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Henry Blodget

Henry Blodget

Posted March 23, 2009 | 04:05 PM (EST)

Geithner's Five Big Misconceptions


Tim Geithner has finally revealed his plan to fix the banking system and economy. Paul Krugman, James Galbraith, and others have already trashed it.

Why?

In short, because the plan is likely to be yet another massive, ineffective gift to banks and Wall Street. Taxpayers, of course, will take the hit.

Why does Tim Geithner keep repackaging the same trash-asset-removal plan that he has been trying to get approved since last fall?

In my opinion, because Tim Geithner formed his view of this crisis last fall, while sitting across the table from his constituents at the New York Fed: The CEOs of the big Wall Street firms. He views the crisis the same way Wall Street does--as a temporary liquidity problem--and his plans to fix it are designed with the best interests of Wall Street in mind.

If Geithner's plan to fix the banks would also fix the economy, this would be tolerable. But no smart economist we know of thinks that it will.

I think Geithner is suffering from five fundamental misconceptions about what is wrong with the economy. Here they are:

The trouble with the economy is that the banks aren't lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it. As consumers retrench, companies that sell to them are retrenching, thus exacerbating the problem. The banks, meanwhile, are lending. They just aren't lending as much as they used to. Also the shadow banking system (securitization markets), which actually provided more funding to the economy than the banks, has collapsed.

The banks aren't lending because their balance sheets are loaded with "bad assets" that the market has temporarily mispriced.
The reality: The banks aren't lending (much) because they have decided to stop making loans to people and companies who can't pay them back. And because the banks are scared that future writedowns on their old loans will lead to future losses that will wipe out their equity.

Bad assets are only "bad" because the market doesn't understand how much they are really worth. The reality: The bad assets are bad because they are worth less than the banks say they are. House prices have dropped by nearly 30% nationwide. That has created something in the neighborhood of $5+ trillion of losses in residential real estate alone (off a peak market value of housing about $20+ trillion). The banks don't want to take their share of those losses because doing so will wipe them out. So they, and Geithner, are doing everything they can to pawn the losses off on the taxpayer.

Once we get the "bad assets" off bank balance sheets, the banks will start lending again.
The reality: The banks will remain cautious about lending, because the housing market and economy are still deteriorating. So they'll sit there and say they are lending while waiting for the economy to bottom.

Once the banks start lending, the economy will recover.
The reality: American consumers still have debt coming out of their ears, and they'll be working it off for years. House prices are still falling. Retirement savings have been crushed. Americans need to increase their savings rate from today's 5% (a vast improvement from the 0% rate of two years ago) to the 10% long-term average. Consumers don't have room to take on more debt, even if the banks are willing to give it to them.

These two charts from Ned Davis illustrate the real problem: An explosion of debt relative to GDP. The first is Nonfinancial Debt To GDP. The second is Total Debt To GDP. Click here for charts >

In Geithner's plan, this debt won't disappear. It will just be passed from banks to taxpayers, where it will sit until the government finally admits that a major portion of it will never be paid back.

See Also: Krugman Trashes Geithner Plan And Obama