stabilize it.  In the Cannon House Office Building, starting at 9:30am, the Joint Economic Committee will hear from Thomas Hoenig, Joseph Stiglitz, and me, on whether Big Finance is too big to save (see yesterday’s preview for details).

At 10am over on the Senate side (Dirksen Senate Office Building), Secretary Geithner will appear before the TARP Congressional Oversight Panel.  We preview that event this morning on The Hearing, with a discussion of the context, the latest numbers, and our forecast of the ideas that will be expressed; it’s a viewer’s guide – but one that you can talk to by sending in comments (and, most important, your questions for the Secretary).

My questions for Secretary Geithner remain about the same as they were on February 7th.  As reflected in those questions, I continue to worry that the Administration’s “wait-and-see” strategy is just increasing the ultimate costs – in terms of financial losses and unemployment.  No government ever likes to tackle a severe banking crisis head on (mostly because that would greatly upset the financial elite), but it’s almost always the right thing to do.

I remain unconvinced by the Treasury’s line that “there is no alternative” to their approach.  Or perhaps they are shifting towards the line that: “based on information that only the government has (and can have), it is our assessment that all other approaches would be more damaging.” 

If that is now their position, we have built a financial system that is immune to democracy – today’s complexity and lack of transparency mean that it is easier than even to become too big to fail.  The major banks now know this and will behave accordingly.

By Simon Johnson

Leaving aside the question of subsidies, which has gotten piles of attention on the Internet, Simon and I are skeptical that the Geithner Plan will achieve its basic objective: getting enough toxic assets off of bank balance sheets to restore the financial system to normal functioning. We discuss this in today’s Los Angeles Times op-ed, although our regular readers could probably fill in the blanks by themselves.

Update: At 2:30 PM Eastern today, I’ll be on a live chat at Seeking Alpha with Felix Salmon and possibly Brad DeLong and Mark Thoma discussing the Geithner plan. Salmon is strongly against, Delong is moderately (strongly?) for, Thoma is moderately for.

Update 2: At The New Republic, Simon discusses one plausible scenario under which the Geithner Plan is the first step in a comprehensive bank rescue strategy. But he’s skeptical that we will see the other necessary steps.

Update 3: Chat is done; replay is here.

By James Kwak

I finally got around to listening to Tim Geithner’s interview with Adam Davidson for Planet Money. (Simon already commented on it.) I had two main reactions.

1. Around the 14:30 mark, in response to a question about the problem of valuing bank assets, Geither said this:

If somebody asks you, “what’s your home worth today?,” your answer to that question would be dependent on whether you had to sell it today, or you were planning to sell it in three years . . . or you were planning to sell it in ten years . . . So that basic challenge of trying to figure out what your home is worth, or what any asset is worth, depends a lot on how long are you’re going to hold it, and it depends a lot on whether there’s going to be financing available to people out there who might buy it. And in the absence of financing, if you had to sell it today, it would be worth a fraction of its basic value. Now, what’s happening in our market today is that we have just a broad shortage of financing available. And what the government needs to do in that context . . . is to try to make sure that the government and the central bank together can provide the financing to help get those markets working. And that will make it more likely that these assets are worth and will have the value that is their basic inherent economic value rather than an artificially depressed value that reflects the absence of financing and credit.

Yes, someday the economy will start to recover. And yes, someday it will be easier to get a mortgage (although it should be noted that mortgage rates are historically low right now, so mortgage rates will probably be higher in the future). When the economy starts to recover, housing prices will start going up. But we have no idea where the bottom will be, and so there is no assurance that even in ten years you will be able to sell your house for more than you paid for it. There isn’t even any assurance that you will be able to sell your house for more than it is worth now. If, as some people believe, housing prices still have another 20% to fall, it could take ten years to make that up. And there are some people who argue that, in the absence of increasing population density, there is no reason for real housing prices to go up at all.

The idea that houses have a “basic inherent economic value” other than the prices they can fetch in the housing market is, I think, a fallacy. And so the idea that therefore houses will naturally return to some “basic inherent economic value” that is higher than current market prices is, I think, wishful thinking of the kind that has hampered responses to this crisis from the beginning. They could; but they could just as well not.

