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Planet Money has a great segment called Get Tougher, Please.  Give it a listen.  Economist Adam Posen of the Peterson Institute argues the financial reforms are way too wimpy – we need to get tough on the banks.

Allowing banks to keep toxic debts on the books for years will create zombies (and stagflation) for a very long time – until the assets magically become worth something (in which case the banks will sell them) or they finally go bankrupt. Adam also argues that the banks tend to make things a lot worse when they are on the brink of solvency – more risks and ultimately less stability for our economy.

So we need to get tough.  Tough means you send in government officials, go through the books and get the banks to declare their real worth on all these toxic assets. This will mean a fair number of bankrupt banks, but we have experience and institutions that can properly deal with that.

The downside for this nationalization type of action is the short term hit our financial markets will take. But once everyone knows who is solvent, and who is not, the foundation for future growth will be solid. But is there enough political will to battle through short term disruption for long term growth and prosperity?

The stimulus package the U.S. Congress is completing would raise the government’s commitment to solving the financial crisis to $9.7 trillion, enough to pay off more than 90 percent of the nation’s home mortgages.

9.7 trillion. That’s 13 times what the U.S. has spent so far on wars in Iraq and Afghanistan and almost enough to pay off every mortgage in the country. At bit staggering, no? Nouriel Roubini has a post about the banking system that is worth the free registration:

“The capital backing the banks assets was last fall only $1.4 trillion, leaving the U.S. banking system some $400 million in the hole, or close to zero even after the government and private sector recapitalization of such banks. Thus, another $1.4 trillion will be needed to brink back the capital of banks to the level they had before the crisis; and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector. So these figures suggests that the US banking system is effectively insolvent in the aggregate; most of the UK banking system looks insolvent too; and many other banks in continental Europe are also insolvent.”

If the whole system is in the red, then throwing cash in that black hole is not our best solution. Nouriel Roubini wants you to think about receivership and nationalization:

paradoxically nationalization may be a more market friendly solution of a banking crisis: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and – most certainly – even the unsecured creditors in case the bank insolvency hole is too large; it provides a fair upside to the tax-payer. It can also resolve the problem of avoiding having the government manage the bad assets: if you selling back all of the assets and deposits of the bank to new private shareholders after a clean-up of the bank together with a partial government guarantee of the bad assets (as it was done in the resolution of the Indy Mac bank failure) you avoid having the government managing the bad assets. Alternatively, if the bad assets are kept by the government after a takeover of the banks and only the good ones are sold back in a re-privatization scheme, the government could outsource the job of managing and working out such assets to private asset managers if it does not want to create its own RTC bank to work out such bad assets.

Nationalization also resolves the too-big-too-fail problem of banks that are systemically important and that thus need to be rescued by the government at a high cost to the taxpayer. This too-big-to-fail problem has now become an even-bigger-to-fail problem as the current approach has lead weak banks to take over even weaker banks. Merging two zombie banks is like have two drunks trying to help each other to stand up. The JPMorgan takeover of insolvent Bear Stearns and WaMu; the Bank of America takeover of insolvent Countrywide and Merrill Lynch; and the Wells Fargo takeover of insolvent Wachovia show that the too-big-to-fail monster has become even bigger. In the Wachovia case you had two wounded institutions (Citi and Wells Fargo) bidding for a zombie insolvent one. Why? Because they both knew that becoming even bigger-to-fail was the right strategy to extract an even larger bailout from the government. Instead, with nationalization approach the government can break-up these financial supermarket monstrosities into smaller pieces to be sold to private investors as smaller good banks.

He believes that the current actions are because plan N (nationalization) is not currently politically feasible. There is a small hope of recovery, and some banks still look like they are solvent. That may change in the near future:

“… with the government forcing Citi to shed some of its units/assets and the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC the administration is putting in place the steps for the eventual and necessary takeover of the insolvent banks.”

Time will tell.

NPR/PRI has some great stories on the return of Keynes theories, and possibly the very first test of them.  This American Life:

373: The New Boss – Stories about what happens when someone new takes over—someone with a vision of how things ought to be. Plus, NPR international economics correspondent Adam Davidson of the Planet Money podcast on how Obama’s new stimulus plan might actually be the first ever test of a very, very old theory.

