So Now We Know . . .

Counting down to the announcement of the Geithner plan, the New York Times has this account of how it came into being (and why it should be called the “Geithner plan,” although maybe Larry Summers is hiding behind him):In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.

Mr. Geithner, who will announce the broad outlines of the plan on Tuesday morning, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.

I’m not a huge fan of executive compensation caps, as I think they are something of a sideshow. But I think the general approach of playing nice with banks and their shareholders is a mistake, because it leads to intransparent subsidies like the privately-financed bad bank is sure to be. (If the government is guaranteeing assets bought by private investors, as is widely rumored, it’s still a subsidy; it’s just not as obvious as writing a check.)

The most important thing in the bank rescue plan should be cleaning up their balance sheets to the point where even in a worst-case scenario we don’t need to worry about bank solvency (at least for those banks that are left standing by the rescue). If the government announced, “we will buy any assets you want to sell, at their current book values,” this would be a massive subsidy worth hundreds of billions of dollars (and requiring trillions of dollars in initial outlays), but it would at least restore confidence in the banks. If the government announced, “we are taking over Citigroup, Bank of America, and JPMorgan because they are insolvent, and we will write down their questionable assets to nothing, recapitalize them, and later reprivatize them,” this would also restore confidence, although it would unleash a flood of litigation and political attacks against the government for engaging in “socialism.” But if instead you try to split the difference, avoid too much government involvement, and pretend you are not subsidizing the banks, you end up coming up with these too-clever-by-half subsidies that you are trying to hide from Congress and the public, and no one can be confident that they will work.

It’s possible that the “uniform stress test” will be rigorous enough to weed out and either close or recapitalize all those banks that may become insolvent in a severe recession. And it’s possible that the government guarantees will be generous enough to bring in enough private capital to buy up enough toxic assets to make bank balance sheets trustworthy enough. So it will take a few months to learn if the plan will work.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.