Image by TW Collins

Yesterday I discussed the "let the banks go under" option.  Let’s talk about the ups and downs of this possibility, because there are significant risks associated with it, which is why folks like Summers and Geithner are acting like they stared at the Gorgon and have been turned to stone.

The case for it is simple enough: if you don’t force the losses and the write downs, and instead allow a combination of impaired bank balance books and government accepting the losses, whether through a bad bank, insurance or other means, you have to write off trillions and trillions (I’m guessing, globally, a minimum of 8 trillion, and it is probably much higher than that).  That money will not be available for useful investments, for income, for social security or anything else.  It will be commited for a generation.  This is essentially what happened in Japan, when Japan refused to have its banks really accept and acknowledge their losses.  If you’re old enough, you remember the days when Japan had probably the world’s most dynamic economy.  No longer, instead they have an economy that’s in and out of the hospital, one where the good times have never, ever returnred.

That’s the zombie bank route combined with a bad bank that doesn’t nationalize banks.  Pay it off over a generation. 

This method has the advantage (from the point of view of decision makers) that it leaves the same class of people in charge of the economy.  From the point of view of ordinary citizens that’s probably a bad thing, since the current elites are not only incompetent, they are wedded to old infrastructure and and old model of organizing the economy.  Just as England did not succesfully make the leap from a coal economy to an oil economy in time to avoid its own fall, current interests are stoppng America from investing in the future—whether that is true in the internet, where the US has awful broadband compared to its competitors or in new energy technology, where others are ahead in solar wind and indeed virtually every renewable technology.  Keep these folks in charge, and this will continue.

Now the problem with letting banks go under instead is that it forces an acknowledgment of losses in a short period.

  Not too short, doing it smart means unwinding carefully, probably the majority in a couple years, and the rest over a few more years.  But still, short enough and clear enough that people are forced to take their losses—stockholders wiped out, creditors forced to take whatever value exists and no more, contracts based on fraud (ie. possibly the majority of Collateralized Debt Obligations and Credit Default Swaps) nullified.  This will, absolutely, cause a chain reaction.  As people are forced to take their losses, they will call in their good investments, causing a downwards spiral in various markets (including the stock market).  A lot of value will go away, and some value will actually be destroyed.  Credit default swaps which aren’t nullified will fire off, causing another wave of payments and losses.

This is why you keep hearing Geithner say that he prefers a private system.  Oh he may prefer one for other reasons, but this is why he’s paralyzed by the idea of forcing banks that are not really solvent into the arms of the Fed. 

If you’re looking at these two options, then, there are downsides to each of them.  Do you want the pain over with, even if it means a lot of pain right now?  Or do you want to drag it out?

The caveat, unfortunately, is that the drag-it-out option may not work.  I see three possibilities if you go that route:

1) A generation or so of a lousy economy.  (Japanification)

2)  It only works for 4 to 8 years, because unlike Japan, the US does not have a trade surprlus with the rest of the world.  When it ends, you get to the crisis all over again.  And there will be no avoiding, that time, a massive crash.

3) It doesn’t work at all.

Of course, the downside of the "one fast rip" strategy is that it could cause a spiral that throws the world into a Great Depression.  Mind you, that Great Depression might happen anyway.  

The big upside of doing it fast is simple enough: you can really start lending again.  The Fed, those banks which survive and the credit unions, knowing that all the bad stuff has been acknowledged, don’t have to fear counterparty risk.  All money earned can actually be used to build the future, rather than pay off the past.  Growth, freed of debt to the past, can occur unfettered.

Now there are other options.  The "split the differnce option" is to simply nationalize all the banks that are effectively dead anyway, have the government pull the crap out of them into a bad bank (this is doing a bad bank right, as opposed to taking the crap off them and not nationalizing), refloat the banks and take your losses as fast as you can.  Unlike doing a bad bank wrong, this has the advantage that the government and taxpayers get all of the upside—all appreciation in banks values and that of any of the junk they took on goes to paying back taxpayers.  No, you won’t get it all back, but you’ll get a lot of it.   While creditors are badly damaged and shareholders are wiped out, the damage to them is not as severe in a "let them go under" option because many of the instruments will be held to maturity or sold—the government will be eating a lot more losses than if it simply said "the bank is effectively gone, if you’re a counterparty take your losses).

A final option is "inflate it away".  This  is the traditional method used by countries with debts that are too high, whether private or public.  The problem with this is that high inflation hurts everyone, and inflation is like the devil, one you invite it into the house, it’s hard to get it to go away.  Worse, deliberate inflation can lead to hyperinflation, and not only does that destroy economies, it tends to lead to very nasty governments in reaction.  (See Republic, Weimar). 

There are a lot of moving parts on this, and I’ve oversimplified this a fair bit.  Nonetheless, at this time, these seem to be the main options under consideration.  Which one do you prefer?