Paul Krugman channels Adam Posen on Japan's lost decade, and what it means for us:

The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under TARP, closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses. The result then, and the emerging result now, is that the banks' top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch.

These kind of half-measures to keep banks open rather than disciplined are precisely what the Japanese Ministry of Finance engaged in from their bubble's burst in 1992 through to 1998 ...

Why is the government so reluctant to hand losses to the bondholders?  The standard explanation on both far left and far right is that Treasury and the Fed are in the pocket of the banking industry, and Geithner et. al. are simply bailing out their corporate masters.  I don't entirely discount this theory, though I would (and did) put it more nicely:  all the information the regulators has comes from the people they are trying to regulate.  This naturally biases them towards the regulated.  Every time I am tempted to get outraged about this, I think through the alternative:  regulators who don't have much interaction with those they oversee.  I'll take Tim Geithner over Maxine Waters any day of the week, and twice on Sunday.

And in this case, I don't think that's the whole, or even the greatest part, of the explanation.  Rather, I think their problem is largely political:  avoiding the "n" word, yes, but more importantly, avoiding any more crisis injections of capital into the system.

It's easy to blithely say "Why don't they just make the bondholders take a haircut?"  Harder when you think about who those bondholders are:  insurers.  pension funds.  the bond component of your 401(k).  Financial debt makes up something like a third of the bond market, and the largest holders are pensions and insurers.

The insurers are the biggest problem, because they're just so heavily regulated.  They're not allowed to hold risky assets.  Convert their bonds to equity and they will be forced to dump that equity at prices that will trend towards zero.  Many insurers will see their capital impaired below the regulatory limits, requiring a government bailout.

Pension funds are the next biggest problem.  They're already in big trouble because of stock market declines.  The bonds are the "safe" portion of their portfolio, the stuff that's supposed ot be akin to ready cash.  Convert their bonds to equity--or worse, default--and suddenly they're illiquid and even further underwater.

Nor is the 401(k) problem small.  Bond funds are typically held most heavily by the people closest to retirement; they're for income, not capital gains.  What is your mother going to do when a third of her mutual fund income gets converted to equity that produces no cash and can't be sold because the insurers have all had to dump their shares on the market at once?  Or simply disappears into the land of bankruptcy lawsuits?

There's also the problem of what it does to the ability of banks to raise capital.  Bank bonds are sold on the implicit assumption that the taxpayer, not the lender, will eat capital deficiencies.  Changing that understanding risks runs on the bank a la Lehman whenever a financial institution looks the least bit shaky.  Banks are inherently highly leveraged institutions even in a good regulatory environment; this might make our banking system much more volatile in the future.  It's somewhat akin to what would happen if we simply announced that the FDIC would stop tomorrow.

I think what Geithner et. al. fear is that nationalizing or reorganization will put the government on the hook for massive and immediate losses in both the banking system, and the "safe" entities that lent it money.  I fear they may be right.  But I think the lesson of Japan is that we have to do it anyway.  I don't know what form the fix should take.  I don't know how painful the fix will be.  But I'm pretty sure any fix that makes us recognize the losses, recapitalize the banks, and move on, will be better than two decades of zombie banks and glacial growth. 

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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