2. Near the end, when Adam Davidson was trying to get Geithner to say something, anything, about nationalization, he said this:

It’s not the right strategy for our country for basic practical reasons that our system will be stronger if it remains in private hands with support from the government to make sure those institutions can play their critical role going forward.

I listened to the end but I didn’t hear any “basic practical reasons.” To be blunt, it sounded like the “private is better” mantra we heard from the Bush administration, and (to a slightly less extent) the Clinton administration before them. Sure, most people agree you don’t want all individual lending decisions being made by bureaucrats in Washington, but that’s just a straw man. There are valid reasons to debate whether nationalization is the best solution; in particular, if you were to take over Citigroup, even for a short period of time, would that immediately weaken Bank of America so much that you would be forced to take it over the next day? And what about JPMorgan Chase? But that’s not what Geithner said. He said “private is better.”

Now, maybe that’s just because Tim Geithner doesn’t want to get into a serious debate about the merits of government takeovers on national radio, because he’s afraid of the impact that might have on the markets. I respect that. But let’s hope that when they have these debates in private, they don’t just write “private is better” on the whiteboard and call it a meeting.

Secretary Geithner spoke with NPR’s Adam Davidson today and the result, on the Planet Money podcast, is a helpful guide to official thinking.

The Secretary’s best line, at around the 18 minute mark is, ”If you underestimate the problem; if you do too little, too late; if you don’t move aggressively enough; if you are not open and honest in trying to assess the true cost of this; then you will face a deeper long (sic) lasting crisis.” 

The contrast he draws is with those who favor a more gradual approach to banking system problems that would “stretch it out.”  After about 17 minutes (and again around 20 minutes), Secretary Geithner contrasts what he is doing with “letting the market sort it out by itself”.  

He does not even hint at the possbility that there is a government-led strategy that could faster than what he has in mind.  So could it be that he really has in mind something that will actually be bold and move fast?

I don’t think so.  He says we will “make capital available where it is necessary”.  But he also stresses, in response to Adam’s last question (after around 25 minutes), “[Nationalization] is not the right strategy for the country.”  And Secretary Geithner says clearly “that broad strategy” would do more damage than his policies.

The bottom line is that the government will support the credit system a great deal and in many innovative ways, but Treasury will try really hard to avoid FDIC-type takeovers/reprivatizations of large banks.  This is quite striking, and presumably the hope is that a big “no nationalization” rally in the price of banks’ common equity will turn the tide more generally.

But the government’s stress scenario is quite optimistic, the real economy continues to weaken, and global problems mount.  How much government capital can you put into the banking system until the lack of taxpayer upside becomes quite awkward?  And if that taxpayer upside takes the form of common stock, how do you prevent the state from effectively acquiring a controlling stake in large troubled banks?  Numerous smart people are at work on this problem, but it is probably intractable.

The underlying question is in any case much simpler.  How long can you say, “we are being bold” when in fact you are not?

At management team meetings at my old company, there was a slogan I was known for: “No wishful thinking.” I would trot it out whenever I felt like our expectations for the future (say, our sales projections, or our product delivery dates) were being influenced by our desires for the future. Let’s say, for example, that you have to hit your sales target, raise more money, or lay people off. It is very easy to plan around hitting your sales target, because the other options are unpleasant. But that would clearly be folly.

I thought of this when listening to an interview Adam Posen did for Monday’s Planet Money (beginning around the 6-minute mark). The Geithner Plan had not yet been announced, but Posen already had the right diagnosis: wishful thinking. The administration, on his analysis, is hoping that it will be able to turn the economy around without having to take tough measures with the banks.

Martin Wolf puts it this way:

[H]oping for the best is what one sees in . . . the new plans for fixing the banking system. . . .

The banking programme seems to be yet another child of the failed interventions of the past one and a half years: optimistic and indecisive.

I also thought this was particularly insightful:

Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress.

It does seem like Geithner’s proposals are a kind of effort to piece together a solution given those three constraints, ultimately founded on the hope that the underlying problems are not all that serious.  But I’ll stop there. Sometimes we bloggers compete to come up with marginally more interesting ways of telling the same story. For today I’ll just recommend reading all of Wolf’s post.

