economic stimulus: prognosis for recovery?

As the credit crunch deepened into a crisis, AIG was found to have huge losses that required infusion of billions of government financing to keep it afloat and a counterparty to the many deals it had entered into, Lehmann was allowed to go under, and even giant Citi became the brunt of insolvency rumors, solutions that seemed good one day seemed half-hearted and ill-thought-out the next.  Eventually, an economic stimulus bill was passed, but as so often the case in Washington these days, the bits and pieces stuck in the bill to get it through a philosophically divided Congress raise questions about its efficacy, and the bank bailout remains a puzzle seeking a solution, as the government appears to go on the line for what could be billions or trillions of losses that should be borne by the shareholders who made the investments and the managers/owners who took the risksl.

Ben Bernanke appeared before the Senate Banking, Housing and Urban Affairs Committee Tuesday and acknowledged that a recovery is at least months, and maybe years, away, as we attempt to recover from a recession that could get worse before it starts getting better. See Fed Chief Says Recovery May Wait Until 2010 or Later, NY Times, Feb. 24, 2009.  He apparently assuaged some investors' anxieties by arguing that the government should just nurse banks back to helath and not nationalize them. 

But that doesn't do much to assuage ordinary Americans' anxiety that we will be left holding the stick for all those losses long into the future, while the share holders and managers continue to enjoy their huge gains from the speculative risktaking that put us in this position.  Consumer prices and home values continue to plunge, and jobs are being lost daily as GDP declines.  Ordinary Americans continue to be repulsed by the havoc wreaked by the greed of the big banks.

I, for one, am not convinced by the "neighbor smoking in bed whose house catches afire" analogy  (see id.) to whether we should let banks' shareholders suffer their losses.  We can save the banking system without putting all our assets at risk to let the smoker continue puffing away in his luxury condo.  We can do that by letting the shareholders have the toxic assets, and making a "good bank" out of the good assets, or by taking over--after all, if the government had to come in or the bank would have defaulted, the shareholders only have an interest in the insolvent institution, meaning that the creditors including the government are the real owners now) and setting new terms for the management while we restructure and resell the banks to new owners.

I am equally unconvinced about the US plan to refinance mortgages to the tune of $275 billion.  It's not new interest rates, but lower principal amounts that underwater families need.  That could best be done--fairly--through modifications in bankruptcy, as I have long argued.  The banks don't want that, because then they will KNOW what those toxic assets are worth.  But that's the right answer, and it's high time we made it possible.  Eric Posner on Volokh Conspiracy agrees, at this link.  Most of the arguments made by opponents of mortgage modification in bankruptcy (see, e.g., Randy Barnett on Volokh Conspiracy, at this link) just don't hold water.  Various bills have been introduced already in this session of Congress that would permit bankruptcy modifications.  It's amazing that the banks apparently have the clout to keep this legislation from getting passed, when it is so central to helping to solve the current economic crisis.  See, e.g., H.R. 200, Helping Families Save Their Homes in Bankruptcy Act of 2009 (and links there to other proposed legislation).

Comments

[Taxrascal]

One problem here is that if Congress can decide to modify the principal of a mortgage, you have two giant risks:

One is that the homeowners are more politically powerful than banks, and banks know that every loan they make could end up being revalued down. That would give them a good reason not to make many loans.

The other risk is that the banks come out ahead (someone who owns a couple thousand mortgages can probably afford a better lobbyist than any of the people paying those mortgages).

Once Congress has the power to distribute billions of dollars, that money is going to be a political football. The results of that are never good.

[LindaMBeale]

The idea on modifying principal is that bankruptcy courts could modify that, just like they do every other kind of loan, including loans on second homes and yachts and similar items. This is a no brainer, because it's doable, it's the right answer, and it will make a big difference in a reasonably workable way. The banks shouldn't have the clout to fight this. If they do, something is really wrong with the system.