About the best thing that can be said about the latest government plan, to invest up to $250 billion in various U.S. banks, giving the government an equity - or ownership - position in those banks, is that it is probably a less-harmful, less-risky use of some of the $700 billion Congress gave the government to try to fix the financial system than the original plan. The original plan, you may remember was for the Treasury Department to buy troubled ("toxic") mortgages and mortgage-backed securities from financial institutions and then try to see if any actual value could be coaxed out of them.
But Treasury still hasn't figured out just how to do that, and it's not hard to understand why. When there is no active market for such securities, how do you know what would be a "fair" price - presumably one that won't cause too much loss to taxpayers? People talked about a "reverse auction," but nobody in government has run one or would know how to put a good one together. And is it a good idea for government to assume direct responsibility for all kinds of foreclosed properties - which might include upkeep to prevent further lost value - yet another chore at which government has shown zero competence?
The trouble is, instead of simply abandoning that ill-conceived plan, it is likely that government, once it has spent the first $250 billion on a less-worse plan, will face pressure to spend the rest on the original proposal, or on something even less likely to yield success.
Now why is this plan less worse than it might have been? As Esmael Adibi, who heads the Anderson Center for Economic Research at Chapman University, explained, despite the government buying direct shares in various banks, it is not quite the step toward full socialization of the banking system that many fear (or favor). The government will be buying what are called preferred, or nonvoting, shares. These shares will dilute the ownership stake of previous shareholders but not give the government anything like controlling interest. The banks will have to pay the government special dividends of 5 percent for five years, which will rise to 9 percent after that. That, along with the restrictions involved, constitutes an incentive for the banks, once they are more stable, to buy back those shares. So government equity is supposed to be temporary.
However, as Lee Ohanian, who teaches international economics at UCLA, said, if the banks haven't recovered by then, or if the economy is in recession, isn't it likely that the banks will ask for more help, or for an extension of the 5 percent dividend? Or as Gerald O'Driscoll, former chief economist for the Federal Reserve in Dallas, suggested, what if inflation is at 10 percent, and 9 percent looks pretty good? Could the government end up with effective control of the banks, as in a fascist economy?
The ostensible purpose of this massive capital injection is to encourage banks, which have been reluctant to make loans (even those that have money to lend), to begin making more loans, and especially to participate in interbank lending, thus relieving what is perceived as a credit crisis.
Whether it will work is anybody's guess. So far the previous posturing seems only to have increased uncertainty and the perception that the sky is falling, which markets generally hate. With government making up new rules on the fly and changing direction virtually every other day, that's not surprising. This equity-purchase may hold promise as a short-term fix. The best bet is to give it time to begin to work (or even appear to work), and tell Ben Bernanke, Henry Paulson and President Bush to stay off television for at least a month.