When you cut through the technical details and the marketing distractions, sorting out the US banking fiasco comes down to one, and only one, question. How tough are you willing to be on the people who control the country’s large banks?

One option is to be gentle with them and adopt only ideas that they pre-approve. This route involves complicated schemes to purchase, lend against, or otherwise “wash” toxic assets out of the banks using taxpayer subsidies. This will be expensive (for the taxpayer), messy politically, and – most likely – will not work, in the sense of restoring the banking system to something close to its normal mode of functioning; check with Hank Paulson for details.

Alternatively, you can be tough and take steps towards really assessing which banks are insolvent when you use market prices to value their assets. These banks can be taken over in a scaled-up FDIC-type procedure (no golden parachutes!), and controlling stakes in fully recapitalized banks can be sold off immediately to new private owners. The new private owners can handle, under proper anti-trust supervision, the break up the banks.  This approach will be cheaper for the taxpayer (but nothing is free at this stage), easier to explain to the electorate and their representatives, and it will work – this is in fact the standard prescription because it always works.  But it will not make powerful bankers happy.

So which way is the Obama Administration heading?  We honestly don’t yet know; the signals are mixed.

Indications that we are rolling over for the banker lobby are: (1) weak executive compensation caps, announced last week, and (2) insufficient money available or yet sought to back up the recapitalization that should follow the “once and for all” stress test of the banking system.  The math on point (2) is: there is only $320bn left from TARP, of which – we learned today – $100bn is to go in further support for the securitized credit market, $50bn for housing support (and this could end up higher), and at least $50bn for private-public toxic asset purchase/loan scheme (thi is my inference from the statement that this bank should be $500bn going on $1trn total).  The $120bn or so left over is probably not enough to recapitalize one major troubled bank, let alone the entire system.

But there are also more positive signs.  Secretary Geithner was much more critical of bankers and their compensation schemes than officials have been to date.  And President Obama is clearly angered by bankers’ arrogant bonuses. The Administration’s messages of transparency and accountability are refreshing and exactly on the mark. And I liked this line from Geithner (from CNNMoney),

“These banks need to understand that access to government resources is a privilege, not a right. It’s not for the banks. It’s for the people, and companies depend on that.”

Do the banks understand this?  Read Lloyd Bankfein’s article in Monday’s Financial Times, and tell me if you see any such indication from the CEO of Goldman Sachs.

So how do you get the message across?  Obviously, we need the comprehensive stress test immediately and it has to be transparent and very tough.  And this is where David Axelrod and Rahm Emanuel have apparently been exactly right in the past 10 days.  According to press reports (NYT yesterday and WSJ last week), both have pushed for tougher symbolic and substantive actions that would hurt bankers’ pocketbooks and weaken the largest banks.

Remember, weakening the big banks and their bosses should not be seen as an unfortunate side effect of beneficial medicine.  It is exactly what we need to do under these circumstances.  Unless and until these banks’ economic and political influence declines, we are stuck with too many people who know exactly what they can get away with because their organizations are “too big to fail.”

And weakening these banks (or actually having some of them go out of business and be broken up) as part of a comprehensive system reboot – with asset revaluations at market prices and a complete recapitalization program – will help return the credit system to normal. 

For reasons that are not obvious, Axelrod and Emanuel have not prevailed on the degree of toughness towards the American Banking Oligarchy.  But this may change.  Let us hope it is soon.

Counting down to the announcement of the Geithner plan, the New York Times has this account of how it came into being (and why it should be called the “Geithner plan,” although maybe Larry Summers is hiding behind him):

In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.

Mr. Geithner, who will announce the broad outlines of the plan on Tuesday morning, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.

I’m not a huge fan of executive compensation caps, as I think they are something of a sideshow. But I think the general approach of playing nice with banks and their shareholders is a mistake, because it leads to intransparent subsidies like the privately-financed bad bank is sure to be. (If the government is guaranteeing assets bought by private investors, as is widely rumored, it’s still a subsidy; it’s just not as obvious as writing a check.)

