There is a lovely comment on the last post accusing me of financial chauvinism – suggesting it is wrong to guarantee all bank liabilities.
This gets to the nub of the issue.
The current US policy is – pretty close to officially – that there should be “no more Lehmans”. Bernanke said it this week. Geithner has said similar.
It is unequivocal that a policy of “no more Lehmans” requires an effective guarantee of all the large US financial institutions. When one of them threatens to become the next Lehman it needs to be bailed out. The US government tips $30-300 billion in and gives us a Sunday evening press release – just for me to read in my Asian time zone before our local market opens!
Face it – the current policy is to issue the broad guarantee. That is what we have done. That is what “no more Lehmans” means. It means losses are covered when they are incurred by the taxpayer.
Once we have done that there is no real argument against a non-recourse funded troubled-asset program. That is just another form of non-recourse funded financial institution. The argument really is “how much capital should we demand the private sector put in, and on what leverage and confiscation terms?” It is the same argument for regulation of a bank.
But it is not universally accepted that the right policy is “no more Lehmans”. Chris Whalen (who I respect) thinks the right model for the dismantling of large financial institutions is Lehman. As he says the model is easy to determine – just go down to the Southern District of New York and talk to the trustee.
I think the consequences of allowing several uncontrolled large bank failures would be catastrophic – and the cost to the taxpayer of the effective guarantee will be huge (but probably less than a trillion dollars by the end of the cycle) – but lower than the cost of the great-depression event that would follow from a cycle of mega-bank collapses.
In Sweden the right policy was the guarantee – and selective nationalisation – precisely because the cost of the guarantee was not large. The institutions were not very insolvent. In Iceland the institutions were so large that the guarantee just was not feasible.
It is however very hard to tell what is insolvent in advance. Svenska Handelsbank was brimming with solvency and the market wrote it off for dead. It was a rapid 20 bagger when the crisis ended. If it were easy to tell how insolvent then there would be no big banks that were rapid 20 bagger stocks when financial crises end.
And it would be easy to tell the right policy.
The most important policy question is whether you issue the blanket Swedish guarantee. I think the answer is an unequivocal yes in the US – and a probable no in the UK. Krugman is edging towards a yes as he says in this post.
If it is a yes (open for debate) then the non-recourse finance model for the troubled asset funds does not pose any further problem.
The facts on the ground are that the policy is a de-facto guarantee – as officials regularly say that there will be “no more Lehmans”.
Krugman’s current position (probable yes on the Swedish position, blanket opposition to new capital on a non-recourse basis) is untenable.
PS. I have stated before - and it is reiterated in the comments
The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).