By Gerard Caprio
The lack of clarity in the US Treasury’s plan to deal with the financial system is hardly unexpected. The administration is just one-month-old, and the specifics of this crisis, like many of its antecedents, are unique. As the plan becomes more specific, we can hope that the administration will be able to educate the public, including the supposed friends of free enterprise, that any plan for dealing with the banks must include the failure of those that are truly and deeply insolvent.
In getting to this next stage, there are lessons from past crises, of which there have been no shortage over the last several decades. The good part of the current plan is that the US government will inspect the banks (which of course should have been earlier; we are, after all, spending more on bank supervision than at any time in world history). But the plan is not specific on how government supervisors, or stress testers, will evaluate the portfolio of banks.
However, there is near unanimous consent among informed observers that a number of banks, including a number of very large banks, are clearly insolvent. Resolving large banks is especially difficult, and President Obama made a fair point when he said that other countries, such as Sweden, were able to deal with their banking crises by government takeovers and reprivatisation in part because of the small number of banks and their country, not to mention the greater degree of political consensus in their society.
Still, consider what happens when a non-financial firm is in difficulty. Immediately, bank funding and other sources of finance dry up. Firms that are going through reorganisation find it impossible to get new money until they have downsized to a profitable core and have taken the painful steps of laying off workers, shedding business lines, and sacking managers. Shareholders’ claims are wiped out and creditors often are informed they their debt was converted into equity. Once this reorganisation plan is complete and these brutal adjustments are underway, only then does new money come in.
The message that society sends is that failure to use well its scarce resources, principally its labour and capital, will be punished. Yet in many countries, certainly in many of the developing country crises of the 1980s and 1990s, the tendency on the part of government was first to add money to the banking system and then discuss changes, even though once new money was produced, the incentive that the banks had to make any changes was reduced. Ironically, US authorities, as well as the International Monetary Fund and the World Bank, often criticised countries that were reluctant to take these hard measures.
We have not been in this exact situation before, but in the 1930s, when numerous banks were insolvent, thousands were closed, and others, about 50 per cent of the banking system, received injections of government money (preferred equity, purchased by the Reconstruction Finance Corporation) with significant and for the banks unpopular conditions attached.
That programme was largely viewed as successful, as many of the banks were able to buy out the government position within about five years. A key reason for its success was that thousands of banks were closed first, and the worst remaining banks did not receive RFC assistance and also had to close. In other words, the US government was able to make tough decisions, and tough decisions are what capitalism is all about. A big difference between this crisis and the 1930s: then many of the ‘money centre’ banks were able to make it. Now, a number should not.
Let us hope that the US has not changed so much that we cannot take tough measures. The way to make a bad bank plan work is to take over deeply insolvent banks, break them up, wipe out shareholders, write down debt, and pay off only the insured depositors. The claim that this is nationalisation is a canard; it is not a way to get us to state ownership in the banking sector but to restore a viable private banking sector and uphold the principles of a market system. A bad bank plan that instead gives government money to private banks is rewarding their shareholders and creditors – that’s just a bad plan. In the 1930s we avoided socialism with the New Deal.
Today, the risk is socialism for the rich and capitalism for the rest of us. Let’s not fall for it!
Gerard Caprio is professor of economics at Williams College, chair of the Center for Development Economics at Williams College and a former director of financial sector policy at the World Bank
