The heart of the matter

Here is what I think is the best description of the heart of the bailout plan — from Steve Lohr’s column in the New York Times Bailout Is Only One Step on a Long Road:

The rescue package, if successful, would make the recognition of losses and the inevitable winnowing of the banking system more an orderly retreat than a collapse. Yet that pruning of the banking industry must take place, economists say, and it is the government’s role to move it along instead of coddling the banks if the financial system is going to return to health.
Japan’s experience in the 1990s is a cautionary example of the peril of propping up banks after a real estate boom ends. The Japanese government helped keep many troubled banks afloat, hoping to avoid the pain of bank failures, only to extend the economic downturn as consumer spending and job growth fell.
The Japanese slump continued for many years, ending only a few years ago, a stretch of economic stagnation known as Japan’s lost decade.
“The lesson from Japan is that tough love for the banks is what’s needed,” said Kenneth Rogoff, an economist at Harvard. “In the current crisis, you do want to get rid of the bad assets from the banks, to get markets working again. But the key is going to be in the details of how the bailout works. You don’t want it to be a subsidy in disguise that keeps insolvent banks alive. That would just prolong the economic pain.”

As I’ve noted before, there is going to be a fair amount of blood on the floor before this is over. The legislation attempts to deal with some of the past bleeding by allowing banks to take a tax-deduction on their losses on Fannie/Freddie stock — Section 301 of the bill. (In the interest of complete disclosure, I own stock in a community bank that has had to write-off its investment in Fannie/Freddie). But clearly the work is only beginning.
So, to paraphrase Churchill, “while this may not be the beginning of the end, it may be the end of the beginning.”

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