[Marxism] We Need to Recapitalize the Banks by Edmund Phelps

[Robrecht W. Uyttenhove]

Article:
http://online.wsj.com/article/SB122282719885793047.html#


We Need to Recapitalize the Banks

Let's have cash infusions in return for warrants.

By EDMUND S. PHELPS

When the speculative fever finally broke in America's housing industry
and house prices began falling in search of equilibrium levels, banks
everywhere suffered defaults and subsequent losses on a range of
assets. In short order, the housing contraction morphed into a banking
crisis.

Among most economists, it came as a surprise that the banking industry
and, indeed, most of the financial sector, was so devoted to houses.
We had not realized that the investment and innovation in the
country's business sector was largely getting by on rich uncles, a
tiny cottage industry of venture capitalists out West, and a few
private-equity funds doing alternative energy. And we didn't foresee
that a trillion or two of losses in an economy with $40 trillion of
financial wealth could bring high anxiety and, two weeks ago, near
panic.

The banks' losses might seem poetic justice after their abominable
performance. But costly feedback effects on the rest of us are in
prospect. Uncertainty over the quantity and valuation of banks' "toxic
assets" has meant that many cannot count on loans from each other to
meet daily needs, and this illiquidity in the markets has impaired
their ability to lend. Among banks that had excessively leveraged
their capital through borrowing and other devices, the losses wiped
out much or all of their capital, and this near-insolvency has
dampened their willingness to lend.

The resulting credit contraction is starting to crimp working capital
and investment outlay at small businesses and is having wider effects
on business activity through its impact on interest rates, exchange
rates and consumer loans. This feedback is causing a fall of
employment on top of the direct effect of the housing contraction on
employment in construction and finance. The added fall in jobs will in
turn add to mortgage defaults.

Will this chain reaction produce a deep slump, like Japan's in the
1990s or, worse, America's in the 1930s? In my view, the claim by
Keynesians that the economy can be stabilized around a satisfactory
employment level, thanks to economic science, is false. So is the
claim by latter-day neoclassicals that such stability is automatic,
thanks to the market. Both dogmas fatally miss the point that the
normal activity level is driven by structural shifts, which monetary
policy and price-level changes usefully accommodate but cannot
reverse. The end of the speculative fever and the credit crunch each
have structural effects on the real prices of business assets, real
wages, employment and unemployment. As I see it, the former has pushed
up the normal, or "natural," volume of structural unemployment. The
latter (and the excess houses) is pushing the economy into a temporary
slump. It will last as long as required for the banks' self-healing
and government therapy to pull us out of it and into the neighborhood
of our new, postboom normalcy.

I believe that leaving the process of recovery entirely to the healing
powers of the banking industry, as libertarians suggest, would be
imprudent, even if the banks could manage it. Lacking much government
intervention, Japan's recovery took a decade. Sweden's recovery, with
state intervention, took hardly any time at all.

Right now our banking industry is barely operational. Whatever the
corrective surgery indicated, the priority is to get the system
operating again. Delay would be costly and risky.

The most discussed of the proposed programs would address banks' toxic
assets by authorizing the Treasury to buy them, issuing debt to
finance the purchase. Proponents of this program add that the
government's eventual sale of the assets purchased might repay the
investment with a profit -- grossing, say, an 8% rate of return while
paying 4% interest.

House Republicans and some economists object, saying that the
government could attain its goal with a bigger or surer profit by
selling the banks "default insurance" on their distressed assets: the
premiums paid are hoped to far exceed the default costs. To me,
government entry into the default insurance business is little
different from government purchasing the assets. It is not clear to me
that selling default insurance would be more profitable.

House Democrats want a parallel program that would help defaulting
mortgage borrowers to avoid foreclosure -- to help them "stay in their
homes." Such a step might set an undesirable precedent in economic
policy. If, after investing in my vocational training, I cannot make
it in the line of work I chose -- not at the real wage that the market
has since established, at any rate -- will I be entitled to help from
the government to "stay in my work"? Furthermore, many defaulters are
housing speculators not families caught up in an adjustable rate
mortgage they did not understand. Finally, the overinvestment in
houses does not present the systemic risk of economic breakdown that
the overextension of credit does.

However, the program to revive the operation of the banks through
purchase of the toxic assets faces a sticky wicket. If the government
sets the prices too low, the banks will supply little of their assets;
they will prefer to hold them to maturity in order to get the price
appreciation for themselves. The Treasury will then need to raise the
terms. But that may cause the banks to hold off longer, speculating on
still better terms ahead.

If, instead, the Treasury sets its prices too high, its funds will go
far enough to buy only a portion of the toxic assets offered in
response. Thus, it is not certain that such a program would work to
clean out the toxic assets at all quickly. Subnormal operation of the
banking industry might drag on for a few years.

A program of asset purchases, however needed, is limited in scope. It
cannot be counted on to increase the equity capital of the banks -- to
shore up their solvency. Underpaying for the toxic assets would
actually inflict a further loss of capital. Overpaying the banks for
their toxic assets could contribute capital, but that may not be
politically feasible or attractive.

So it is clear that the main prong of any "rescue" plan must serve to
advance the recapitalization of the banks. Cash transfusions in return
for warrants are a good way to do it, as it lets taxpayers share in
the upside. The rescue of Chrysler used warrants. This past Monday the
FDIC got $12 billion in preferred stock and warrants in the deal that
saw Citigroup buy Wachovia. The question is which banks are to be
thrown a lifeline, which will have to sink or swim. This one-time dose
of corporatism is unpleasant, though the banking industry is to blame
for its necessity.

But these steps toward making the system operational again will leave
it dysfunctional. We don't want to restore the system as it was. And
the risk that the industry would cause another round of wreckage is
not the only reason.

What has occurred is not just an old-fashioned banking crisis but also
a banking scandal. Most of the big banks were shot through with
short-termism, deceptive practices and self-dealing. We must institute
basic changes in corporate governance and in management practice to
restore responsibility and honesty for the sake of the economy and for
the self-respect of the country.

We also need to return investment banking to its roots. There is more
to the influence of the financial sector than merely its effects when
it goes off the rails. The financial system is not a sort of
circulatory system that passively carries fresh saving to the places
in the economic body that demand the greatest investing -- as if
guided by some "invisible hand." Judgment and vision -- of bankers,
fund managers, angel investors and the rest -- matter hugely. So do
the distortions, the limits and the license created by the regulatory
system and the moral climate. To prosper and advance, the American
business sector is going to need a financial system oriented toward
business, not "home ownership."

Mr. Phelps, the winner of the 2006 Nobel Prize in economics, directs
the Center on Capitalism and Society at Columbia University.