Yesterday the Dow Jones industrial average shed a little more than four percent and ended under the 8,000 mark, the biggest decline on an Inauguration Day in the index’s 124-year history. The S&P 500 posted a 5.3 percent fall. Asian and Europe markets today followed suit as investors around the world began to realize the extent of the weakness of European and American banks.
Nouriel Roubini, the New York University economist, thinks American financial institutions are carrying $3.6 trillion in credit losses. Of that amount, half belongs to banks and broker dealers. “If that’s true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion,” he noted. “This is a systemic banking crisis.”
Not surprisingly, the Obama administration has yet to figure out how to deal with what could be the complete failure of the American banking system. There are many proposals on the table – Roubini predicts nationalization and many suggest the creation of a “bad” or “aggregator” bank for toxic assets – but the magnitude of the problem makes fashioning any solution difficult. There are, however, valuable lessons from past crises, domestic and foreign.
The first lesson is that a series of partial bailouts don’t work. Why? Because, when bankers suspect that more help is on the way, they don’t have the incentive to change imprudent practices. So the next bailout should be the last one.
Second, government attempts to merge weak institutions into strong ones in times of crisis just create more weak ones. Bank of America’s absorption of Merrill Lynch and Wells Fargo’s takeover of Wachovia – both arranged under government pressure – has now created problems for the survivors. This tactic may work in normal times when one institution flounders, but it can bring down the whole system when, as has been the case for the past half year, the dislocations are systemic.
So what should we do? It’s time to accelerate the liquidation of the weakest institutions and make sure the survivors are not so large that they become “too big to fail.” This solution could take years to implement, but, given the severity of the downturn, there are no promising shortcuts. In any event, it will take even longer for the rest of the economy to absorb overcapacity, a precondition to general recovery.
The remedies can no longer be piecemeal. And the time for more fumbling in the dark is over. We probably have only one more chance to get the financial system right.
