How to Lift a Falling Economy

Sunday, February 22, 2009

Hope is in short supply during these trying economic times. Nowhere is this clearer than in the financial system. Since Treasury Secretary Timothy Geithner's recent announcements, shares of the main U.S. financial institutions have imploded yet again. The Dow Jones industrial average keeps falling.

And to make matters worse, politics has decidedly entered into the process of economic policymaking, which makes it all the more likely that we will end up with the wrong policy response, one that is probably too late anyway. Talk of nationalizations has become widespread, as if government takeovers were a panacea, further reinforcing the deadly spiral of fear and panic.

Already, this illness has spread to the global economy. It has ravaged the wealth of citizens around the world by about $40 trillion, according to some estimates. This continuous wealth destruction has frozen consumers and companies alike, so the real economy is in a free-fall as well. How do we stop and reverse this process?

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

While the policy is about future (and unlikely) interventions, the immediate impact would be enormous. In particular, it would turn around the negative dynamics of stock markets, and it would allow banks to raise private capital.

The most direct effect would be an increase in the price of banks' shares, as the pledge puts a floor on the price, but the upside potential is huge once we get over the hurdle posed by this crisis. That is, buying equity from these banks would become like buying Treasury bonds plus a call option on the upside. By the strong forces of contagion, this rise would immediately spread to non-financial shares. Consumers, especially retirees, would see some of their wealth replenished; insurance companies' balance sheets would improve; destabilizing short sellers and predators would be wiped out (as happened in Hong Kong in 1997); and we would have the foundations for a virtuous cycle.

The second, and reinforcing, effect would be the stabilization of the financial sector, as banks would possess the conditions necessary to raise private capital. Until now, banks have not wanted to raise capital because it would be highly dilutive at current prices. Potential investors have no interest in injecting capital because there is an enormous fear of further dilutions, especially through public interventions or, worse, outright nationalizations. A pledge to support the shares would reverse these dynamics and quickly recapitalize the banking sector.

How much would this cost taxpayers? Probably nothing. It is unlikely that the crisis will last five years, especially in the presence of an aggressive policy response, and most banks' shares are likely to soon trade for many times current prices. If the market prices surpass the government-pledged sale prices, there would be no cost to taxpayers.

There would be implementation issues, including how to customize to each bank's needs and the extent of the liquidity discount of the different portfolios. But the market needs good news sooner rather than later. And there is no real reason not to try such a proposal -- not unless the "cut off your nose to spite your face" attitude grows even more prevalent.

The writer is head of the Economics Department and director of the World Economics Laboratory at MIT.

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