Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

23 February 2009

Only Shock Therapy Will Do

[For an update on the latest plan, click here.]

A little over a week ago, I posted an essay speculating on how the current global economic catastrophe might produce America’s collapse and China’s rapid rise. I used an unusual device to make my point: a fictional “future history.” Apart from brief introductory and concluding explanations, the post was an excerpt from a fictional “history” of the Great Collapse, written by Chinese scholars in the early 2030s.

Sometimes life mimics art quicker than anyone expects. Today the New York Times reported what may be a trigger to my Great Collapse: massive unemployment and resulting unrest in China.

Why is that a vital bit of news? Because widespread, unemployment-spurred political unrest is one of the few things that might make China divest its $ 1 trillion investment in U.S. Treasuries, plus its second $ 1 trillion in other foreign reserves. If China’s leaders think they can’t trust their foreign counterparts to do the right thing, or to do it quickly enough, they may begin to tend their own garden, divesting their foreign assets for that purpose.

What would happen then? Probably both the dollar and international confidence in America and its economy would collapse.

At the moment, we have a strange economic paradox. With awe-inspiring stupidity and greed, our Masters of the Universe caused the worldwide catastrophe we are now experiencing. Of course our own economy was the worst hit, but it is so big, dominant and globally intertwined with others’ that all thoughts of “decoupling” were short lived.

Everyone is angry at us for starting the snowball rolling down the hill. But paradoxically everyone is still investing in America—or refusing to divest—because everyone still thinks our economy is the world’s safest and strongest.

All that could change if China pulled out. The result would be a plunging dollar, skyrocketing American interest rates, and a deep freeze of credit that would make the current stasis look like a little nip of frost.

How can we avoid this outcome? I think we need to demonstrate the capacity for sudden, bold and dramatic action.

I have praised the President and his new administration repeatedly on this blog for their thoughtful, deliberate and prudent approach to solving problems. But prudence and care have their downside: they take time.

We may not have much time. While recalcitrant on the issue of human rights, China has been remarkably patient with our collective economic mismanagement and malfeasance. Part of the reason is the extent to which China’s and our economies are intertwined.

But domestic unrest has always been the thing that China’s leaders fear most. Disorder in China is the economic equivalent of nuclear war. If it grows, China may divest.

Our own biggest current problem is denial. Our clueless bankers insist that our big banks are just fine, thank you, although they aren’t lending and many economists think they are already insolvent. The markets agree with the economists, as last week’s stock-market meltdown proved. Tim Geithner, in his methodical, careful, thoughtful way, is planning to “stress test” the twenty biggest banks in secret to find out.

Reportedly his testing and response may take weeks. We may not have weeks.

Bankers and others may point to isolated bright spots. But the truth is everything is collapsing at once. Credit, banking, finance, industry, housing, mortgages, employment, consumer sales, auto sales, international trade, and confidence in all of the above—all are collapsing simultaneously. The world is in economic free fall. So far that free fall is in slow motion, but it could accelerate without warning.

If the Great Depression taught us anything, it taught us this: you don’t mess with collapsing banks. You don’t temporize; you act. The first thing FDR did on taking office was declare a bank holiday to sort things out.

I’m not suggesting a bank holiday. But right now, our top bankers are in deep denial. They insist—as they have throughout the crisis—that “the fundamentals are sound.” Even if they are right, no one believes them anymore.

These jokers have to go. So what I am suggesting is a dramatic gesture to prove that our top leaders “get it” and will crush denial whenever and wherever it occurs. We can’t solve this massive accelerating collapse with more denial.

Right now, the market values of Citigroup and Bank of America are so low that our government could buy control of both for a few tens of billions, a pittance compared to what we have already spent.

It should do so. It should make a big show of doing so. Then it should examine their books on a crash basis.

Far from keeping the results secret, it should post every dime of debt and assets on the Internet. Then it should break up these banks, rationalize them, seal off their toxic assets, and sell what’s left back to private investors. It could sweeten the deal for current shareholders and insure fairness to them (in case these banks actually have any net value) by giving existing shareholders warrants to participate in any upside.

This dramatic action would have several salutary effects. First, it would show that our government can act boldly and decisively. Second, it would dissipate some of the global (and justifiable!) anger at our bankers’ stupidity and greed, as well as the world’s debilitating fear of their consequences. Third, it would signal the entire financial community that the days of denial are over and that people will pay for their mistakes, and soon. Fourth, it would let the world know what these banks are worth and how well or poorly they have been managed. Finally—and most important—such a dramatic gesture just might stay China’s divesting hand.

UPDATE (2/23/09 1:10 p.m.) Just about two hours after my post above, the New York Times reported Geithner’s plan to seek voting stakes in big banks—and perhaps even control—after he completes his “stress tests,” which will take several weeks.

The plan doesn’t make much sense to me for three reasons. First, it’s more temporizing, while the markets and the economy demand reassurance now. Second, taking a non-controlling equity stake in a big bank makes no sense at all. Right now the government owns preferred shares in Citigroup, which give taxpayers a guaranteed return. Why exchange those shares for common stock, with minority voting rights but no guaranteed return, unless you also buy control? No rational private investor would make that trade; it’s not an investment but a giveaway.

Finally, keeping current management in place will not restore confidence unless and until the banks pass their stress tests with flying colors. Geithner appears to be banking (pardon the expression) on that result. He’s gambling that the banks won’t fail their tests, or that, even if they pass, the economy won’t collapse irretrievably in the interim.

Geithner’s plan does have one advantage. If a bank fails the “stress test,” its stock will fall dramatically, unless Geithner plans to keep that fact secret, as well as the details of the test. Then the government can buy control at a lower price. If the bank passes the “stress test,” then maybe the government won’t need control after all.

Apparently Geithner has more confidence than the markets or the economy that Citigroup and B of A will pass their exams. He’d better be right. If he’s wrong, we’ll be weeks lower in our free fall with no solution in sight.

Already we are months or a year into this crisis, depending on how you count. I have yet to see convincing evidence that Citigroup or B of A is solvent, let alone ready and able to resume normal lending. I have yet to see any credible assertion, other than bald denial and “spin,” that either bank knows what its toxic assets are worth.

Under these circumstances, delay and secrecy don’t promote confidence. They undermine it. I’m trying hard, but I’m having trouble believing that Geithner is realistically taking the extent of our economic collapse into account, let alone the collapse in confidence that is causing it.

If it were up to me, I’d act more decisively. I’d have Treasury buy control of Citigroup and B of A now, on the open market, at their low current market prices. Then I’d shake them out. If they turned out to be as sound as their management claims, I’d sell the government’s controlling stakes back to private markets at a profit for the taxpayers. If they turned out sour, I’d be in a position to change management, split up the banks, and sell their assets immediately, thereby reassuring markets and the global economy. Whatever happened, the government’s decisive action would boost confidence immediately.


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