What’s a bad bank? Today, just about anything calling itself a bank is bad. The financial crisis has banks around the world in trouble. Policy makers remain unwilling to simply let banks sell off assets at a loss and close their doors if necessary.
In a London speech this week, Federal Reserve Chairman Ben Bernanke outlined three possible programs to help banks get bad loans off their balance sheets and stay in business: buy the bad loans outright, guarantee them, or transfer them to a government-backed bad bank.
The third approach is similar to the Resolution Trust Corp established two decades ago to liquidate all the bad loans on the books of failing savings and loans. There were many calls for just such an establishment last fall as the crisis began, but policymakers chose the current direct-cash-to-banks approach for fear they had to act quick.
Trouble remains months later. The many loans remaining on banks' balance sheets are inhibiting private investment and new lending. Any of the three above approaches to shore up existing banks is certain to cost a lot of taxpayer money.
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How can the federal government keep it up? Clearly, deficit spending will be with us for a long time now.
Our nation’s total income, or gross domestic product (GDP), is divided among four components of expenditure: consumption, investment, government purchases and net exports.
Consumption makes up more than two-thirds of the U.S. economy and includes all household spending on goods and services. Investment includes both business and household spending on new equipment and structures (like new housing). Government purchases include spending on goods and services by local, state and federal governments. Net exports equal the value of goods and services produced domestically but sold abroad (exports), less the value of goods and services produced abroad but sold here (imports).
When government purchases increase such that the deficit rises, there will always be effects on the financial system like those we are experiencing now. The long-run implications are profound unless we change our ways.
Because a government deficit represents negative public saving, it lowers national saving. This leads to a decline in the funds available to the financial markets. The government sector crowds out other savings.
One effect is a rise in the real interest rate on investments. Both households and businesses will lower their spending on new equipment and structures. A further effect is a rise in the real exchange rate of the U.S. dollar. U.S. goods will be more expensive relative to foreign goods, and exports will fall.
To continue increases in government spending for the bank bailouts or any other economic stimulus, we will face bigger government and trade deficits - a double drag on the economy.
The only way to avoid a massive slowdown in economic activity is for households to offset government’s unwillingness to save with more savings from abroad or more of our own. It’s time to pinch more pennies. We can’t expect the rest of the world to bail us out any longer.
Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.