Thursday, January 29, 2009

Let Jeremy Stein Sort It All Out

Terrific news: Harvard economist Jeremy Stein is joining Obama’s team of savants who are trying to form a plan for dealing with the financial mess. I like this guy a lot. Check out this from the WSJ Real Time Economics site (the bolding is mine):

He advocated aggressive government audits of banks, aimed at separating solvent ones from insolvent ones. Once that was done, insolvent banks would be forced into closure or sale while solvent ones would be pushed to raise more private capital. In addition to dealing with the bad bank problem, putting the plan in place would remove much of the uncertainty in financial markets that the government’s ad hoc approach to banks thus far has helped instill.

Great stuff. The nationalization debate has heated up lately, with some justification as it becomes clear to everyone that many U.S. banks are insolvent. But how do you take over swaths of a banking system gracefully, effectively, without setting off a mass panic? I'm coming to the conclusion that it's a mistake to lead the discussion with the nationalization idea -- it freaks out Republicans too much and also introduces too many thorny "how do we do this and what are the effects?” questions.

A better approach: begin with aggressive government audits of the banks, as Stein proposes. Aggressive means a tough accounting of those distressed assets on their books. In the first round start out with the largest 20, 50, 100 U.S. banks -- however many you can audit in a relatively short time frame, say two to four weeks. (This exercise should be easier right now since the banks have just done their end-of-year audits.)

After round one, you have a very critical commodity that the Paulson-led Treasury never possessed or seemed much interested in: good hard information about who’s fine, who’s in some trouble, and who’s in really deep doo doo. Now you don't have to indiscriminately sling around bailout dollars; you can make calculated decisions on who is strongest and should be propped up. The insolvent ones, if they can't raise capital, should be unwound in an orderly fashion. Or, if they're too big to fail, they get nationalized as a last resort.

Two reasons why this is a good approach: one, it's not a perfect way to eliminate the moral hazard problem, but it's a vast improvement over Paulson's scattering of funds without regard to viability. Think of it as like grading along a curve. The banks that made the worst bets, or the most insolvent, will go bust. That's as it should be. Others who are solvent or who are close to solvency will be rescued.

Two, as Stein astutely points out, this process restores a degree of certainty to financial markets in an area where it matters hugely: which of the players in the financial industry are on solid financial footing. Not resolving this issue arguably contributes the most to the freezing of credit. After a series of hard-nosed audits, banks essentially will become marked as either survivors or losers, with an impartial auditor’s stamp of approval (or disapproval).

Hiring Jeremy Stein was an excellent idea. Now Obama should listen to him. Carefully.