Felix Salmon has fun with Mohamed El-Erian:
Europe’s insoluble problems: Mohamed El-Erian is calling for massive recapitalization of the banking system:
The global financial system is being refined “day in and day out,” El-Erian said, and as a result the balance between public and private is shifting and regulation is altering. “This is not being done according to some master plan,” but in reaction to a series of crisis management interventions. None of these piecemeal policy moves restored confidence in the markets, he said. What is needed is a coordinated and simultaneous set of policy actions globally in four areas: restoration of credit markets, elimination of deteriorating assets from balance sheets, injecting capital quickly into the banking system, and regulatory forbearance.
Oh, wait, that was El-Erian back in October 2008. But he’s saying something very similar now:
In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalization must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.
The main difference, here, is the move from “regulatory forbearance” the first time around, to governments forcing “fundamental changes in the way financial institutions operate” today. But either way, this is basically, the bank-nationalization debate all over again. In the U.S., we didn’t nationalize in 2009. We ended up taking only modest stakes in banks, and getting through the crisis through the massive application of liquidity by the Fed. If the central bank, as lender of last resort, ensures that banks will always be funded, then you don’t need nationalization. It’s a bailout by monetary rather than fiscal means, and it’s a lot friendlier to bank shareholders than nationalization is.
But the problem in Europe is that the ECB is displaying neither the willingness nor the ability to act as a lender of last resort — and in that situation, the only policy action left is for governments to step in and try to backstop the banking system directly. This is a very dangerous road to travel down…. So color me unconvinced that the solution to a liquidity crisis is an injection of capital. At best it’s insufficient; at worst it’s unnecessary, and only serves to exacerbate the painful process of deleveraging in a pretty drastic manner. After all, liquidity problems can hit anybody, no matter how solvent they are — just ask the German government. The Bund auction failed in large part because the European liquidity-go-round is utterly broken right now, and it’s hard to see how things would improve if Europe’s sovereigns, including Germany, started getting into the banking business.
The idea behind sovereign recapitalizations is our old friend Anstaltslast — the idea that if a bank is owned by the state, then there’s an implicit government guarantee on its liabilities. If Europe’s sovereigns started taking substantial equity stakes in their own banks, then there would be fewer worries over bank solvency: it’s almost impossible for a bank to go bust if the sovereign really doesn’t want it to. But in the context of serious worries over sovereign solvency, this tack doesn’t make a lot of sense. Once you’ve nationalized, there’s no real end to the degree to which you might end up being on the hook for the banks you now own: you can’t credibly claim that the banks you own are now so well capitalized that they’ll never need any more money. And in this case, of course, the worries over European bank solvency are worries over European sovereign solvency. You can’t tie these two rocks together, through nationalization, and expect them to float…
One thing that Felix misses, I think, is that liquidity crises and their cousins are always relative phenomena: people don't want to hold X in their portfolio because they want to hold the safer Y. But there is some financial asset Y that is the safest financial asset in the world--and whoever issues the Y can solve the liquidity crisis by flooding the zone, if they desire.
At the moment, it is pretty clear that the issuers of the ultimate Y is the U.S. Treasury and the U.S. Federal Reserves--with Japan and Germany close seconds and thirds. They can, collectively, solve our problems with very little substantive pain anywhere--if they wish.
The "you can't tie two rocks together and expect them to float" sounds good, but misses most of what is going on--for there is always something that is not a rock but rather helium.
Another thing that Felix misses is that gradual-bank-recapitalization-through-monetary-forebearance gives banks enormous incentives to rebalance themselves by shrinking their asset bases. And the rest of us would really rather that they rebalanced themselves without cutting back on the loans they make.