Staying the Course . . . Toward 1990s Japan?

University of Oregon economics professor and Economist's View blogger Mark Thoma filed this guest post.

More than a year ago, I called for the Federal Reserve to begin aggressively removing toxic assets from the balance sheets of troubled banks in order to minimize the fallout from the collapse of the mortgage market. Shortly after that, the Paulson plan emerged, and the essence of the plan followed along these lines. But the plan was never implemented because of problems valuing the toxic assets, among other things, and with the election approaching, the decision was made to leave the toxic-asset problem for the new administration to resolve.

Once the new administration took over, it began developing its own plan, and after a few false starts, Timothy Geithner's Public-Private Investment Program was announced. It appears that this plan may actually be put into place, but here we are more than a year from when everyone knew we had to do something, yet we are still waiting for a plan to be implemented. How much better would the economy be now if we had planned for something like this, and executed the plan immediately?

If a quick response was needed, and it was, why did the new administration opt for the PPIP even though it delayed the implementation of a financial rescue plan for several more months? The new administration had three basic options to choose from: some version of the Paulson plan whereby the government buys assets directly from troubled banks; nationalization whereby the government temporarily takes over entire banks; and its own plan, which turned out to be the PPIP.

Although the Paulson plan could have been put in place relatively fast, it bails out those responsible for the problems we are having, making it politically infeasible, and the toxic-asset-valuation problem is difficult to overcome. The public would have strenuously objected to this plan, and rightly so. Nationalization is, in my view, the surest way to proceed in terms of resolving the problem, and it also distributes the burden more equitably.

But the costs of this approach could be very high, it was tagged with the "socialism" label; there was no on-the-shelf plan like this; and the government does not have the legal powers it needs to put nontraditional banks through the bankruptcy process, something that Fed Chairman Ben Bernanke mentioned again and again in today's hearing. So that left the PPIP, which is much cheaper and less politically volatile and could be implemented under existing authority. But it is risky in that it relies on the creation of a set of economic incentives intended to induce the private sector to join the government in taking the assets off the banks' balance sheets.

My fear, and it's one buttressed by both Bernanke's testimony today and by what we are hearing about the stress tests, is that the political environment has put us on the path the Japanese followed in the 1990s: doing just enough to keep troubled banks alive but never decisively solving the problem. The result in the Japanese case was a sustained period of economic problems and slow growth, and we may be headed in the same direction.

If the Geithner toxic-asset-removal plan doesn't work as intended -- and there's no guarantee that private-sector participants will step forward in sufficient numbers -- or if the stress tests were not strict enough, missed essential risks, etc., and some of the banks are in much worse shape than we thought, will policymakers be willing to change course? Or will they continue to avoid the more costly but arguably more effective solution of nationalization, cite the stress tests as evidence that banks are relatively healthy and continue to string banks along through a series of capital injections in the hopes that the PPIP will eventually work?

It's been convenient for all involved to say that the legal authority for putting these banks through bankruptcy (nationalization) does not exist, so we have little choice but to stick with the PPIP and hope it eventually works, but Congress could change the law quickly to grant the necessary authority if it really wanted to. But it prefers to avoid the more costly, yet more certain, step and invest in hope instead.

Policymakers have a lot of time and effort and their own reputations wrapped up in the PPIP program, and they do not want to pursue costly solutions given the state of the federal budget. So they will not abandon the current course easily, something that today's testimony made clear.

For that reason, I hope I am wrong about the stress tests and they really do tell us about the health of banks instead of mainly providing political cover, and that the PPIP works better than we could have hoped. Because if it doesn't, we won't save a thing by following in Japan's footsteps and sticking with programs that only prolong the inevitable.

-- Mark Thoma is an economist at the University of Oregon and blogs daily at Economist's View.