The Obama administration seems to be doing too little too late in resolving the country's banking crisis. And it is coming up with even less to break the downward spiral in which the economy now finds itself.
There's an egregious disconnect between the new administration's diagnosis of the country's immediate economic predicament and the policy proposals that it has on offer.
At a conceptual level, Larry Summers, President Obama's chief economic adviser, has correctly pinpointed that this recession is not of the garden-variety kind that has been experienced 10 times in the postwar period. Rather, it bears a closer resemblance to the Great Depression of the 1930s and the Japanese crisis of the early 1990s.
Summers has correctly advised President Obama that halting the economy's downward slide requires bold policy intervention on three fronts. First, together with Federal Reserve Board Chairman Bernanke he has cautioned about the urgent need to get credit flowing again through America's clogged and loss-ridden financial institutions. Second, he has argued that there is the need for an immediate and appropriately sized fiscal stimulus that might cushion the major part of the spending pullback by an overindebted American consumer. And third, he has pointed to the importance of setting policies that might stabilize the housing market.
As the details of the president's economic strategy have finally emerged, one has to be struck at the gaping gulf between the administration's diagnosis of what ails the economy and its prescription for a recovery. Particularly striking is that instead of addressing bank insolvency head on, the administration is continuing the charade of seeing the banks' problems as largely those of liquidity rather than solvency.
As Treasury Secretary Tim Geithner's most recent presentation of his bank rescue plan reveals, the administration is choosing to pursue its own version of the failed Tarp policies of Hank Paulson. Rather than following a "good bank/bad bank" model that might actually get bank lending flowing again, Geithner is restricting himself to engineering the purchase at fair value of around $1 trillion of the banks' toxic assets. He is doing so seemingly oblivious to the Japanese experience in the early 1990s of supporting zombie banks that led that country down the road to deflation.
Most perplexing perhaps is the nature of the $800 billion fiscal stimulus package. Far from being front-loaded as the immediate downward economic spiral would seem to dictate, it defers its major impact to 2010 and 2011. And far from focusing on measures that would get the most "bang for the buck," it relies too heavily on tax cuts — of the sort that failed to boost the economy in 2008 — and on infrastructure spending that by its very nature is slow-acting.
Japan's painful experience with deflation during the 1990s would counsel that the Obama administration would do well to stop dithering about addressing the financial sector's insolvency problem by adopting a good bank/bad bank approach to the issue. By the same token, the administration would do well to revisit its fiscal stimulus package with a view to making it more front-loaded.
Japan's deflationary experience also holds lessons for Bernanke. In particular, it would suggest that he might build on his recently announced program of buying mortgage-backed securities and $300 billion in long-dated government bonds to dispel any notion that the Fed will allow deflation to take hold. He might do so by announcing a formal inflation target as well as by buying Treasury inflation-protected securities, the government-linked bonds that presently imply a market expectation that inflation, excluding food and energy, will be a negative 1% a year over the next five years.