The most important thing in the bank rescue plan should be cleaning up their balance sheets to the point where even in a worst-case scenario we don’t need to worry about bank solvency (at least for those banks that are left standing by the rescue). If the government announced, “we will buy any assets you want to sell, at their current book values,” this would be a massive subsidy worth hundreds of billions of dollars (and requiring trillions of dollars in initial outlays), but it would at least restore confidence in the banks. If the government announced, “we are taking over Citigroup, Bank of America, and JPMorgan because they are insolvent, and we will write down their questionable assets to nothing, recapitalize them, and later reprivatize them,” this would also restore confidence, although it would unleash a flood of litigation and political attacks against the government for engaging in “socialism.” But if instead you try to split the difference, avoid too much government involvement, and pretend you are not subsidizing the banks, you end up coming up with these too-clever-by-half subsidies that you are trying to hide from Congress and the public, and no one can be confident that they will work.

It’s possible that the “uniform stress test” will be rigorous enough to weed out and either close or recapitalize all those banks that may become insolvent in a severe recession. And it’s possible that the government guarantees will be generous enough to bring in enough private capital to buy up enough toxic assets to make bank balance sheets trustworthy enough. So it will take a few months to learn if the plan will work.

At 11am this morning, from the Cash Room at the Treasury, Secretary Geithner will lay out his vision (and hopefully some convincing details) regarding how to get the US financial system back on its feet.  What should we listen for as indications that this is heading in the right direction?

1) If there is a “once and for all” audit of the banking system, as President Obama seemed to say yesterday, what do we learn about the toughness of the rules under which this will be conducted?  Annoucing an thorough assessment is potentially a positive step, but vagueness spells trouble (for us, not the banks) down the road.  We need this audit to force major banks to use market prices to mark down fully their portfolios; anything else is evasion and procrastination. 

2) Are there any indications that the Treasury will pursue other policies that are tough on the bankers?  We already know that in terms of executive compensation, Mr Geithner argued for – and won – very weak limitations (or, you might say, a generous insurance scheme for their future bonuses).  And the NY Times is reporting that he also prevailed on whether bank executives should lose their jobs or bank shareholders suffer further losses.  Is there anything at all in the speech that would at least make the CEO of a major bank frown?  Writing in the Financial Times yesterday, Lloyd Blankfein (head of Goldman Sachs) essentially said that it is “business as usual” – is there any sign Secretary Geithner will call his bluff?

3) Is the Secretary using private equity to reform or to shore up the banking system?  Any hint that Treasury will send private equity in to clean up banks and clean out their managers would be most welcome.  But if today’s proposals bring private equity’s interests into line with the bankers, e.g., because they both gain from hidden government subsidies in a private-public toxic assets acquisition, that is not helpful.  The financial lobby is powerful and our only hope is to split it and use, for the time being, some of the Finance Oligarchs against the others. 

4) Then, of course, we have to figure out how to contain the power of the Oligarchs who win big.  It would be would be a major breakthrough for the Secretary recognize, in any fashion, that the largest banks are “too big to exist.”  Is there even a hint that he thinks the size and concentration of our banking system is a problem, and that our new regulations and supervisory structures should take this on?  Does he make any move that would create incentives or pressure for large banks to break up (or to be broken up by new owners)?

5) What is the market reaction?  If the stock prices of the largest, most troubled US banks are up after his announcements, that means the market is expecting further generous handouts for these compananies and the people who run them.  This is a rare instance when a Treasury Secretary’s words should aim to push down at least some prominent stock prices. 

I’ve talked over the past few days with people with extensive financial market experience, with journalists who’ve covered every angle of this story, and with academics who think about these issues all day and night.  And I’ve had remarkably similar conversations with each.  After a short warm up on the depth of our predicament and the excess of our bankers, the person looks at me and says: “of course, we should just nationalize.”

Personally, I don’t favor nationalization in the sense of the government trying to run the banking system.  But I increasingly feel that, ultimately, the government will have to (a) properly recapitalize the banks, (b) as a result, acquire the right to determine who are the next private owners of these banks, and (c) bring in private equity and other financial interests to clean up the banks (yes, oligarch v. oligarch).  I don’t know how long it will take to get there, but I’m afraid most of the time between now and then will be wasted.

