In the wake of Treasury Secretary Tim Geithner's unveiling details concerning Treasury's public-private partnership aimed at removing up to $1 trillion in troubled assets from the banking sector's balance sheets, stocks soared. The Dow Jones Industrials rose 497.48 points (6.84%) and the S&P 500 surged 54.38 points (7.08%). The beneficial psychological impact of the dose of certainty that was provided in the plan's details that suggested that the nation's policy makers might have caught up with the unfolding financial sector crisis and perhaps were moving ahead of the curve was the easy part.
Real risks remain. For instance, while Treasury's plan seeks to address the issue of troubled assets, it does not seek to resolve so-called zombie banks. In today's syndicated column, Paul Krugman wrote:
As economic historians can tell you, this is an old story, not that different from dozens of similar crises over the centuries. And there’s a time-honored procedure for dealing with the aftermath of widespread financial failure. It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.
Krugman's concerns have merit. Although the U.S. has moved far more quickly than Japan in making capital injections into the banking system, creating a "bad bank" mechanism, and adopting fiscal stimulus measures, Japan ultimately needed a resolution of its zombie banks before a sustained economic turnaround was achieved. At a recent conference on Japan's financial crisis hosted by the International Monetary Fund, Jonathan Fiechter, from the IMF's Monetary and Capital Markets Department, observed that one of the important lessons of that experience was that "AMC's [asset management companies] and banks were slow to address problem borrowers--weak corporations (zombies) were kept afloat." In a paper published by the National Bureau of Economic Research in December 2008, University of California San Diego professor Takeo Hoshi and University of Chicago professor Anil Kashyap explained, "The main problem with the Japanese approach was that the banks were kept in business for far too long with insufficient capital. This limited the banks willingness to recognize losses and they took extraordinary steps to cover up their condition and in doing so retarded growth in Japan..."
This raises the logical question: If Treasury's plan does not provide a sufficient remedy to materially improve the capital situation at such large banks as Citibank and Bank of America--the two most often cited as zombie institutions by economists--will the newly-announced initiative underperform relative to expectations. Certainly, Paul Krugman is in that camp.
In any case, early indications of how well the plan is working should begin to show up in subsequent releases of the
Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices. If the plan is working, one should begin to see a softening of the trend toward tighter credit and afterward, a loosening of credit.
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