Obama’s cowardice hits India too

India cannot return to rapid growth till the world economy recovers. And that cannot happen till the US economy recovers. Alas, the Obama administration is prolonging the recession by avoiding surgery to remove dead wood from its financial sector.

Some call this as cowardice. Others, such as former IMF chief economist Simon Johnson, writing in The Atlantic, say Wall Street has captured the White House. This is no longer a leftist accusation. Johnson says the US now resembles Russia, where business oligarchs and government officials protect each others’ financial interests, at the expense of the economy.

This is surely an exaggeration. Yet it highlights the priority given by the Obama administration to save the titans of Wall Street rather than end the recession quickly.

It is now clear that the toxic assets—securities and loans with impaired values—of US banks are $ 2-2.8 trillion, while tangible assets are only $ 1 trillion. Technically, the financial sector is comprehensively bust.

It needs to recognize the losses, writing off trillions. But for that somebody must first inject trillions of new equity into the banks. Private investors will not do so. The market solution would be to force insolvent banks into bankruptcy, with shareholders and creditors taking a huge hit, and their good assets being auctioned (at bargain prices) to surviving financiers. Many titans of Wall Street will disappear, but others will rise to take their place.

But while this will clean up the mess, the financial sector will collapse, perhaps converting the recession into a depression. Politicians are unwilling to risk this. Their preferred alternative is to rescue insolvent banks to thwart systemic failure. So, they have provided billions to the very banks responsible for initial mess. But the public has protested loudly that this helps horrible bankers rather than the economy, and is yelling for blood. A chastened Congress refuses to sanction additional rescue funds.

This has led to a troubling impasse. The government views banks as too important to fail. The public views banks as too plutocratic to be rescued with taxpayer’s trillions. Result: the US has a zombie financial sector, technically dead but kept on life support. It simply does not have the capital to increase lending and thus spark economic growth.

A plan last fall for the government to buy toxic assets at a premium was shot down as a gift to horrible bankers. Now, a private-public partnership is proposed to buy the toxic assets. This too has been widely criticized as a way of subsidizing private financiers to buy with little risk and huge potential gains.

Accounting norms have been tweaked to permit zombie banks to pretend they are alive and solvent. The hope is that the public will swallow this fiction, animal spirits will revive the economy, and the consequent growth of bank profits will eventually suffice to write of the toxic assets. Very optimistic!

The obvious option is for the government to temporarily take over the insolvent banks, examine their books, and segregate their toxic assets into a “bad bank”. This will clean up the balance sheets of the banks, which can start lending again, and then be re-privatized at a profit.

This will not be a slide into socialism, and actually makes market sense. It mimics bankruptcy procedures—the owners and creditors of existing banks will take a huge hit—without causing the systemic financial collapse that formal bankruptcy would. The government will aim not to run the banks (as India Gandhi did), but to restructure them (as in bankruptcy) and sell them.

This solution has been suggested by the Financial Times and the Economist, which are surely not socialists. Simon Johnson writes, “The challenges the United States faces are familiar to the people at the IMF. If you hid the name of the country (USA) and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.”

So, even the IMF, supposedly a free-market maniac, would routinely suggest temporary nationalization in such circumstances. This is an orderly variation of bankruptcy, not socialism.

Yet the Obama administration refuses to contemplate this obvious solution. Obama has been attacked by Republicans as a closet socialist, and the US public is leery of nationalization, even temporarily. Faced with this populist pressure, the Obama administration prefers half-measures to clean surgery of dead wood through nationalization. It has ordered stress tests to reveal the true weaknesses of banks. Yet experts agree that the tests have been designed to hide rather than reveal. Economist Nouriel Roubini says that the macroeconomic assumptions of the stress tests are out of date.

Even this sorry tale is actually a charitable interpretation of current events. The uncharitable explanation is that Wall Street has captured the White House, so nothing will be done to imperil the politico-financial network that rules the US. Robert Rubin and Hank Paulson, Treasury Secretaries of Clinton and Bush, were both from Goldman Sachs. Larry Summers, the current Treasury Secretary, earned millions as a hedge fund consultant.

In a market economy, well-managed companies should be rewarded with profits, while mismanaged companies should go bust. This basic rule has been suspended almost entirely for the titans of Wall Street. Only one titan, Lehman Brothers, has been allowed to go bust, and Wall Street says even that was too much. This is now official policy.

It was once said that what’s good for General Motors was good for America. Today, official policy implies that what is good for Goldman Sachs is good for America. This, says Simon Johnson, is a recipe for disaster. He fears that this crony capitalism will lead to a prolonged recession, maybe another Great Depression.

I see the problem as Obama’s cowardice rather than corruption. I don’t expect another Great Depression: at worst, the US will suffer stagnation of the sort Japan had in the 1990s. Most likely, we will see a long, weak recovery. Either way, it’s bad news for India, which badly needs US resurgence.

What do you think?