Unless Secretary Geithner can lay out an alternative path with convincing detail today, my expectation remains: the banks will not be fixed with the current approach, and the true reckoning still lies before us. 

(Along these lines, our detailed proposed questions for Secretary Geithner’s Senate hearings, this afternoon and tomorrow morning, are here.)

Next week, Tim Geithner will have an opportunity to explain his plans for the financial system (Cash Room of the Treasury, Monday, 12:30pm), and defend these plans in front of the Senate Banking Committee (Tuesday, starting at 10am) and Senate Budget Committee (Wednesday, also from 10am). 

Here are the questions (in bold) we would ask him.  And, just in case any of you are involved in preparing the Secretary’s briefing book, we also suggest some answers.

1.   Do you agree that, to restore trust in the financial system, it is essential that the Treasury (working with other relevant US authorities) take rapid steps to “once and for all” completely recapitalize the banking system? 

2.  Would you also agree it is critical that you and your colleagues tell the unvarnished and unequivocal truth regarding the needs of the financial system and your plans to recapitalize banks, so that clarity regarding the policy framework can be restored and uncertainty diminished?

3. Do you agree that a one-off, transparent assessment – with the methodology and results fully divulged in public – of the solvency and financial condition of all banks is required within three months so that we can precisely define and address the problem?

-   The only answer that should give any credibility to questions 1 and 2 is: yes.

4.  Many banks value securities, mortgages, and other loans close to the face value of the obligation on their books, while market prices for similar assets are far below book value.  Which value should be used when assessing these assets to determine if banks are solvent or not? 

-  The only fair answer for taxpayers, and the only way to ensure adequate capital comes into the banks subsequently from private investors, is: we will value all assets at market values. If market values are not available, then a highly conservative approach should be taken, i.e., assign a very low value. This will lead to major asset write downs at all banks and a larger need for capital, but it will ensure that this is the last time (in the foreseeable future) the Treasury needs to recapitalize banks.

5. Some sources report the Treasury is considering purchasing assets from banks which have been marked to market, while insuring assets which have not been marked to market.  This would enable banks to avoid marking down assets, i.e., so that they don’t need to recognize further losses.  Why should taxpayers insure any asset at a price significantly different from the market price?

-  The concept of “insuring” assets that have been priced above market value is a non-starter.  It would be a means to provide taxpayer money to banks by stealth, and is not credible since it will become transparent (and face a major political backlash) as soon as the details face serious scrutiny. 

- The Treasury needs to state clearly that most banks need large recapitalizations based on current asset prices, and it would not be fair to taxpayers if we provide cheap insurance (e.g., as if the assets are really AAA) for bad assets that are marked too high on banks’ balance sheets.  

-  If the banks are forced to mark assets to their true prices, there is no need to provide insurance.  You may as well recapitalize the banks fully to reflect those losses and then let them also manage all the remaining risk on their balance sheets.

6.  How much money is Treasury expecting will be needed in the recapitalization of banks, i.e., what will be the net new injection of capital?

-  If the answer is not at least $1trn, in line with the estimates of the IMF, then it’s not enough. (Note: the headline number may need to be larger, depending on the approach; focus on the recapitalization/increase in capital of the banking system as the bottom line).

-  We can rely on private capital also to inject funds, but only if the principles the authorities use for valuation of banks are very conservative so that there is adequate upside to new investors.

- If the headline amounts are less than $1 trillion, this is surely not enough.

- If the headline amounts are vague or we hear statements such as “it’s too early to know,” then the entire approach is not credible and we will need to reconvene when the Treasury is properly prepared and ready for a serious discussion.

7.  Where will Treasury get this amount of money at short notice?

-   The best answer would be a mix of private and public funding, but initially at least $1trn of public funding for recapitalization needs to be available.

-  If the answer for public funding is: “the remaining TARP funds plus backstop loans from the Federal Reserve”, this is unlikely to be enough.

- Treasury needs to request further funding from Congress in the next month or so, in particular several hundred billion dollars in additional debt limit authorization; this can then be combined with Federal Reserve financing to get to scale quickly.

