The question is, "Will the Geithner plan work?" There are responses from Paul Krugman, Brad DeLong, Simon Johnson, and me:
A bailout plan must do two things to be effective. It must remove toxic assets from bank balance sheets, and it must recapitalize banks in a politically acceptable manner. I believe the Geithner plan has a chance of doing both of these things, but it’s by no means a sure bet that it will.
How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem. If the free insurance against downside risk that comes with the non-recourse loans the government is offering doesn’t induce sufficient private sector participation, then it will be time to end the Geithner bank bailout. Even if increasing the insurance giveaway would help, legislative approval would be unlikely and the political fight that would ensue would hurt the chances for nationalization.
If the price of these assets is increasing sufficiently fast, then the loans will be safe.
The second factor to watch is the percentage of bad loans the government makes as part of the program. These non-recourse loans are the source of the free insurance against downside risk. Borrowers can walk away if there are large losses, and if the number of bad loans is unacceptably high (a potential political nightmare), then policymakers will need to act quickly and pull the plug on the program.
Unfortunately, however, the loan terms make it unlikely that we’ll have timely information on the percentage of bad loans. But there is something else we can watch to assess the health of the loans: the price of the toxic assets purchased with the loans. If the price of these assets is increasing sufficiently fast, then the loans will be safe. But if the prices do not respond to the program, then the loans will be in trouble.
In that case, we will need to end the program as quickly as possible and minimize losses. The next step will have to be bank nationalization, though the political climate will likely be difficult. Sticking with the plan until it completely crashes and burns on the hope that a little more time is all that is needed will make nationalization much more difficult.