OF CONFIDENCE AND CAPITALISM

By Stephen Smith

February 5th, 2009

The fear of a nationalization of the banking system continues to scare equity markets. Only days into the Obama presidency, members of the new administration and leaders in Congress are already dancing around one of the most politically delicate questions regarding the financial bailout. Is the administration prepared to nationalize a big portion of the nation’s banking system? Others talk of the semi-nationalization in which the government owns a sizeable chunk of the banks but not a majority, which is currently the case with the government being the biggest shareholder in Bank of America, with about 6 percent of the stock, and in Citigroup, with 7.8 percent. But the government’s influence is far larger than those numbers suggest. It has guaranteed to absorb the losses of some of the banks most toxic assets, a figure that could run into the hundreds of billions of dollars.

The banks are in a “Catch 22” with many being reluctant to write off their bad debts and absorb huge losses unless they can first raise enough capital to cushion the blow. But they cannot attract that capital without first purging their balance sheets of the toxic assets. Cash hoarding by banks has surged from 3.2% to 8.9%. Current banking sector cash levels are the highest they have been since 1986. Cash hoarding by banks is symptomatic of their unwillingness to originate new loans and uncertainty about the value of their collateral assets. That is exactly what happened for nearly a decade in Japan beginning in the mid-1990s when interest rates near 0% did little to spur bank lending, end deflation, or spark a recovery in consumption or investment.

Like just about everything in the world, economies run better when confidence is high and are subdued when confidence is low. The challenge for the U.S. government then is not to just replace the current loss in economic output, but to restore confidence in the long-term prospects for the U.S. economy. To be successful, the funds expended and reforms made will need to lay the foundation to create an environment in which the private sector can drive innovation and productivity gains. The challenges will be massive, and the fiscal costs potentially enormous, but the silver lining of this crisis is that it provides the opportunity for an overhaul of key areas of the American economy that may not have been possible otherwise. Perhaps the key factor will be whether the Obama administration's plan is able to provide sufficient hope that this money will contribute to a sustained recovery and build structural improvements that we can use for years to come.