It’s Time for some Banks to Fail

In his inaugural address, President Obama said

Our journey has never been one of shortcuts or settling for less. It has not been the path for the faint-hearted — for those who prefer leisure over work, or seek only the pleasures of riches and fame. Rather, it has been the risk-takers, the doers, the takers of things — some celebrated but more often men and women obscure in their labor, who have carried us up the long, rugged path towards prosperity and freedom.

It is time to live up to those words. This is a time to take the hard path: let some firms fail that others may thrive. Give the risk-takers, the doers, and the makers of things a chance to do what they do best unencumbered by a failed financial sector.

The Federal Reserve has approached the entire crisis as one of liquidity. The Fed’s response has been large. The Fed has expanded its balance sheet by more than ten percent of GDP. This is the largest injection of liquidity in history. Yet, the liquidity injections have not helped (despite vociferous claims that “these policy actions helped to support employment and incomes” (Bernanke 2009). The economy has steadily deteriorated under this support. Banks have continued to fail.

Forced (or at least highly encouraged) mergers of banks have created even greater problems. Indeed, the “complex credit products and other illiquid assets of uncertain value” on the balance sheets of these half-failed banks—the assets that were allegedly suffering from fire sale prices—were overpriced in retrospect. The government has not been a good judge of the underlying value of assets.

The illiquidity (in my view) appears to stem more from banks wishing their assets were worth more and hoping they will be worth more in the future than any inability to accurately price the assets now. Economies are always fraught with uncertainty; asset pricing is hard. The only way to find the price is to put the assets out there and find a buyer. If there is no buyer at that price, the asset is not worth that much. When the price is sufficiently low, the assets will sell and markets will clear.

The liquidity injections have not helped because the financial crisis is not caused by a liquidity crisis. The crisis is clearly and absolutely one of solvency. The financial intermediation sector grew too big and must shrink. I suppose it is possible that all of the existing firms (at least those that are left) could simply shrink in size. That is not, however, the typical adjustment path. Usually in an industrial upheaval, the weakest firms fail and the strongest survive. There is a certain amount of dislocation inherent in this process.

Some banks must be allowed to fail.

The lessons of Japan in the 1990s have not been learned. If banks are allowed to hide their bad assets and if the government continues to transfer just enough capital to the banks to keep them solvent, the financial crisis is drawn out. Indeed, the Japanese economy showed few signs of life between 1990 and 2002. Zombie firms and zombie banks worked as an anchor on growth. Japan’s economy did not recover until the banks were forced to cleanse their balance sheets.

Chairman Bernanke has chosen Japan’s path for the United States. He believes he can shelter the U.S. economy from the worst effects of the crisis through ordinary monetary policy. To date, he has refused to even consider taking the hard steps that are necessary. He refuses to even consider the hard steps that may be necessary.