The economic news this week has focused on the battle over the stimulus plan and Obama’s cap on executive payouts at companies receiving bailout funds. Next week, Timothy Geithner will announce his plans regarding the banking system. Meanwhile, the U.S. financial system continues its collapse. 

The bank bailouts of last year have had few results in making the economy any better than it was before. It could be argued that it is, at least, not any worse. The failure of Lehman Bro.- and the aftershock it caused- has the government ready to pitch money at any large financial institution that seems troubled. But the usage of that money by the institutions isn’t being monitored closely nor are they required to pump it back into the economy via loans. 

There has recently been much discussion among economists and talking heads about bank nationalization. The word “Sweden” is usually inserted into the conversation because of that nation’s relatively successful resurrection of their economy in the 90s.  Baseline Scenario details the actions that Sweden took: 

So what did Sweden do? If the options on the table in the U.S. right now are (a) additional recapitalization, (b) an aggregator bank to buy up bad assets, and (c) nationalization, the Swedish solution included all three. First, in late 1992, the government guaranteed all bank creditors (but not shareholders), with no upper limit. Because investors did not at the time question the solvency of the government, this meant that they would continue to lend money to the banks, and the central bank provided unlimited liquidity just in case. Although the U.S. has guaranteed new debt issued by banks, and there is virtually an implicit blanket guarantee for at least the largest banks, there is still uncertainty among bank creditors, as witnessed by credit default swap spreads.

However, even if an insolvent bank has access to credit, it is still an insolvent bank, hoping somehow to become solvent, so it’s unlikely to lend or, even worse, it may be tempted to make extremely risky loans as the only possible path to solvency. As a condition of government support, government auditors reviewed the balance sheets of the all the banks involved, with the goal of taking writedowns immediately and showing the true state of affairs. When it turned out that two major banks, Nordbanken and Gota, were insolvent, they were nationalized (Nordbanken was already largely state-owned), giving the state control of over 20% of the banking system (by assets). Gota was merged into Nordbanken, which only held onto “good” assets, and the “bad” assets were moved to two new entities, Securum and Retriva. These entities were capitalized by the government, and bought 21% of Nordbanken’s assets and 45% of Gota’s assets. This is an example of the good bank/bad bank plan that has gotten so much attention lately. Nordbanken itself (the good bank) was recapitalized by the government, to the tune of 3% of GDP, and become a healthy bank, while Securum and Retriva were told to get whatever value they could out of the bad assets.

Securum and Retriva were run like a cross between private equity firms and asset management companies, both managing and improving assets and also finding buyers for the assets. According to the Cleveland Fed, they managed to return $1.8 billion out of their $4.5 billion in initial capital to the government, for a net taxpayer loss of $2.7 billion. (I can’t figure out if the government also lost money on the loan guarantee, although the sources I read implied that it didn’t.) And Nordbanken, after being run by the government, was eventually privatized (the government’s ownership share is now 19.9%), and the taxpayer recovered the capital put into it in the rescue… 

In other words, the banking system in Sweden never fully nationalized, as it is sometimes implied. Before the Swedish government would give financial help to anyone, they had auditors determine exactly how bad off each financial institution was. The insolvent banks were nationalized and merged. Their bad assets were rerouted into newly created “bad banks” and the government then supplied funds to the merged “good bank”, which eventually privatized. 

The bailout system we have in place right now in the United States is creating what could be considered “zombie banks”. The industry has become so deregulated that no one is really sure what the assets of banks are worth. That’s part of the reason why no one was able to predict how bad and how fast the system would go down. There may be more insolvent banks than we know about right now. There isn’t much sense in pumping money blindly into an institution that a) may be worse off than we know and b) doesn’t have a clear strategy for getting rid of bad assets. 

NPR had a live chat with economists Simon Johnson and Arnold Kling on Monday. The topic of discussion was nationalization and whether it was the way to go for the U.S. banking system. Kling offered up the following plan: 

1. Shut down insolvent banks, and dispose of their assets. 

2. Let healthy banks alone. 

3. Put in-between banks (the ones with a lot of hard-to-value assets) under close supervision.

4. Stop focusing on bailing out banks!!!!

5. Use fiscal policy to improve profits at nonfinancial firms. Let the financial sector shrink, and look to the nonfinancial sector to lead the recovery. 

It’s hard to see how the banking system can recover while maintaining its current shape. The government doesn’t need to let banks fail ala Lehman. But it may be time to look at merging some of these institutions to better consolidate the bad debt so that it can be dissipated. The bad debt is flying from so many directions right now that everyone is taking cover rather than devising a battle plan.