Obama and the Swedish Solution

I don’t often discuss politics or political figures, and the reason is simple: when people discuss politics, emotion overtakes stoicism, often leading to anger and conflict. Very rarely do people discuss politics in a calm and rational manner; it is an area in which biases are all too prevalent, and opinions are very seldom changed. That being said, I wanted to post a very brief piece commenting on an Obama interview I saw recently. Please note that I am as close to a political polygamist as they come, I therefore hope to be as unbiased as possible. Also note that this will not be a recurring type of post…

TERRY MORAN: There are a lot of economists who look at these banks and they say all that garbage that’s in them renders them essentially insolvent. Why not just nationalize the banks?

PRESIDENT OBAMA: Well, you know, it’s interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what’s called “The Lost Decade.” They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn’t see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.

And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.

President Obama’s response shows a reasonable amout of consideration. That being said, it seems as though he may be misinformed here.

First, the 6 largest Swedish banks in 1991 (SE-banken, Handelsbanken, Nordbanken, Gota, Sparbanken Sverige and Foreningsbanken) and the 6 largest American banks today (BAC, C, MS, GS, JPM and WFC) have (or had) similar economics relative to GDP. Although there are indeed thousands of banks in the US today, the majority of toxic assets can be found on the balance sheets of the banks mentioned. Examining the Swedish solution is therefore appropriate.

So how did Sweden solve its financial crisis in the early 1990s? The first noteworthy step was that government auditors were required to immediately write down bad assets in order to make clear, from the get go, the extent to which banks were solvent. The current crisis has been ongoing for over one year in America, and the public (and government) still has no idea of the extent to which these major banks are solvent.

Once the Swedish government had figured out which banks were zombies (Nordbanken and Gota), and which assets were toxic, they embarked on a 3 step plan which included additional recapitalization – for banks that were not insolvent, nationalization – for insolvent ones, and an aggregator bank to buy up bad assets. Note that the key here was the immediate write down of bad assets. This way, regulators were fully aware of what needed to be done, and balance sheets were thoroughly cleaned out as assets were taken over (or bought) at realistic prices.

What about the cost of the Swedish plan? Yes, the plan was expensive (amounting to approximately 6% of GDP). A similar plan in the US would likely cost more, but even if it were to amount to 10% of GDP – say $1.5 trillion – it seems as though it would be much more effective than throwing money every which way, hoping that it solves the problem. If this were a problem of illiquidity, the “plan to have a plan” outlined by Geithner could possibly work. Unfortunately, the plan as described will not respond effectively to the insolvency issue, which is at the heart of the problem. As stated by James Kwak, “Even if an insolvent bank has access to credit, it is still an insolvent bank, hoping somehow to become solvent, so it’s unlikely to lend or, even worse, it may be tempted to make extremely risky loans as the only possible path to solvency.”

Of course, there are differences between Sweden in 1991 and the US today. For one, the organisation of the US banking system is far more complex. Also, today’s international economy is heavily globalised and flows of capital between nations have lead to an intricate cross-national web. Sweden’s minute economy did not have to deal with such complications. I’m not sure how this would play into the solution; it could possibly call for much more unilateral cooperation between governments.

Still, in my humble opinion, the “nationalization solution” or “receivership solution” should at least be examined in detail. Today, leading economists are not claiming that every bank should be nationalized permanently (this is where the negative stigma comes from): they are simply pointing out that forthrightness and transparency should be prioritized, insolvent banks should be identified and, with the help of the government, should quickly be resolved through the necessary processes. I’m hoping that the “stress test” Geithner spoke of will identify such banks and act accordingly, but there is no assurance, based on his statement, that this will be the case.

Martin Wolf has pointed out that, in the 1990s, the US gave very specific advice to Japan: “admit reality, restructure banks, and above all, slay zombie institutions”. Perhaps we should take our own advice, lest the US enter its own lost decade. The FDIC has taken a large number of mid/small sized banks into receivership and has been doing so for quite a long time; why not do the same with larger ones? Obama mentions that this will not work culturally, however, bailouts and “give-aways” are also quite un-American, yet we’ve been employing them as of late because they are necessary.

In 1999, Greenspan stated that the key to Swedish recovery was a quick and adequate response. They planned for the worst, instead of hoping for the best. Right now, as the plan stands, we are clearly hoping for the best in America. Our goal should be to clean up bank balance sheets so that, even if the worst case scenario does occur, we don’t have to worry about bank insolvency. Cutting corners will do nothing but exacerbate the severity of the situation.

So, what type of solutions (plan) would work for America? Recently, the president of the Kansas City Fed posted this piece: Too Big Has Failed. I would highly recommend reading it, he makes some excellent points and provides an outline for what seems like an appropriate plan.

Note:

Austrian Economists describe economics as follows: “The art of economics consists in looking not merely at the immediate but at the longer effects of any action or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

There is a specific type of leader which, in my opinion, is most capable of delivering the kind of actions that fit best with the aformentioned description: level 5 leaders. These leaders, as described by Collins (2001), are known as “Executive Leaders”. They build enduring greatness through a paradoxical blend of personal humility and professional will (Collins). In essence, they put the “organisation” before themselves, and focus on the long term effects of their decisions. As of right now, I would describe Obama as a Level 4 leader (which is good, but not great – or sufficient.)

Level 4 leaders are known as “Effective Leaders”. They catalyze commitment to and vigorous pursuit of a clear and compelling vision, stimulating higher performance standards (Collins). These types of leaders can be very effective, and have very good results; however, in the face of serious problems, level 5 leaders simply stand apart, and manage to turn around struggling organisations remarkably.

Although I fully realise that it is difficult, especially within politics, to make decisions that are beneficial for the nation in the long-run – as they are sometimes unpopular in the short run, it is essential. As an example, I would say that President Lincoln was clearly a Level 5 leader. Many of his actions were unpopular at the time, but few question the positive effect they had on the long term development of our nation (it is also noteworthy that Warren Buffet has often been described as a Level 5 leader/thinker).

Many people believe that the long-run is nothing more than a succession of short runs. In truth, however, the things that maximize positive outcomes in the short run often serve to decrease positive outcomes and increase risk in the long run (Howard Marks). It seems as though, for positive long-term outcomes to materialize, one must have a long-term strategy from the get-go. It is apparent that immediate action is needed to help resolve the current crisis, but let us not confuse immediate with short-term; we can act swiftly and with long-term oriented policies at the same time. I realise that Obama has only been in office for 50 days or so, and it may be too early to pass judgement, but I hope that he can evolve into a Level 5 leader, and if (where) possible, adopt this kind of thinking.

Bounded Rationality