The Bernanke rally

Tuesday’s stock market rally was pretty impressive. But can the mere words of the Federal Reserve Chair actually produce a 4% increase in the value of the U.S. capital stock?

“Stocks up as Bernanke says recession to end in ’09”, declared the AP headline. But Andrew Leonard (hat tip: Mark Thoma) read the fine print:

the actual text of [Bernanke’s] prepared remarks reveals further qualification: (Italics mine.)

If actions taken by the Administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability– and only if that is the case, in my view— there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery.

That’s not just a big “if.” That’s a giant, honking, humongous, get-down-on-your-knees-and-pray-for-salvation “if.” Ben Bernanke predicts that we can hope for an economic recovery next year, only if government action is effective — and that includes, in his view, Treasury Secretary Tim Geithner’s plan to bring stability to the banking system, the details of which are still unknown.

In the full context of his remarks, Bernanke doesn’t sound all that optimistic.

Or maybe, opined the Wall Street Journal, stocks rallied because the Fed Chair “made the strongest comments yet against nationalizing major Wall Street firms.” But Paul Krugman isn’t buying that line, either. Krugman writes:

Here’s my stylized picture of the situation:

krugman_bank_blnc.png At the top are a bank’s assets. Below are its obligations to various parties, with decreasing seniority from left to right. I’ve drawn it to embody a pessimistic assumption about the bank’s finances, because those are the cases we’re interested in: the bank’s assets aren’t enough to cover its debts. Nonetheless, the stock, both preferred and common, has a positive market value. Why? Because of the Geithner put: the bank is protected from collapse, keeping the creditors appeased, but stockholders will get the gains if somehow things turn up.

What we want to do is clean up the bank’s balance sheet, so that it no longer has to be a ward of the state. When the FDIC confronts a bank like this, it seizes the thing, cleans out the stockholders, pays off some of the debt, and reprivatizes.

What Treasury now seems to be proposing is converting some of the green equity to blue equity– converting preferred to common. It’s true that preferred stock has some debt-like qualities– there are required dividend payments, etc.. But does anyone think that the reason banks are crippled is that they are tied down by their obligations to preferred stockholders, as opposed to having too much plain vanilla debt?

I felt that Simon Johnson hit the nationalization nail on the head on Monday when he wrote:

In some important and not good ways, we have already nationalized the financial system…. [M]ost importantly perhaps, we have the expansion of the Fed’s balance sheet as it seeks to step in to replace the weakening banks and the drying up of credit markets. In effect, the Fed is becoming a commercial bank as well as a central bank.

The government is essentially taking over the role of intermediation– take funds in and lend them out– for the US economy. This is a form of nationalization, and it will lead to all the lobbying and politically directed credits we have seen in other nationalized financial systems; taking away this credit once the economy starts to recover will not be easy. We have state control of finance without, well, much control over banks or anything else– we can limit executive compensation (maybe) but we don’t get to appoint directors (or replace entire boards) and we have no say in who really runs anything. Responsibility without power sounds accurate.

Why have we de facto nationalized? Because the private credit system– particularly large banks– is weakened and not getting any better. Attempts to deal with the problem banks are apparently blocked by the political power of influential bankers.

How then do we really privatize? By exercising leadership: take over insolvent banks and immediately reprivatize them. The new controlling owners can replace the boards of directors (tell me: why haven’t they resigned already?), and these boards can decide who to keep and who to let go from existing management. The taxpayer retains a significant number of shares (or the option to buy common stock) as a way to ensure upside participation– the economy will one day recover, and that will be a very good day for owners of the remaining banks.

Above all, we need to encourage or, most likely, force the large insolvent banks to break up. Their political power needs to be broken, and the only way to do that is to pull apart their economic empires. It doesn’t have to be done immediately, but it needs to be a clearly stated goal and metric for the entire reprivatization process.

OK, so if it wasn’t reassurances from Bernanke, do I have a better explanation for what could have produced such a big move in stock prices? No I don’t, other than to suggest that perhaps we were in pretty much the same situation Tuesday afternoon as we had been on Friday morning.


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