Balancing Banks.(The Talk of the Town)

Not long ago, many of America's biggest banks made terrible bets on overpriced real estate and suffered huge losses. While the banks insisted that they were fundamentally healthy, economists and politicians declared many of them to be insolvent. Government regulators, though, allowed the banks to stay in business. The banks hunkered down and cut back sharply on new lending, and the resulting credit crunch made an already weak economy worse.

That sounds like the story of what just happened to the U.S. economy, but actually it's the story of what happened at the beginning of the nineteen-nineties, after banks found themselves sitting on billions in worthless loans to Sun Belt developers and other commercial builders. And, if you tweak the details a bit, it's also the story of what happened in the early eighties; that time, it was loans to developing countries that got the banks in trouble. In other words, while the current banking crisis is exceptionally severe, it's not exactly new. It's the third major banking crisis in the past thirty years, which is at least a couple of crises too many. And that's forcing the Obama Administration to confront two huge tasks at once: rescuing the economy from the current meltdown, and figuring out how to prevent the next one.

The rescue effort, surprisingly, may be the easier of those tasks; although recurrent financial turmoil is hardly a confidence-booster, the fact that the U.S. economy--unlike, say, Japan's--has recovered well from previous banking disasters offers hope that the government's strategy will work. Many economists and pundits have argued that the only solution is to nationalize the weakest big banks, wiping out shareholders and management. Obama has adopted a more cautious and incremental strategy, incorporating approaches like the one unveiled last week by Treasury Secretary Timothy Geithner, which will use low-cost, no-risk loans to encourage private investors to buy up toxic assets--on the assumption that, if the economy improves, bank balance sheets will, too.

Critics of this approach say that it's simply papering over the problem, but it has worked before. During the crisis of the early nineties, for instance, the government did not take over the insolvent money-center banks (as opposed to the S. & L.s). Instead, regulators exercised "forbearance" and the Federal Reserve slashed interest rates, boosting bank profit margins. Over time, increased profits stabilized the banks' balance sheets, and, in a couple of years, they went from insolvency to reasonable health. Today's crisis is, to be sure, far bigger. But so, too, has been the government's response, including a plethora of new initiatives--the stimulus package, the mortgage-relief program, the Geithner plan--and unprecedented activity by the Fed, which has been buying up commercial ...