Former Treasury Secretary and Secretary of State Jim Baker is watching Tim Geithner take the country down the same road that led to Japan’s lost decade…and he can’t take it anymore:
James Baker, FT: Beginning in 1990, Japan suffered a collapse in real estate and stock market prices that pushed major banks into insolvency. Rather than follow America’s tough recommendation – and close or recapitalise these banks – Japan took an easier approach. It kept banks marginally functional through explicit or implicit guarantees and piecemeal government bail-outs. The resulting “zombie banks” – neither alive nor dead – could not support economic growth.
A period of feeble economic performance called Japan’s “lost decade” resulted.
Unfortunately, the US may be repeating Japan’s mistake by viewing our current banking crisis as one of liquidity and not solvency. Most proposals advanced thus far assume that, once confidence in financial markets is restored, banks will recover.
But if their assumption is wrong, we risk perpetuating US zombie banks and suffering a lost American decade…
Baker’s solution is the same as the one proposed by Nouriel Roubini and dozens of others who don’t work in the banking industry or the Obama administration. It will be expensive, messy, painful, and long. But it’s the better of two lousy choices:
First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner’s proposed “stress tests” may work. Any analyses, however, should include worst-case scenarios. We can hope for the best but should be prepared for the worst.
Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage.
To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.
Importantly, Baker also recommends that that government quickly get out of running day-to-day operations.