Bailout Bill's Sine Qua Non

After listening to the Paulson-Bernanke-Cox show at the Senate Banking Committee hearing this morning, Princeton economist Paul Krugman says on his daily blog that something very much like the N0. 1 condition listed by Robert Reich should be a sine qua non of any bailout bill:

[A]ny bank that wants to remove toxic assets from its balance sheet can do it at a stroke — just declare them worthless, and poof! they’re gone. But of course, that would reduce confidence and capital, not increase it — and that’s not what Hank and Ben are talking about. They’re talking about turning the assets over to Uncle Sam, and getting cold hard cash in return. And then the question is how much cash they get in return. It’s all about the price.

Now, if the price Treasury pays is very low — anything comparable to what financial institutions are able to sell the stuff for now — it’s going to do nothing for confidence and capital. If the price is high, confidence and capital will improve — but taxpayers may well take a big loss. * * *

But how can we help the financial situation without making that bet? By taking an equity stake. That way, if it turns out that the feds are pumping money in at above-fair prices, at least they get ownership, just as a private white knight would have.

In fact, Prof. Krugman says it twice:

[T]he plan only helps the financial situation if Treasury pays prices well above market — that is, if it is in effect injecting capital into financial firms, at taxpayers’ expense.

What possible justification can there be for doing this without acquiring an equity stake?

No equity stake, no deal.

There is precedent for this in Sweden's banking crisis of the early 1990's, as the International Tribune explains:

Financial deregulation in the 1980s fed a frenzy of real estate lending by Swedish banks, which spent too little time worrying whether the value of collateral might evaporate in tougher times. Property prices exploded.

The bubble deflated fast in 1991 and 1992. A vain effort to defend Sweden's currency, the krona, resulted in an incredible spike in overnight interest rates at one point to 500 percent. The Swedish economy contracted for two years straight after a long expansion, and unemployment, at 3 percent in 1990, quadrupled in three years.

After a series of bank failures led to ad hoc solutions, the moment of truth arrived in September 1992, when the government of Prime Minister Carl Bildt opted for a clear-the-decks solution.

With the full support of the opposition center-left, Bildt's conservative government announced that the Swedish state would guarantee all bank deposits and creditors of the nation's 114 banks. Sweden formed an agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

The big difference between the Swedish solution and the Bush-Bernanke proposal is that "Sweden did not just bail out its financial institutions by having the government take over the bad debts. It also clawed its way back by pugnaciously extracting equity from bank shareholders before the state started writing checks."

By the end of the crisis, the Swedish government had seized vast swaths of the banking sector, and the agency had mostly fulfilled its tough mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.
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Looking back, Swedish official say the tough approach toward the banks paved the way for success. It eliminated "moral hazard," the problem of relieving investors of bad decisions. And, much as it might be a shock in the United States, the demise of shareholders also underpinned the political consensus that help restore stability to financial markets even before the bailout was truly under way.

To be sure, solving the banking crisis in Sweden took several years, during which the Swedish economy endured a recession, according to Bloomberg News. By now, however, it ought to be clear to all that a prolonged recession is the least we face under every scenario being seriously put forward in Washington.

The alternative of doing nothing is even worse. The proposal of the Bush administration, which involves a straight-forward give-away to Wall Street with no equity stake in anything, is likely to exacerbate the widening class divisions in contemporary U.S. society, just as Hooverism did nearly eighty years ago, with all that mankind's history teaches us this implies for the social order and domestic tranquility.

No equity stake, no bailout.