Monday, April 16, 2012

Is rescuing banks a prerequisite for rescuing economies?

According to a Guardian column, US Treasury Secretary Tim Geithner for years has lectured Europe on the need for rescuing the banks as a prerequisite for rescuing their economies.

While clearly an argument for adopting the Japanese model for handling a bank solvency led financial crisis, is this statement true?

The experience of Iceland and Sweden before it would appear to show the statement is false.  As discussed by Iceland's president in a must read previous post, saving the economy, democracy and society in fact required that the banks not be rescued.

The Guardian column looks at what has happened to the US as a result of rescuing the banks.

America's banks are bigger than ever. 
JP Morgan Chase, Bank of America, Citigroup, Wells Fargo and Goldman Sachs have emerged with more firepower than before the financial crisis following Hank Paulson's generous bailouts and the freedom to swallow rivals on the cheap....
For several years the US treasury secretary, Tim Geithner, lectured Europe on the need to rescue banks as a prerequisite for rescuing economies. Without a massive injection of cash, a co-ordinated guarantee scheme and a monster dumping ground for the bank's most toxic assets, foreign investors would look elsewhere. Worse, a constrained banking sector would discourage domestic companies from investing.
Where did the US banks' most toxic assets go?  While TARP was originally seen as a monster dumping ground for these assets, it morphed into a vehicle for making massive injections of cash.

Instead, the banks were allowed to hide these assets on and off their balance sheet through the suspension of mark-to-market accounting and adoption of mark-to-management's preferred valuation accounting.

Banks in the EU and UK have been allowed to do the same thing.

Apparently, Mr. Geithner's argument also includes the idea that a constrained banking sector would discourage domestic companies from investing.  What discourages domestic companies from investing is their perception of investment opportunities.  How an investment is financed is a trivial consideration compared to issues like how much revenue will the investment generate or cost will the investment save.

Look at the US economy now. While it may be cooling a little, the figures for growth and employment are streets ahead of anything the UK and Brussels can claim...
Comparing three areas that rescued their banking system tells nothing about whether rescuing the banks is a prerequisite for rescuing economies.

To answer that question, you have to compare these three areas against Iceland that did not rescue its banking system.

When this comparison is done, it is clear that rescuing the banks is not a prerequisite for rescuing economies.  In fact, it appears that rescuing the banks, slows down if not makes it impossible to rescue the economies.
Geithner says they should look no further than the pathetic self-flagellating treatment of the banks, which remain hamstrung by excessive regulation and poorly designed and generally puny rescue packages....
Compared to the US banks which effectively have no regulation?
The only route to growth is sorting out the finances of the banks and letting them lend again.
Not true as shown by Iceland.
Taxpayers are the only source of funds and should, like their US counterparts, bite the bullet....
Again, not true as shown by Iceland.
But Geithner has also created a monster that after only three years of recovery is already too big to fail. 
Without subsequent reforms, JP Morgan and the others will sow the seeds of the next crash. 
Their assets will be found again to be toxic and while the accounting may be clearer, there will still be lots of toxic loans to deal with. 
It is a dilemma that is hard to escape.
Actually, Iceland showed how easy it is to escape the dilemma.  First, realize that rescuing banks is not a prerequisite for economic growth.  Second, let the banks go.  Third, focus fiscal spending on supporting economic growth.
Barack Obama vowed to eliminate the possibility of the financial sector being too big to fail. 
Rightly he put growth first, but there is no doubting that restraining banks is harder once they have recovered their powers and legitimacy. It will be a severe test for the next administration.
Actually, it appears that he listened to Tim Geithner and as a result has managed to achieve a miraculous outcome.  He has managed to squander his opportunity and gotten the worst of all worlds - limited growth and a financial sector with firms that are too big to fail.

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