naked capitalism

Columbia professor and Nobel prize winner Edmund Phelps writes in a Wall Street Journal op-ed, “We Need to Recapitalize the Banks,” an article appears not to have garnered the attention it warrants in the blogosphere. Phelps comments approvingly on Sweden’s approach to handling its financial crisis, which had as its cornerstone reducing the size of the financial system and nationalizing banks which were cleaned up and later privatized at a profit.

Phelps serves up an Americanized, meaning watered-down, version of the Swedish model, highlighting the need to inject public funds into banks, a pet theme of ours. Because the bulk of the article explains why this course of action is necessary, his recommendation of how to proceed remains at an Olympian level of abstraction. For instance, he calls for considerable reform to the industry, but does not advocate throwing out current top management (note that might not be inconsistent with what Phelps would like to see, but the Wall Street Journal is not exactly the ideal forum for advocating senior management defenestration).

Nevertheless, for an economist of Phelps’ stature and not-easily-pigeonholed views to focus on the need to recapitalize banks and stress the need for tougher oversight is an important step forward.

Note we also have some commentary further down from the Financial Times’ John Dizard on why the powers that be so far have taken little interest in this idea.

From the Wall Street Journal:

When the speculative fever finally broke in America’s housing industry and house prices began falling in search of equilibrium levels, banks everywhere suffered defaults and subsequent losses on a range of assets. In short order, the housing contraction morphed into a banking crisis.

Among most economists, it came as a surprise that the banking industry and, indeed, most of the financial sector, was so devoted to houses…

The banks’ losses might seem poetic justice after their abominable performance….Among banks that had excessively leveraged their capital through borrowing and other devices, the losses wiped out much or all of their capital, and this near-insolvency has dampened their willingness to lend.

The resulting credit contraction is starting to crimp working capital and investment outlay at small businesses and is having wider effects on business activity….This feedback is causing a fall of employment on top of the direct effect of the housing contraction on employment in construction and finance. The added fall in jobs will in turn add to mortgage defaults.

Will this chain reaction produce a deep slump, like Japan’s in the 1990s or, worse, America’s in the 1930s?….The end of the speculative fever and the credit crunch each have structural effects on the real prices of business assets, real wages, employment and unemployment. As I see it, the former has pushed up the normal, or “natural,” volume of structural unemployment. The latter (and the excess houses) is pushing the economy into a temporary slump. It will last as long as required for the banks’ self-healing and government therapy to pull us out of it and into the neighborhood of our new, postboom normalcy.

I believe that leaving the process of recovery entirely to the healing powers of the banking industry, as libertarians suggest, would be imprudent, even if the banks could manage it. Lacking much government intervention, Japan’s recovery took a decade. Sweden’s recovery, with state intervention, took hardly any time at all.

Right now our banking industry is barely operational….Delay would be costly and risky.

The most discussed of the proposed programs would address banks’ toxic assets by authorizing the Treasury to buy them, issuing debt to finance the purchase…

However, the program to revive the operation of the banks through purchase of the toxic assets faces a sticky wicket. If the government sets the prices too low, the banks will supply little of their assets…

If, instead, the Treasury sets its prices too high, its funds will go far enough to buy only a portion of the toxic assets offered in response. Thus, it is not certain that such a program would work to clean out the toxic assets at all quickly. Subnormal operation of the banking industry might drag on for a few years.

A program of asset purchases, however needed, is limited in scope. It cannot be counted on to increase the equity capital of the banks — to shore up their solvency….Overpaying the banks for their toxic assets could contribute capital, but that may not be politically feasible or attractive.

So it is clear that the main prong of any “rescue” plan must serve to advance the recapitalization of the banks. Cash transfusions in return for warrants are a good way to do it, as it lets taxpayers share in the upside. The rescue of Chrysler used warrants. This past Monday the FDIC got $12 billion in preferred stock and warrants in the deal that saw Citigroup buy Wachovia. The question is which banks are to be thrown a lifeline, which will have to sink or swim. This one-time dose of corporatism is unpleasant, though the banking industry is to blame for its necessity.

But these steps toward making the system operational again will leave it dysfunctional. We don’t want to restore the system as it was. And the risk that the industry would cause another round of wreckage is not the only reason.

What has occurred is not just an old-fashioned banking crisis but also a banking scandal. Most of the big banks were shot through with short-termism, deceptive practices and self-dealing. We must institute basic changes in corporate governance and in management practice to restore responsibility and honesty for the sake of the economy and for the self-respect of the country.

We also need to return investment banking to its roots. There is more to the influence of the financial sector than merely its effects when it goes off the rails. The financial system is not a sort of circulatory system that passively carries fresh saving to the places in the economic body that demand the greatest investing — as if guided by some “invisible hand.” Judgment and vision — of bankers, fund managers, angel investors and the rest — matter hugely. So do the distortions, the limits and the license created by the regulatory system and the moral climate. To prosper and advance, the American business sector is going to need a financial system oriented toward business, not “home ownership.”

And from Dizard on how this line of thinking got short shrift:

In last week’s hearings, Representative Carolyn Maloney asked Ben Bernanke about the utility of government purchases of preferred stock in banks as a way to recapitalise the system. Bernanke’s response was that this might “frighten off private capital from investing in banks”. As one investment banker to banks told me, “That’s ridiculous.” It would have been better, of course, for the Federal Reserve and the Treasury to have organised a systematic recapitalisation of the banks and dealers earlier this year, as was suggested in this column and elsewhere. But the Federal Reserve people were dismissive because it wouldn’t fit their econometric model, which is the measure of all things, and the Treasury leadership because they thought they knew how markets worked. The people who raise capital for banks doubt that a post-bail-out equity rally will open the door to raise enough capital. Cash flow from net interest margins will be strong, as it has to be to cover write-offs. That is the result of Federal funding and a steeper interest rate and credit curve. Remember, all those “reforms” will cost capital. Why not face that fact explicitly? The Paulson approach wasn’t adequate for that. Also, be sure that the government-sponsored recaps will be larger, and the structures more varied, than you have heard so far.

Update 5:30 AM: Steve Waldman offers what he calls a “Semi-Swedish Solution” and unlike Phelps, goes into considerable detail on how it would work.