Zombies: First, We'll Try to Outrun Them

The (sketch of a) plan unveiled by Treasury Secretary Geithner last week left many unimpressed. The main line of criticism is that many of the large banks are insolvent, if their assets are valued at market prices, and that the US should bite the bullet now with a more decisive intervention (e.g., nationalization). Failure to do so means that the economy will be burdened, Japanese-style, by a "zombie" banking sector that does not supply the credit the economy needs.

There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what's called "The Lost Decade." They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn't see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again.

That's, um... President Obama... (via Felix Salmon) who went on to explain why we won't be following the Swedish model:

So you'd think looking at it, Sweden looks like a good model. Here's the problem; Sweden had like five banks. [LAUGHS] We've got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would -- our assessment was that it wouldn't make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America's different. And we want to retain a strong sense of that private capital fulfilling the core -- core investment needs of this country.

And so, what we've tried to do is to apply some of the tough love that's going to be necessary, but do it in a way that's also recognizing we've got big private capital markets and ultimately that's going to be the key to getting credit flowing again.

Matthew Richardson and Nouriel Roubini make the case for nationalization in a Washington Post op-ed, concluding: "We have used all our bullets, and the boogeyman is still coming. Let's pull out the bazooka and be done with it." At Naked Capitalism, Yves Smith has scathing assessment of Geithner's plan (Mussolini, really?!).

However, the banking sector has come through periods of crisis before, without such drastic measures, and without dragging down the economy. This useful analysis by the Times discusses that alternative:

Raghuram G. Rajan, a professor of finance and an economist at the University of Chicago graduate business school, draws the distinction between “liquidation values” and those of calmer times, or “going concern values.” In a troubled time for banks, Mr. Rajan said, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.

“If they had to sell these securities today, the losses would be far beyond their capital at this point,” he said. “But if the prices of these assets will recover over the next year or so, if they don’t have to sell at distress prices, the banks could have a new lease on life by giving them some time.”

That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before.

In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system.

Brad DeLong has some pithy notes on the Geithner plan. Apparently, that screaming CNBC guy likes it (Alexander Hamilton, really?!).

While the Japanese experience has useful lessons, Dean Baker reminds us of some important differences:

[B]anks play a much less central role in providing capital in the U.S. economy. For example, most mortgages are financed through securitized mortgage pools. The same is true of car loans and other types of consumer debt. Large corporations typically obtain short-term capital by selling commercial paper on the market. The Fed and Treasury have taken steps to ensure that this route of obtaining capital is open, which means that the problems of the banks will have less consequence for the U.S. economy than was the case for Japan.

Update: See also Joe Nocera, who is pro-nationalization.
Update #2: Krugman, too.