The aim should be to avoid a deep recession or prolonged weak growth, and to avoid a rapid recovery, which would induce a rise in inflationary expectations. This means a year or more of sub-trend growth, i.e. GDP plus or minus 1 per cent per annum. I think we have a good chance of muddling through, but at the moment the risks of inflation are surely much less than the risks of a deep recession. If that occurs the cause will be inadequate credit growth induced by the inadequate equity of banks and also, very importantly, inadequate profit retentions to support balance sheet growth. (As the latest FDIC report shows, US banks had negative retentions in the first half of 2008.)
Banks need more equity, and sufficient retentions to allow them to grow their balance sheets. It is generally believed that the prices of banks’ assets if sold at auction would be “too cheap”. The authorities should require banks to value their assets at these levels and to make conservative reserves against future losses. Banks would then fall into one of three categories: (i) those with adequate capital for regulatory purposes, who would need to take no action (ii) those with inadequate regulatory capital, who would be required to raise new equity and would be capable of raising it from private sources and (iii) those that would need the injection of preferred capital by the government as proposed by Charles Calomiris.
Provided that the prices of bank assets were then truly underpriced and the reserves were truly conservative, banks would experience good profit growth as the assets were repaid and new loans made with higher margins. If this induced too rapid a recovery, the Fed should respond quickly with higher interest rates.
Originally published at Financial Times and reproduced here with the author’s permission.