NPR Planet Money:

Obama Tests Keynes – President Barack Obama says that only government can pull America out of a recession this severe. Obama calls his plan for stimulus spending of well more than $800 million a new idea, but Adam Davidson and Alex Blumberg say this kind of public spending relies on an old theory. John Maynard Keynes wrote it up in 1936 — and this recession marks its first real-world test.

The WSJ ran an oped from Dick Armey that was critical of the Keynes-like plans. Though I don’t agree with his suggestions (tax breaks), the article does a decent job of outlining the issues issues being ignored by current plans – Washington Could Use Less Keynes and More Hayek:

Government spending is, according to Keynes’s construct, a key component in determining aggregate demand, so more spending, even to resod the Capitol Mall or distribute free contraception, drives the economy in the short run. A father of public choice economics, Nobel laureate James Buchanan, argues that the great flaw in Keynesianism is that it ignores the obvious, self-interested incentives of government actors implementing fiscal policy and creates intellectual cover for what would otherwise be viewed as self-serving and irresponsible behavior by politicians. It is also very difficult to turn off the spigot in better economic times, and Keynes blithely ignored the long-term effects of financing an expanded deficit.

This is one thing that Keynes theory didn’t address – what happens when the govt is always spending and stimulating? We haven’t exactly been saving for a rainy day in good times; since Regan we have been borrowing against our social security and medicare.  Keynes theory was created in a very different time:

Today, one problem with manipulating the economy through “discretionary” spending — that part of the budget not mandated by one entitlement or another — is that entitlements have grown large enough to influence the economy, a phenomenon unheard of when Keynes was alive. Medicaid, Medicare, Social Security and other entitlements are becoming larger factors in economic decision making than what Congress spends on, say, roads. Discretionary spending is becoming irrelevant as a fiscal tool.

If the engine is flooded, do you keep mashing the gas pedal?

I’ve been meaning to write a post about this, but Caroline Baum has written many of the same points I had in a piece for Bloomberg called “Economic Cures Are Like Booze for an Alcoholic”.

“…the U.S. economy was buckling under the weight of the burst housing bubble. The blame game was in full swing, with the villains ranging from Alan Greenspan and his easy money policies to consumers borrowing and spending beyond their means to financial institutions enabling profligate spending to a misallocation of capital to housing.

Fast forward one year, the crisis is still going strong, the villains are still under attack, yet something curious has happened: The policies and actions responsible for the economy’s illness are now being prescribed as cures…”

“President Barack Obama’s crack economics team, including Larry Summers and Christina Romer, and Fed officials from Ben Bernanke on down have to understand that the problem of too much leverage can’t be fixed with more borrowing; that a misallocation of capital to housing can’t be cured with incentives to buy more homes; that consumers (and the nation) can’t spend their way to prosperity.

At least I hope they do.”

Me too. Mr O is doing a number of positive things. For example, I’m very happy with things like a commitment to openness ethics rules. However, I’m not so happy with some of the economic plans floated. To me, the issues we are facing today are primarily a result of excess. The US economy has lurched from bubble to bubble. Our last one was driven by cheap credit and underestimating risk. Now the markets are correcting for that. Profits will not quickly return to their same levels as before, because companies will not be able to leverage on that scale again and the US consumer is still over leveraged.

Keynesian economists are arguing that it is possible to spend and stimulate our way out of a recession, and then before inflation decimates the economy we can return to fiscal prudence. There are several issues with this plan. One, excessive spending caused the boom and bust – we can’t just continue to create bubbles indefinitely. If stimulus could create permanent jobs, then why not triple or quadruple it and eliminate unemployment forever?  It just doesn’t work that way – we would be in ruins and the cost of servicing our debt would be massive.  The second hole is with regards to timing – I have very little faith that any institution would be able to accurately time inflation and adjust accordingly. History agrees.

There are also those out there that believe the US govt does not even have the capital to “save” the markets, even with ridiculous creation schemes. I on the other hand believe that they can come up with enough crazy Zimbabwean monetary policies to get the cash, regardless of the long term effects on our currency and long term wealth. Sadly inflation is a very tempting end result for a large debtor nation like the USA.

If you want to hear just how silly this all sounds, watch this video of Fred on the economy.