Barack Obama's presidency will likely be decided by one single issue - his ability to deal with this financial crisis. With the release of his Treasury Secretary Tim Geithner's Public Private Partnership Investment Program two months into his administration, we now have a fairly comprehensive view of Obama's strategic approach. Edward evaluates 'will it work?' ultimately arguing for getting behind the current strategy, with complete transparency and accountability. If not, we may not only fail economically, but it will become too late for the Obama admin to recover after spending much political capital, and exhausting populous support.
I believe this strategy could be successful in rekindling some increasing credit liquidity and, therefore, some consumer demand. However, the strategy will not be successful in eliminating the underlying causes of our crisis - excessive leverage and insolvency -- and therefore systemic risk will remain.
An unresolved crisis could lead to a worsening economy. The loss of political capital and popular support that would result would cripple Obama's administration. Four critical factors will determine Obama's fate:
1. Success of Geithner's Plan: Barack Obama's fortunes depend in the main on Geithner's Public-Private Partnership Plan. If this plan is unsuccessful, Obama is sunk. The plan has merits, but many deficiencies as well.
2. Efficacy of Economic Stimulus: Obama's stimulus will not be sufficient given the state of the economy. Recently revised budget projections from the Congressional Budget Office confirm this -- the budget deficit, therefore, will be significantly worse than originally projected. Nevertheless, the Japanese experience in the 1990s demonstrates that even a depressionary economy can experience brief respites from economic turmoil. This could be Obama's saving grace.
3. Ability to connect with disenfranchised: Populist sentiment is running high because people have finally realized that the last quarter-century or more has seen a massive divergence of economic fortune between the wealthy and everyone else. In essence, while credit was flowing and asset prices rose, ordinary Americans appeared to prosper along with the wealthy. However, now that credit revulsion has replaced easy money, it is plain to all that standards of living will decrease. President Obama would be wise to use his inner Bill Clinton and demonstrate he can "feel your pain" or he risks being perceived as aloof.
4. Will in setting political agenda: While I (Nikhil) agree that the Republican party was in tatters after the 2008 election, giving Barack Obama a free hand, Edward argues Obama has grossly miscalculated politically on numerous occasions, costing Obama political capital. Whether he can reassert his agenda now -- with Democrats in Congress responding to populist sentiment out of self-preservation and the Republican party newly reinvigorated -- remains to be seen
Economic Background
Leverage, in a nutshell, is what led us to this point. The leverage in our global financial system - as represented by credit outstanding and credit derivatives has mushroomed out of all proportion to the underlying economy. This was a credit bubble, plain and simple, and it was destined to pop.
When it did pop, it was manifest first in the U.S. subprime market as this was the weakest link in the chain. However, policy makers were unable to ring-fence the problem and the crisis crossed over into numerous related and unrelated markets which have become dependent on leverage or liquidity.
Eventually, this credit crisis became a full-blown banking crisis as the attendant de-leveraging created such tremendous asset price deflation that financial institutions were forced to write down their assets by hundreds of billions of dollars. Therefore, capital adequacy at many financial institutions reached a distressed level, triggering a crisis of confidence and the bankruptcy of major institutions like Lehman Brothers and Washington Mutual.
After this point, the main question for most policy makers was this:
Has the de-leveraging and asset price declines which triggered the banking crisis been excessive? If asset price declines have indeed been overdone, many troubled institutions are stressed more due to 'irrational despondency' than any inherent capital inadequacy. On the other hand, if asset price declines represent a reversion to the mean, large swathes of the banking sector are effectively insolvent.
The Geithner Public-Private Partnership plan implicitly takes the former view - that asset prices are artificially depressed, creating weakness that should not exist. Treasury's press release yesterday says as much (note the bold):
The challenge posed by these legacy assets began with an initial shock due to the bursting of the housing bubble in 2007, which generated losses for investors and banks. Losses were compounded by the lax underwriting standards that had been used by some lenders and by the proliferation of complex securitization products, some of whose risks were not fully understood. The resulting need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.
Success can still mean defeat
Unfortunately, Geithner's view is not a correct interpretation of events. While prices have declined considerably in a number of markets, often to excessively low levels, there are many other assets which will become impaired going forward or have been impaired, but have yet to be written down. Commercial Real Estate, credit cards and prime mortgages are all distressed markets where one should anticipate further writedowns. So, even if the Treasury's interpretation of events is correct -- that many asset prices have fallen too far -- it is irrelevant because there are so many more writedowns still to come.
Let's assume the Geithner plan will be successful in increasing the prices of the assets it targets (even though this is far from a good assumption. See Yves Smith's take on this). But, we have a workable plan here, and let's assume it can get the job done to boot. Mark Thoma does a good job in presented a balanced picture.
I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear...
So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none - to me - is so off the mark that I am filled with despair because we are following a particular course of action...
What's important to me is that we do something, that we adopt a reasonable plan that has a decent shot at working and that satisfies the political test it must pass (though the administration could certainly do more to sell the plan to the public and help with this part, so passing the test is partly a reflection of the effort that is put into selling it). We've been spinning our wheels for too long, and it's time to get this done. We can't wait any longer.
So I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.
What's more, we have the TALF (Term Asset-Backed Securities Facility) and other programs sponsored by the Federal Reserve as well. That's a lot of firepower.
But, what if...
What happens if economic weakness creates more losses on other asset prices? As an example, what if credit card charge-offs increase much more than is anticipated and prime mortgage defaults increase equally dramatically?
In that case, this program will be insufficient and another round of asset buying, bailouts or nationalization would be necessary. Given the bailout fatigue we are already seeing, I reckon it will be impossible to allocate more federal monies to bailouts or buying toxic assets.
I do anticipate many more writedowns irrespective of what happens with the TALF, TLGP , the Public-Private Partnership or any of the other plans. Therefore, the likely result of this program is the nationalization or bankruptcy of a more weakened banking system down the line. This will end up costing considerably more to fix than had the nationalization/ bankruptcy been achieved on the first go round.
So, to be clear, even if Geithner is successful here, I believe the plan will end costing more than had he bitten the bullet now. This will weaken the economy and cost Obama politicially.
Sources
Has a ‘Katrina Moment’ Arrived? - Frank Rich, NY Times
Take the Steering Wheel out of Geithner's Hands - Arianna Huffington
Which Bailout Plan is Best? - Mark Thoma
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