Monday, June 8, 2009

The most biting critique of the plan is likely to be that it failed to disrupt the political influence of the banks

From Free Exchange:

"Did the Obama banking plan fail?
Posted by: | WASHINGTON
Financial markets

EZRA KLEIN notes the quiet demise of the PPIP legacy asset plan and asks an important question—has the Obama administration's banking plan failed? Mr Klein suggests it has, noting that 1) PPIP was meant to discover the prices of the so-called toxic assets, and it hasn't, and 2) even if PPIP didn't discover asset prices it was meant, in combination with the stress tests, to reveal definitively which banks were insolvent, and it hasn't. True, we still have the stress test results, he says, but the adverse scenario in those tests included an unemployment rate of 8.9%, which we've already jumped through. Given that we know neither the value of the assets or the solvency of banks, it seems clear to Mr Klein that the banking plan has failed.

Here's something on which we can agree—insomuch as the goal of the banking plan was to determine the value of toxic-assets and determine definitively which banks were solvent, the banking plan has failed. But that doesn't tell us very much. We didn't want to know the value of the assets or the solvency of banks just because; that information was presumably important for some other reason, namely, it was viewed as crucial to the stabilisation of the banking system to learn one or both of these variables.

And in that sense, I think there are a number of ways in which the administration's plan has succeeded, if only by luck, and some other ways in which it is too early to tell, but no meaningful ways in which it can be said that the strategy has failed.

How has it succeeded? Well, it has generated, or coexisted with, or managed not to derail the calming of interbank lending markets, all without requiring the hundreds of millions of additional bail-out dollars that were widely deemed necessary for the task. It's not easy to lay sole responsibility for this at the administration's feet—both the Federal Reserve and the natural trajectory of the recession (particularly stability in equity markets) helped significantly—but the administration absolutely had the ability to err in ways that would have kept markets in crisis mode. They didn't, which must be judged as a success.

How else did the administration succeed? The Fed and the Treasury managed to provide the market with meaningful information about the absolute and relative status of financial institutions without blowing anything up. There are a lot of things we don't know, but there are some important things that we do know, with certainty, as a result. We know which banks are really and truly healthy. We know which banks might not be, but we also know that the Obama administration is committed to assisting them in ways that will not disrupt markets. And we know which firms have some serious issues, and that the administration isn't afraid to move toward back-door nationalisation in those cases. This, again, must be judged as success.

There are matters on which the jury is still out. We don't yet know whether predicted loan losses are optimistic or whether banking stability is likely to stick, but that would have been an issue with any solution to the banking crisis. A Swedish-style intervention would not have eliminated the possibility that a deeper-than-expected recession would have caused the government's bill to explode, potentially destabilising financial markets or the broader economy. It might also have caused market disruption immediately upon its intervention. It's difficult to know how this will play out, but impossible to declare failure at this point.

Other questions remain open. Will the administration's plan ultimately lead to the reduced effectiveness of financial markets, thanks to moral hazard concerns or excess debt or some other factor? Possibly, but we can't know now, and these questions would apply to alternative policy choices. Did the administration fail by selling stimulus before a banking rescue, thereby expending political capital and limiting the aggressiveness with which it could take on the banking system? Back in March I might have said yes; now I would say no, but not until the recession is long over will we be able to assess this properly.

The most biting critique of the plan is likely to be that it failed to disrupt the political influence of the banks, thus ensuring that forthcoming regulatory measures are too weak. We can't rule on this until the regulatory reform package is in, but it's also difficult to say anything given the recursively determined nature of the question. In other words, given a Congress captured by banking interests, how free a hand did the administration have to smash banking interests as part of a banking rescue? The administration might have failed to rein in the bankers via nationalisation, but only because the bankers could apply pressure on legislators to deny the administration the authority to nationalise.

I can understand giving the administration's banking strategy a number of different marks depending on what kind of curve one is using (that is, how one weighs political constraints and the influence of outside factors), but the one grade it should not receive is an F. At worst, Barack Obama and Tim Geithner have earned themselves Incompletes."


Don the libertarian Democrat wrote:
June 8, 2009 21:09

Has Richard Posner started posting here? All of a sudden, Free Exchange is like a ticker tape. Actually, what's impressive with Posner is not so much the number of posts, but their length. Each post is an essay.

"1) PPIP was meant to discover the prices of the so-called toxic assets"

What this means is discover the price at which buyers and sellers can agree. It was an attempt to close to the gap between bid and ask through a subsidy, not open Pandora's Box or Schrodinger's Box, say, discovering a hitherto unknowable question. The problem now is simple: The sellers are more inclined to hold onto the assets. Since the economy seems to be stabilizing, and the stress test are now basically seen as a government guarantee, the price on the TAs has gone up. However, the buyers, hedge funds, for example, aren't inclined to up their price, even with the subsidy. And this answers:

"2) even if PPIP didn't discover asset prices it was meant, in combination with the stress tests, to reveal definitively which banks were insolvent, and it hasn't."

On the contrary, it has given the government guarantee of these banks the seal of approval. That's why the banks themselves are less inclined to sell, and more inclined to buy.

By the way, this reaction signals inflation, and so it does add credence to QE, if you believe, as I do, that QE, in order to work, needs to lead to a real perception of inflation down the road. I seem to be agreeing with Bernanke and Geithner, at least on this.

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