Back in August, when the financial crisis became real and yet hadn’t matured, there was an article in OpenDemocracy.org by Anne Petifor called “Debtonation.” In it, she argued that the problem facing the economy was not widespread illiquidity, but rather massive insolvency in US banks. Whereas illiquidity indicates assets that can’t be converted to cash, i.e. “toxic assets,” insolvency is when your liabilities exceed your assets. In other words, it leads straight toward bankruptcy unless something is done. With respect to the latest proposal by Treasury Secretary Geithner to fix the financial system, that distinction seems to be becoming more relevant. Indeed, consensus has developed in unlikely places. The other day I had just been reminded of the whole issue when a friend of mine sent me an article by Martin Wolf, when I read a Maureen Dowd Op-Ed that got at the same point. Wolf was more specific, but they flagged the same issue. Since it’s always nice to go from general to specific, I’ll start with the Dowd quote:
The Obama crowd is hung up on the same issues that the Bush crew was hung up on last September: Which of the potentially $2 or $3 trillion in toxic assets will the taxpayers buy and what will we pay for them?
…
There’s a weaselly feel to the plan, a sense that tough decisions were postponed even as President Obama warns about our “perfect storm of financial problems.” The outrage is going only one way, as we pony up trillion after trillion.
Geithner is coddling the banks, setting it up so that either we’ll have to pay the banks inflated prices for poison assets or subsidize investors to pay the banks for poison assets.
And now here’s Wolf:
All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency.
Under the first view, the prices of a defined set of “toxic assets” have been driven below their long-run value and in some cases have become impossible to sell. The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses. This was the rationale for the original Tarp and the “super-SIV (special investment vehicle)” proposed by Henry (Hank) Paulson, the previous Treasury secretary, in 2007.
Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities. The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.
Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so. But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a “no brainer”.
The new plan seems to make sense if and only if the principal problem is illiquidity. Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers. Indeed, any toxic asset purchase or guarantee programme must be an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions: ineffective, because the government must buy vast amounts of doubtful assets at excessive prices or provide over-generous guarantees, to render insolvent banks solvent; inefficient, because big capital injections or conversion of debt into equity are better ways to recapitalise banks; and inequitable, because big subsidies would go to failed institutions and private buyers of bad assets.
What seems strange to me is that this distinction hasn’t yet been clarified in public discussion. Are our representatives talking about it? Does the public know? Are our representatives — Obama even — not bringing it up because they think it would be too depressing? I heard a woman on the radio the other day talking about how she already felt betrayed by Obama because she was hearing nothing but gloom and doom from him about the economy. Well, if you follow the consensus developing here that the problem is massive insolvency that is going to get worse and not limited illiquidity, in fact she’s quite wrong. Obama is all sunshine, inappropriately so. So, well, let’s get the net talking about this distinction. Let’s see if this network actually does allow for greater and more rapid engagement with the problems that face us.
