Do the banks matter?

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Ryan Avent responds to my earlier post on the fixing of the banks by saying . . . well, that's not that important, and anyway, the stimulus can fix the banks, too:

This sounds lovely, but I think it glosses over all the crucial questions. Why aren't the banks lending? I think Megan would be hard pressed to show that the principle reason is something other than a decline in demand for credit and uncertainty over the path of the economy and the ability of potential borrowers to pay. That is, the way to fix the banks is to get the economy going again in order to create profitable lending opportunities for the many solvent banks out there.

That point aside, it's not clear to me that there's an obviously better way to handle the banks than what we're currently doing. There is a case for a Swedish solution -- guaranteeing bank liabilities and nationalising where necessary -- and I would approve of such a move, but it's not at all a sure thing that the benefits to such a plan are worth the potential risks. Reasonable people can disagree. The same can be said for other options out there. It's all well and good to say that fixing the banks is most important. Fine. How? What's the easy solution that everyone is missing?

I don't think it's at all correct to say that the "standard model" of the Great Depression implies a greater role for fixing the banks than for fiscal policy. The banking issues then were quite different. Moreover, there's ample evidence that fiscal policy was effective when allowed to work, and that monetary policy -- and getting off the gold standard -- were crucial. Given the circumstances, reasonable people can disagree over whether the most important thing at the moment is to pursue an appropriately sized stimulus, or engage in aggressive quantitative easing, or start guaranteeing bank debts.

Taking the last point first, I'd suggest he consult the work of people like Christina Romer, Ben Bernanke, or any of dozens of other writers on the Great Depression, all of whom are pretty much united in believing that while the bank holiday, the FDIC, etc. may not have been sufficient, they were certainly necessary preconditions for recovery.  I believe Brad DeLong has said as much in re: the awesomeness of the New Deal.  Or he could consult writers like Anil Kashyap, who say the same thing about Japan.  If you do not get the banks lending and creating money, everything else you do will fizzle.  Frankly, I have a hard time believing that we are even arguing about this.

Why aren't the banks lending?  Yes, in part, it's that the economic uncertainty is making people unwilling to borrow.  And what is a major, major source of that economic uncertainty?  The fear that a lot of banks are about to fail.  There's also, however, the fact that bank debt is not exactly trading at handsome rates, and like everyone else, banks are afraid that if they need to tap some capital to tide them over, they won't be able to.

As to whether there's a better plan than what we're currently doing:  well, if not, I wish the administration would say so, rather than making vague promises that at some point in the future . . . not today, not tomorrow, maybe not next month, but someday . . . they're going to lure a bunhc of private investors into the market to solve all the problems in the banking system.  Because right now we're not really doing much of anything.  And the uncertainty about what the government might do is making things worse.

In some sense we're in the worst of both worlds:  the size of the problems implies some radical government action may be in store, but the understaffing at Treasury suggests no way to find out what it might be.  If he hasn't, Ryan should talk to some people on Wall Street.  Doing so is, of course, generally an exercise in spin and wishful thinking about the vitalness of every single dollar of Wall Street pay to every single banker.  But there's one thing that comes through loud and clear: the uncertainty about what is going to happen is making things worse.  No one wants to lend, borrow, hire, or do anything else when the government may swoop in and change the rules tomorrow.

Ryan ends the post with a slam at me, claiming I only care about the stupid banking system because I'm just looking for a reason to dislike Obama.  I could turn that around just as easily and claim that he's only defending the complete lack of action by Treasury because he wants to prop up Obama's presidency by any means necessary.  But that's not very useful.  Perhaps we could stick to arguing the facts and theory instead of the relative unsavoryness of our putative motives.

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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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