- There is no substitute for an early and completely frank conversation with Congress regarding why this new funding is needed, how exactly it will be used, and what the impact will be on various stakeholders (including insiders at the large banks, new investors, and the taxpayer).

-  If the Treasury requires banks to write down assets to market prices, it will provide the clarity needed for private investors to re-enter the market.  The stock prices of the worst banks will fall because it becomes clear the government is not prepared to provide further cheap taxpayer money as a subsidy, but this will finally put the banks at valuations that attract new private owners willing to make substantial investments.  The government will then be providing funds alongside the private sector and less government funding will ultimately be needed.

8. How many of the largest 5 banks will likely end up with government as majority owner?

-  Any honest market-based valuation of bank assets will show a majority of large banks are presently insolvent but can be righted with substantial new capital. 

- If the answer isn’t “at least two,” then either the Treasury does not plan to properly value assets, or someone is not yet prepared to tell the full truth.

9. How does Treasury plan to use its shares when it has a controlling stake?

-  If the answer is, “as a passive shareholder,” then we are really in for a rough ride (as seems to be the approach of Gordon Brown in the UK). 

- The Treasury needs to have a plan to get shares back to the private sector quickly.  We need new, strong private owners.  This is the only way to really restructure the banks and force the necessary changes in management personnel and systems.

10.   Does Treasury anticipate changes in management at these banks as a consequence of these actions?

-  There is a critical need for new management in banks, but this should generally come alongside the infusion of new private capital.  New private owners should restructure the banks and greatly improve how they are run.

- It is important that strong anti-trust provisions be attached when the government sells its stakes to new investors.  This will ensure they have an incentive to break the largest banks into smaller, more manageable entities, all of which could productively be placed under new management.

- Any bank that is “too big to fail” is also “too big to exist”.  This should be a fundamental principle applied by both regulators and anti-trust authorities overseeing all dimensions of the financial system.

This Q&A was drafted by Peter Boone and Simon Johnson.

What are your expectations for the impending Geithner Bank Plan?  Listening carefully to the messaging from the top, you are probably hoping for an increase in bank lending.  In fact, over the past few weeks, Congressional leaders (e.g., at the Senate Budget Committee hearing last week) and the President (e.g., see the penultimate paragraph of last week’s TV address) have repeatedly insisted that, going forward, banks that receive government support should increase their lending.

And you’ve probably seen matching statements from the banks recently, either (a) explaining why the fall in lending was not their fault, or (b) celebrating the fact that, against all odds, they did manage to increase loans in the last quarter. 

So the perception has been created that the new Bank Plan will succeed if it raises bank lending, and that it can be judged by this metric.

But this is the wrong framing of the problem.  Or, perhaps it was the right framing for last October, when credit supply was severely disrupted, but it is an out-of-date and perhaps dangerous way to think about what is now needed.

If many creditworthy consumers and firms currently want to borrow less (i.e. increase their savings/strengthen their balance sheets), the amount of outstanding credit in the economy should fall. 

Banks have definitely tightened lending standards (subscription link, but the point is in the free part) - there might be some overreaction here, but everyone agrees that overly loose standards were a major cause of the crisis, so what else would you want them to do?  Certainly there are some creditworthy borrowers who cannot currently get loans at the prevailing interest rate, but how many? 

If you think there was overlending in the boom (and who doesn’t?), then you should expect a contraction in total credit now – this is the simple and compelling idea behind the fancy term “deleveraging”.

The task is not so much to force lending to increase now, but rather to clean up the banking system so that, when the recovery begins in earnest, credit will be available on reasonable terms and subject to sensible lending standards. 

This difference matters because the real danger is that either the executive or legislative branch will see the need to mandate that lending must increase – or that loans must be made to particular categories of borrowers, such as small business or housing.  This would be a recipe for more bad loans and further damage to the banking system (and more costs for you, the taxpayer.)  It would also lead to corruption, scandal, and reform fatigue.

The Geithner plan may work – let’s see the details before we take a more definite view on that.  But if the wrong expectations are set, it could even work well and still be judged a failure.