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Steady Through This Storm

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By Ricardo J. Caballero
Monday, April 6, 2009

President Obama recently stated that he is a big believer in "persistence," and he provided examples of how he will persist in many areas of economic policy. That word and his examples gave me more hope for the future of the U.S. economy than I have had in some time.

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We are experiencing the mother of all modern financial crises. Real and imaginary counterparty risk, policy uncertainty, and widespread panic have reduced purely private financial transactions to a trickle in many vital markets. Unfortunately, an already complex economic problem is being compounded by an awful political environment, and the prefrontal cortex of our political system is freezing up as well. Politicians and commentators from the left and right are in panic mode and have retrenched to their basic instincts, moving away from reasoned analysis. It is, frankly, scary to hear the right regurgitating the untimely liquidationist claims that Treasury Secretary Andrew Mellon made during the onset of the Great Depression. It is also frightening to see the left going after Wall Street "oligarchs" and the financial institutions they have always hated, which finally are easy prey.

Fortunately, some voices of reason remain, and the Treasury, Federal Reserve and Federal Deposit Insurance Corp. are among them. They have been persistent. It is true that the announcement made in early February by Treasury Secretary Timothy Geithner lacked specifics, but it was not short on principles and general guidelines. These principles recognized the systemic nature of today's crisis and the critical role that uncertainty has played in it. The announcement of the "legacy assets" program last month confirmed these principles. From this, one can get a sense of perseverance and determination, which are exactly what an economy needs during times of massive uncertainty.

The basis of the U.S. financial system and economy is private capital. Policies must encourage rather than discourage private capital participation for the short run as well as the long run. One of the main problems behind the crisis is excessive leverage, which means too much debt relative to equity. We need more, not less, equity and more, not fewer, shareholders. Because it is the government's responsibility to ensure a well-functioning financial system during episodes of panic, it is not anti-capitalist for the government to support private capital during these episodes, just as it is not anti-capitalist to charge for this service in advance and to regulate financial institutions of systemic importance.

The U.S. financial system is worth preserving, and the only safe policy while investors are in panic mode is to preserve it with as few changes as possible, with the government providing the resources needed to get to a point where we can fix the structural problems that contributed to the crisis. Contrary to popular perception, providing this support has nothing to do with the "zombie" policies of the Japanese experience during the 1990s. There, the problem was that banks kept making loans to unproductive companies to avoid having to recognize the losses associated with old loans to those companies. As a result, good companies had less access to loans than they would have otherwise. But a policy of supporting the sale of troubled assets through public guarantees, loans and equity participation, complemented with a public-private program to strengthen the capital of systemically important financial institutions, is the opposite of the zombie strategy. Such a framework builds a solid foundation for new lending and does not create incentives for banks to lend to the wrong clients.

If the administration's economic team can keep a steady course, and if it is persistent, we have a good chance of getting out of this mess in the near future. I am hopeful.

The writer is head of the economics department at the Massachusetts Institute of Technology.


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