President Obama deserves immense credit for being willing to spend serious money to prevent recession from becoming depression. He has resisted pressures from fiscal conservatives to put budget balance first, or to make social insurance bear the brunt of spending cuts down the road. And he has used his gifts as a teacher to enlist the broad support of the American people for a far-reaching strategy of public investment.
However, all of this good work will be for naught if his team doesn't get the banking system functioning again. And so far the grand design of Treasury Secretary Tim Geithner is entirely on the wrong track.
On Friday, the Treasury made its latest deal with Citigroup to infuse even more public money into the essentially insolvent zombie bank. The terms were appalling. Basically, the government gets more preferred stock with little voting power. It can be converted to common stock, but if Citi goes deeper into the red, the government takes the loss. If by some miracle, Citi recovers, its shareholders get the gain. Once again, Treasury has declined to convert its de facto ownership into effective management control, preferring to bargain with Citi's executives at arm's length.
Geithner has also come up with the idea of subjecting the largest banks to "stress tests" to determine just how badly damaged their balance sheets are. This has been advertised as government examiners crawling all over bank records, but much of this belated effort will rely on the banks' own risk models--the same risk models that got the banks into this mess.
Come to think of it, where have the examiners been all along? Why wasn't there serious investigation of bank balance sheets all along? Why should stress tests be performed only after disaster has struck (shades of Hurricane Katrina)?
The worst culprit among the feeble regulators is the Federal Reserve Bank of New York, whose examiners are responsible for assessing the safety and soundness of the holding companies of Wall Street's largest banks. It was high risk speculative activities by holding company affiliates that put the big banks under water.
Who dropped the ball? You may recall that Secretary Geithner, before he assumed his present post, was president of the New York Fed Bank. According to a withering feature piece from Bloomberg, he was asleep at the switch, and far too cozy with the banks. Heckuva job, Timmy.
The stress tests are likely to find what everyone already knows. Surprise, the big banks are bust. To put the best possible face on what Geithner is up to, it's possible that he is just playing for time. While the stress tests are going forward, the public and the financial markets can be prepared for the eventuality of nationalization. But there is no good evidence that Geithner is there yet. The greater likelihood is that he is just improvising, as he has done for months. In this latest banking rescue, as in the effort to stem mortgage foreclosures, the man's slogan might as well be: "Details to follow."
President Obama has just taken a huge political risk in his budget by proposing to put another $750 billion at Geithner's disposal to save the banks. Before the banking system is returned to health, we will need this much money and more. But if that money is dripped out in modest increments, as has been the pattern to date, the banks will only continue their slow bleed.
Eventually, the administration will get around to nationalizing the big banks, because it has no choice. Officials can prettify this reality by calling it a receivership or a conservatorship. But the exercise, done properly, will entail shutting down Citi in its present form, getting the bad assets off the bank's books, sharing the loss with Citi's creditors, breaking up Citi, and getting a sound bank functioning again.
The government may well need to do this with one or more other large banks, including Bank of America. And it can't achieve this by proxy using existing management. Civil servants accountable to the public need to run the operation. The Treasury has no such mission and no such staff. Only the Federal Deposit Insurance Corporation has hands-on experience taking over, cleaning out, and running failed banks. The mission will need to be entrusted either to the FDIC or to a new agency created for the purpose. If the government needs to hire more people, plenty of Wall Street veterans are looking for work. With different masters and different motives, their technical competence is more than adequate.
The government can either act quickly, the way the Swedes did when they faced a similar financial collapse; or the government can belatedly take banks over after delaying and trying half-measures, the way the Japanese did it. The Swedish economy got back on track and the banking system was returned to private ownership in fairly short order. The Japanese economy bled for a decade.
Why is Geithner dithering? Because he is asking the wrong question. The question he is posing is: how can the government save Citigroup? The right question is: how can the government rebuild the banking system?
Some in the administration may be wishing that they hadn't called in so many chits with senators to save Geithner from the consequences of his failure to comply with the tax laws. On the ability of Geithner (or his successor) to get this job done properly hangs the fate of the banking system, the capacity of the economy to avert a depression, and the political fortunes of the Obama administration.
Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is "Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency."