Paul Krugman: The Banks Are Not Alright

The failure to pursue the best strategy for cleaning up the financial system, temporary nationalization and a large injection of capital, is slowing down the recovery, particularly for "the part of banking that really matters — lending, which fuels investment and job creation":

The Banks Are Not Alright, by Paul Krugman, Commentary, NY Times: ...[Many people] reacted with fury to the spectacle of Goldman Sachs making record profits and paying huge bonuses even as the rest of America, the victim of a slump made on Wall Street, continues to bleed jobs. ...

Ask the people at Goldman, and they’ll tell you that it’s nobody’s business but their own how much they earn. But as one critic recently put it: “There is no financial institution that exists today that is not the direct or indirect beneficiary of trillions of dollars of taxpayer support for the financial system.” Indeed: Goldman has made a lot of money..., but .... only ... thanks to policies that put vast amounts of public money at risk...

So who was this thundering bank critic? None other than Lawrence Summers... Administration officials are furious at the way the financial industry, just months after receiving a gigantic taxpayer bailout, is lobbying fiercely against serious reform. But you have to wonder what they expected to happen. They followed a softly, softly policy, providing aid with few strings, back when all of Wall Street was on the ropes; this left them with very little leverage over firms like Goldman that are now, once again, making a lot of money.

But there’s an even bigger problem: while the wheeler-dealer side of the financial industry,... trading operations, is highly profitable again, the part of banking that really matters — lending, which fuels investment and job creation — is not. Key banks remain financially weak, and their weakness is hurting the economy as a whole.

You may recall that earlier this year there was a big debate about how to get the banks lending again. Some analysts, myself included, argued that at least some major banks needed a large injection of capital from taxpayers, and that the only way to do this was to temporarily nationalize the most troubled banks. The debate faded out, however, after Citigroup and Bank of America, the banking system’s weakest links, announced surprise profits. All was well, we were told, now that the banks were profitable again.

But a funny thing happened on the way back to a sound banking system: last week both Citi and BofA announced losses in the third quarter. What happened?

Part of the answer is that those earlier profits were in part a figment of the accountants’ imaginations. More broadly,... economic distress, especially persistent high unemployment, is leading to big losses on mortgage loans and credit cards.

And here’s the thing: The continuing weakness of many banks is helping to perpetuate that economic distress. Banks remain reluctant to lend, and tight credit, especially for small businesses, stands in the way of the strong recovery we need.

So now what? Mr. Summers still insists that the administration did the right thing: more government provision of capital, he says, would not “have been an availing strategy for solving problems.” Whatever. In any case, as a political matter the moment for radical action on banks has clearly passed.

The main thing for the time being is probably to do as much as possible to support job growth. With luck, this will produce a virtuous circle in which an improving economy strengthens the banks, which then become more willing to lend.

Beyond that, we desperately need to pass effective financial reform. For if we don’t, bankers will soon be taking even bigger risks than they did in the run-up to this crisis. After all, the lesson from the last few months has been very clear: When bankers gamble with other people’s money, it’s heads they win, tails the rest of us lose.