The Financial Stability Plan: A Recipe for Failure

This plan, as with TARP before it, is fundamentally flawed. From the takeover of Fannie and Freddie, to the bailout of AIG, the government has treated this crisis as one of liquidity. With a liquidity crisis all the government needs to do is essentially backstop the financial institutions. With the backstop in place, the liquidity crisis ends and the financial sector returns to normal and eventually the economy recovers.

If the crisis is not a liquidity crisis, if instead the crisis is one of fundamental solvency, government intervention does not necessarily resolve the issue. Indeed governments around the world have a poor track record of resolving solvency issues. According to a recent study by Ela Glowicka, only 40% of European companies receiving government bailouts survive 10 years. This is not the first study to come to such a conclusion.

I wonder how many of those bailouts began because the company claimed a temporary shortfall of liquidity.

What would it take for the Financial Stability Plan to be effective? The federal government has large resources available to it. These resources could be used to bailout the financial system. A sufficiently large transfer of resources from the government to the banks would ensure their viability. But these resources cannot be transferred in a manner that protects “taxpayer equity”.

If a firm is insolvent, the value of its liabilities exceeds the value of its assets. For the firm to become solvent, it must receive a transfer equal to the shortfall. Since all firms and especially financial companies need capital to operate, the transfer must be even larger: the transfer must be sufficiently large that the firm is a viable ongoing concern.

Bailing out all of the financial companies is likely not feasible. Therefore, if the government wants to make the public policy decision to bailout the financial sector, it must first decide which companies should continue and which firms should fail. There is no clear cut criterion by which to choose: nobody said public policy was easy (that’s why I do economics).

Treasury Remains on a Bad Path. Despite its size (I am still reeling over the $2 trillion initial price tag), the Financial Stability Plan does not actually bailout the banks. Rather, the plan provides only enough capital at any one time to keep the firms solvent. The plan is designed to continuously increase the government’s position in the banks as the economic situation worsens or as the banks experience greater-than-expected losses. No firm can survive waiting hand-to-mouth for the next check to arrive.

Japan’s Banking Intervention in the 1990s Should Serve as a Warning: The Japanese government’s intervention in its financial sector is an excellent example of how not to bailout the financial sector. Also as a result of over-leverage on the part of firms, households, and financial companies, Japan’s banks developed a non-performing loan problem (NPL) in early 1990s—in the current jargon, they had toxic assets on their balance sheets.

As a result, credit slowed, banks balance sheets were under pressure, and inter-bank lending became more difficult. The Japanese government also used its “full arsenal of financial tools” to deal with the problem. It guaranteed deposits, it injected capital, and assured investors that it would not let the banks fail.

None of these efforts were successful. Japanese banks did not fail, but they also were unable to operate as efficient financial intermediaries. It was not until late 2001 and early 2002 that the Japanese government finally forced the banks to remove the NPLs from their balance sheet, injecting enough capital to get the banks lending. I do not know the total size of the intervention but it was substantial. Only after this all out solution, did the Japanese economy begin to grow once again like a “normal” industrial economy.

The United States has a Bigger Problem: One of the main reasons for the current crisis is over leverage. Households borrowed too much and so did banks. Neither the households nor the banks can afford their balance sheets. Both must work to correct the excesses.

Unfortunately for financial sector, the work out in the household sector means that the financial intermediation sector needs to shrink. In principle, this adjustment could occur with every financial company simply getting smaller. That is not the way adjustment tends to happen. Typically, in these downturns, some firms must disappear. If the markets are left to their own devices, the strongest best managed (likely most risk averse) firms will survive. If the government decides, the adjustment is much more likely to be simply random.