Breaking the psychological gridlock

It is widely accepted that the global financial markets and economies are gripped by a psychological fear that has frozen lending and borrowing, spending and investing. The risks and uncertainties appear to be too over-powering for any particular fiscal or monetary policy initiative to overcome. As the world economy continues its steep tumble downwards, Ricardo Caballero has an interesting prescription to unfreeze the credit markets and get banks lending and raising capital and thereby stem the asset price declines and break the psychological fear over-hang

The government pledges to buy up to twice the number of bank shares currently available, at twice some recent average price, in five years.

I can't but help feel that this is precisely what one would call a form of "arms-length" nationalization! The government would effectively be holding long-positions in these banks or the banks would be buying put options on themselves from the government! The only difference would be that the tax-payers would be paying the effective cost of under-writing these options. Caballero hopes that in five years, the markets would recover and the prices would be beyond the strike price, thereby making the exercise of the options redundant. The success of such arrangements depends on how much immediate positive splash it can generate in restoring market confidence.

This proposal comes as a sequel to Caballero's initial proposal (here and here) for a universal, government-provided insurance for distressed assets, an effective insurance complement to TARP II. Caballero does not favour nationalization on the grounds that it will have to be universal, in which case it becomes too massive to manage, and the compex inter-linkages of the financial markets risks generating unfathomable systemic risks.

James Kwak agrees with the credit insurance proposal as a cheap way to get distressed assets off the balance sheet, but does not favor (also here) the first one, calling it "wishful thinking", on the grounds that the share prices are so undervalued that even a double price guarantee would not provide adequate cushion to raise the required capital.

Mark Thoma too does not agree with the "call option" proposal of Caballero, and prefers a "plan that has been tried before in some form and worked, perhaps not perfectly but a plan that did lead to clear improvement at a defensible cost" to blank experimentation.

James Galbraith has the answer - the existing law (Title 12, Sec. 1831o) mandating that banking regulators take 'prompt corrective action' to resolve any troubled bank. This law mandates that the administration place troubled banks, well before they become insolvent, in receivership, appoint competent managers, and restrain senior executive compensation (i.e., no bonuses and no raises may be paid to them). The law does not provide that the taxpayers are to bail out troubled banks. Nouriel Roubini agrees to a Swedish style receivership - take ’em over, clean ’em up and sell ’em back to the private sector, preferably in pieces!

David Warsh nicely sums up the various opinions.