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Tuesday January 20, 2009 - 19:20:11 GMT
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Forex Blog - Obama Inherits Insolvent Banking System

Obama Inherits Insolvent Banking System


As the former junior Senator from the state of Illinois, Barack Obama, prepares to be sworn in as the 44th President of the USA and the nation’s first African American President, one can only be elated at the accomplishment of the man and the nation.  It is a great day for America and the world.  


And with a little luck and lots of correct decisions, it may well be a great new era for America and the world…I would not for a minute underestimate this new soon to be US President.


That said President-elect Obama knows all too well that the challenges ahead are enormous, arguably the most daunting for any President since FDR put his hand on the bible in March of 1933.  He has picked a competent team – tax evasion indiscretions aside (I do think fudging on taxes is wrong, especially wrong for a head of the NY Fed, but I also think Geithner has more positives than this negative and believe redemption will make him work ever harder to do the right thing ahead) – to tackle this financial crisis come economic crisis.   This is the nearly the best and brightest and a huge upgrade from what we are leaving with the departure of the 43rd President.


But not even a very smart President with a very smart and capable set of advisors can wish away a broken banking system.  And it is not just a broken US banking system.  It is a broken international banking system – large global banks everywhere are facing insolvency issues.  Nouriel Roubini this week said the losses in the US banking system may reach $3.6trln making it effectively insolvent.  Currently banks have accounted for about half this amount in losses.  And they have no place to raise capital other than from respective governments.  BOA sold shares to the public in October at $22 and today its share price is a little above $5 and this follows a government rescue package worth about $140bln announced this week.  Arguably the Paulson fallacy (think partly shared by Bernanke who admittedly makes monetary policy not fiscal ones and hence has little choice but to go along with Paulson) was that if the government could support banks in the short-run and buy some time, with the Fed making liquidity virtually free, credit creation and the multiplier effect would respond and short-cut a real economy slowdown/recession.  Well we know how badly this response went…for many of us we knew from the get go that anything short of nationalization was pothole filling on the Brooklyn Queens Expressway.  The banking crisis was much bigger than buying time to allow bad assets to recover and banks to pass free liquidity from the Fed onto customers. 


So Obama has to build an alternative credit creation machine outside the 9, now 8, large US banks where the bulk of the heavy lifting in the US and global financial system takes place.  I am sorry but solid regional banks are not in any position to fill the void.  Nor are newly received GSEs or the FHLB system.  Nor are credit card firms or student lending firms.  The government needs to become the credit creation machine in tandem with the Fed doing the smaller chore of supporting non-large-bank credit markets. 


I am not sure even Obama and his economics team are ready to go Nordic on US insolvent banks and become the banking system to the domestic and international economies.  This is socialism.  This is un-American.  This is repugnant.  We are where we are because of our Adam Smith DNA and blind faith in markets.  And free market advocates have had no better home than in financial markets of the last decade or so.  Markets work most of the time but not all of the time and are prone to asset bubbles.  Central banks will have new mandates ahead to address asset bubbles and not simply assume there is no way to identify them much less use policy to unwind them. 


Government spending will get bigger ahead.  The $825bln the House Democrats and the transition team have cooked up is the first in a series of similar sized tax cut and spending measures which like TARP will fill potholes in the private sector but not restore confidence in the banking system and asset markets. 


To get in front of the problem, the first priority should be ending the make believe private banking system – Japan tolerated zombie banks for far too long and saw a decade of stagnation/deflation.  No one wants the government running the banking system for a minute longer than is necessary.  But not taking over insolvent banks and balancing the books because the thought of nationalization is repugnant is a ringing endorsement of the zombie economy Japan’s policies supported as late as 2005.


I am not saying it can’t be done.  Obama has demonstrated time and again that the impossible is possible.  Moreover, he is an all in kind of player…his hand is not great but he has no choice but to play and play hard high stakes poker. 


And there is some basis for optimism as political support builds for a nationalized bank to buy bad assets from banks disguised as the new RTC…toxic waste recycling center.  Still as UK developments showed this week, time is not on the side of deliberation…it is time to act and act decisively…seize the broken, shed the assets and direct credit to households and firms before the zombie hosts take over.


David Gilmore 


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