Government Should Force Bank Capital Up, Not Just Socialize the Bad Loans

by: Jeffrey Frankel

In time of war, there is a tendency for both political parties to rally around the President, as we saw (all too well) in Iraq after September 11. In time of financial panic, there is often a similar inclination. The two presidential candidates, for example, are being very careful in their statements. I don’t blame them. The issues are too complex to be taken on inside the context of a political campaign.   Both candidates realize that the danger of a verbal misstep that the other side can try to blame for worsening the crisis is far greater than the likelihood that either one will come up with a brilliant solution that will gain widespread support or will solve the problem, let alone both.   

Having said that, opposition to the $700 billion plan proposed by Treasury Secretary Henry Paulson September 19  has coalesced quickly, from both ends of the political spectrum. Sebastian Mallaby pursues the Iraq analogy in “A Bad Bank Rescue” in the Washington Post, September 21:   "…in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice.  It would spend billions of dollars on the theory that preemption will avert the mass destruction of banks."

We can all join in, tweaking the supposed free-market conservatives of the Bush Administration for proposing the biggest bailout of history. They deserve it. But it is not the hypocrisy of the bailout that bothers me at the moment, or the size. I have used yet another military analogy:  “They say there are no atheists in foxholes. Then there are also no libertarians in financial crises.” (Mark Shields used the line on the Lehrer Report Friday, and evidently Ben Bernanke did so last week as well.)

The explicit lack of oversight or checks and balances in the Treasury proposal is worrisome – and it worries Congressional Democrats. 

But the nature of the bailout, how the money is to be used, is what bothers me most of all. As Mallaby says, “Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans.” Examples are not tied to economists from a particular political viewpoint or party. He mentions the proposal of Ragu Rajan and Luigi Zingales that the government could tell banks to cancel all dividend payments; and a proposal by Charlie Calomiris and Doug Elmendorf that the government could buy equity stakes in banks themselves, rather than just buying their bad loans.     

Similarly, in yesterday’s New York Times opinion page, Paul Krugman commented on the left side of the page, and Bill Kristol on the right side of the page.  What Mallaby calls the core insight is also the crux of Krugman’s logic (“Cash for Trash”):  “…the financial system needs more capital.  And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.”  Sounds right to me. Don’t socialize the losses without socializing the gains.