Arin Dube explains three options for getting rid of zombie banks:
The Political-Economy of Financial Adjustment – or Ridding Ourselves of the Zombies, by Arindrajit Dube: When it comes to the recovery of the financial sector, I think it is helpful to distinguish three types of adjustment processes, each of which has a nice parallel in biology (well, real or imagined processes in the biological arena). Here they are:
1) Darwinian Liquidation (or “Natural Selection”)
2) Organized Liquidation (or “Intelligent Design”)
3) Bailouts with Temporarily-Soft Budget Constraints (or “Zombies on Life Support”)
Fundamentally, parts of the banking sector are in dire need of re-valuation and liquidation – at least the liquidation of some parties. Almost everyone on the left and right agrees that the zombie banks’ balance sheets are both unsustainable and opaque, that recovery will necessitate bringing the toxic assets out in the daylight, and that eventually this will mean that some people will have to take losses. It is helpful to tease out the details associated with each of these processes, and the likely political-economic ramifications they have for future.
1. Darwinian Liquidation (“Natural Selection”)
Left to its own devices, the capitalist financial sector will recover through self-correcting mechanisms – eventually. I say this with confidence based upon the historical record in the nineteenth and early twentieth century in the West, and the record in developing countries over the twentieth century. In terms of the latter, even with highly contractionary IMF structural adjustment policies, many countries recovered and subsequently grew. Note the operative word – eventually. This process may take years, and during that time, people who will lose are largely outside the financial sector – workers whose firms cut employment and wages due to the credit crunch and the worsening aggregate demand. Eventually, most likely new financial intermediaries will emerge to fill the niche and eventually put us on the long run growth path (Romer's work comes to mind). By the time they do, existing shareholders, bondholders and likely some counterparties in banks will all get liquidated. But so will a substantial portion of the “real economy.” Indeed, this is the path that was suggested by then Treasury Secretary Mellon to President Herbert Hoover. The zombies will be selected out – eventually – but they will take down many innocents as they prey on the healthy.
2. Organized Liquidation (“Intelligent Design”)
The second option is an orderly and organized liquidation of shareholders in the banking sector, some bondholders, and maybe even some counterparties through federal intervention. This is usually called “nationalization” but as many others have pointed out, this is not about seizing the commanding heights of the economy. It generalizes the current process that the FDIC has been following with failed banks at a greater level. Unlike in the biological world, there is room for “intelligent design” when it comes to the economy – it’s called public policy. Are there risks – like taking over one bank may cause another to fail and hence needing a takeover, etc.? Of course. And the federal government should plan and prepare for reasonable contingencies. But we do not have the option of pursuing a risk-free strategy. “Intelligent design” can help bring about the same outcome as “natural selection” – getting rid of the zombies - but it can also make sure large swaths of species (firms in this case) don’t become extinct in the process.
3. Bailouts with Soft Budget Constraints (“Zombies on Life Support”)
The final option is the status quo. Keeping zombies on life-support is pretty much what the Geithner Treasury is doing now the best I can tell, and that seems to be the conclusion others have drawn as well. The only principled reason to do this would be the belief that this is a liquidity and not a solvency crisis. In other words, you keep pumping blood into zombies and hope that their own immune system eventually picks up and defeats the zombie-producing antigen. It’s also a strategy that most economists – left or right – think is a bad one. With a (temporarily) soft budget constraint, it leads the financial firms to demand more and more money – and the more the Treasury is invested in this policy, the more it probably buys into the sunk-cost fallacy and refuses to stop the bailout process. The only people who may benefit from this (at best) are those who just postpone their judgment day - i.e., eventual liquidation.
Now some think the Obama administration might be postponing option 2 to make it painfully clear to everyone that we need it (“look we tried to avoid it, but just didn’t work.”) But I think the political-economic equilibrium is likely to be the opposite. Perhaps the most pernicious thing about option 3 is that it creates a political atmosphere where option 2 (organized liquidation) becomes infeasible. After a year of us pursuing option 3, conservatives can rightly point to the fact that government intervention doesn’t work, and we need a Reaganite or Thatcherite approach to cleaning up the mess. In other words, we need the market to work by instituting option 1. And after sinking so much money on the zombies, going back to Congress for more money for recapitalizing the new and healthy banks is a hard sell. So the longer we wait, the more we forego the possibility of a rational approach to this crisis. And the more pain we will likely endure due to the resulting political economy.
So here is praying for intelligent design.