There are, as far as I can tell, a lot of people out there who are for the stimulus, but don't want any nasty bankers bailed out with government money; a smaller number who favor the reverse; and then sizeable groups that favor both, or neither.  Which of them is right?

One argument is that we can't fix the economy without fixing the banking system, for reasons that Matthew Yglesias outlines:

But as Jared Bernstein was explaining on a call with progressive bloggers earlier today, stimulus and financial system recovery go hand in hand. Bernstein described the relationship in terms of a "chain." The technical term involves something I've mentioned previously, the "velocity of money" -- the speed through which economic activity moves through the system. The idea of a stimulus plan is that the government isn't just engaging in economic activity directly, but that the beneficiaries of that activity will spur additional activity. In other words, you get money via a tax cut or a job on an infrastructure program and you use some of that money to buy groceries, creating jobs for farmers and checkout people who spend their money, etc., etc.

You want the money to circulate smoothly and efficiently from those who have it to those who need it. That doesn't mean everyone needs to spend the money instantly. But it means that when people want to park their money, those funds should come available to other people who have good business opportunities that could be exploited with the assistance of a little credit. That's where a healthy financial system comes in.

You may have heard tales from Japan's "lost decade" in which stimulus measures failed to actually get the economy moving. Part of the problem was somewhat ill-conceived and ill-executed stimulus. But perhaps a bigger issue is that the didn't actually clean up their banking system. Instead, they put it on life support. And then they used fiscal stimulus to put employment on life support. But we don't want life support, we want stimulus that actually brings us back to life. And that requires a financial rescue package. Of course it also requires a financial rescue package that works and the jury's still out as to whether that's what the administration's come up with.

This is essentially the argument made by Hoshi and Kashyap in several papers on Japan, and now us.  As long as the banking system is broken, stimulus has limited effect, because the money you inject hits the banking system and just sort of stops moving.  

We're now making many of the mistakes that Japan did.  I know, I know--I supported TARP I.  But I did so because at the time, there seemed to be a reasonable possibility that the funds could stop a liquidity crisis from turning into a solvency crisis.  But if liquidity crises go on long enough, they become solvency crises, so whatever we had then, we now have a badly crippled banking system.  More of the same isn't going to help.

We need a plan that is going to force the banks to recognize and write down their bad loans, restructure dysfunctional borrowers, shut down the banks that are too far gone, and inject substantial capital into the banks that are strong enough to pull through.  But that kind of radical action is scary.  And whether they decide to do it by nationalizing bad banks, or by injecting capital into good ones, the political cost is going to be very high.  So we get baby steps and vague promises of major leaps forward down the road.

Another political problem is that recapitalizing the banking system involves, in the intial stage, conserving capital (read: cutting credit limits), and writing down bad loans means unpopular actions like restructuring failing companies (read:  layoffs) and foreclosing on hopeless borrowers.  One of the major arguments against bank nationalization is that a government-owned bank will find it harder, not easier, to do those things.  The temptation to keep large employers on life support will be large, and every congressman will have a list of firms in their district that can't be allowed to go bust.

Doesn't this sound familiar?

the Japanese banking sector had begun the 1990s having rapidly expanded lending during the boom years of the late 1980s, even though loan demand by large firms was falling due to financial deregulation that made bond financing easier for them.12 Thus, the Japanese banks had more loans on their books than would be desired by their customers over the medium term. Hoshi and Kashyap (2005) argue that consolidation was therefore inevitable and that the government could have exploited this inevitability to lower the costs to the taxpayer by concentrating the capital injections on the better capitalized banks. Doing so would have avoided putting capital into failing institutions and would have rewarded better run banks. To the extent that reorganizations were needed they could be led by the private sector rather than the government. The recapitalization programs, however, did not realize the problem of overbanking.

Instead, the only objective that was pursued forcefully as part of the recapitalization was that
banks were required to increase their lending, especially to small and medium firms. The recapitalized banks were required to report the amount of loans to small and medium firms every six months. The FSA periodically requested the recapitalized banks to increase lending to small and medium firms.13 When some banks substantially cut back the lending to small and medium firms, the FSA started to issue business improvement orders. From 2001 to 2004, five banks received business improvement orders because they reduced lending to small and medium firms (Shinsei Bank in 2001, UFJ Holdings and Asahi Bank in 2002, Mizuho Holdings in 2003, and UFJ Holdings again in 2004). These orders required the banks to increase lending or be subject to fines.

This preference for directed lending created some high profile conflicts. Tett (2003) provides
many examples regarding the experience of Shinsei Bank, the successor to LTCB. When LTCB emerged from nationalization and was up for sale, the government insisted that all bidders promise to accept all the loans on the books that a government committee deemed to be performing. The winning bidder, an American-led consortium, determined that many of their existing customers were not profitable and should not objectively receive credit. The government contested this assessment and pressed the bank to maintain lending.1

The good news is that we're going through this cycle more rapidly than Japan--dithering faster, you might say.  The bad news is that it's hard to see how the banking system is going to be in any shape to support the stimulus unless we get a good plan much faster than is likely.

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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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