Monday, August 29, 2011

2008 Redux?

Current IMF head Christine LaGarde rocked the financial world this weekend, stating that Europe's banks need "urgent recapitalization." She even suggested that some of the (inadequate) EFSF fund set up to bail-out Greece, Portugal, Spain, Italy, Ireland, and Belgium could instead shore-up the banks. This comes on the heels of Bank of America's capitulation to Warren Buffett to pay punitive rates for fresh capital. Meanwhile, the Times of London reports that Europe's leaders may rather simply bail-out their banks than the problematic sovereigns of the Eurozone.

Such a plan amounts to a serious economic miscalculation. As Stephen Roach points out, a major policy error in he US occurred when the government rescued banks and bankers rather than their victims during the subprime fiasco. With trillions for banks and relative pennies for borrowers, those bailouts rang up massive US government debt but left consumers hopelessly sidelined with debt hangovers leading to our current economic malaise. Another recession now looms.

So now Europe rumbles down that same road--leave zombie borrowers to their own defense but by all means save the precious banks. It feels like the global economy faces another credit crisis (did the first one really end?) and global financial leaders operate under the working assumption that banks must be saved above all else. Such reasoning amounts to an economic death sentence.

We need to let banks fail. Economist Paul Romer advocated this fundamental truth way back in 2009. He argued that the old banks with their toxic assets would not lend. Time has proven Romer correct. Instead of bailing-out zombie banks we should form new banks and focus on balance sheet repair for over-extended borrowers.

1 comment:

  1. In Prof. Rogoff's article that you linked, it says:
    For example, governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation.

    That's such a good idea. Everyone wins. The bank wins because they get a future interest in your home when it sells or you die, plus if they just "write down" the amount of your mortgage, they're still getting a present check. The housing market wins because suddenly, people aren't getting kicked out of houses anymore so there's less of a glut of inventory on the market. The homeowner wins, because they get to keep their home in exchange for what would amount to something like what you pay out in sellers' broker's commissions. Plus, since you'd know you'd have to pay (say) 6% to the seller's agent, and 6% to the bank from your selling price, the homeowners that received these benefits would stay in the same area for a longer time, which isn't a bad thing.

    One negative though would be that people who really have to move for work reasons that took this deal could stand to have to pay out quite a bit of money at closing instead of breaking even or making money, I think.

    Tamara Davis (U.Memphis)