Let big banks fail, bailout skeptics say

Top economists tell Congress the administration must change its approach to saving troubled financial firms or risk strangling an economic recovery.

By Colin Barr, senior writer

NEW YORK (Fortune) -- The Obama administration must break up the biggest financial firms if the nation is to return to economic health, three prominent bailout skeptics told a congressional panel Tuesday.

Columbia University professor Joseph Stiglitz and MIT professor Simon Johnson warned the Joint Economic Committee of Congress that the current government policy of propping up troubled financial giants could impede an economic recovery.

They each said spending taxpayer dollars freely on behalf of struggling big banks risks drowning U.S. productive capacity in debt -- while handing what amounts to an enormously costly subsidy to politically powerful financial sector insiders.

If the Obama administration fails to hold troubled banks accountable for their problems, the U.S. could face a lost decade of economic growth like Japan's in the 1990s, they said.

The third skeptic, Federal Reserve Bank of Kansas City President Thomas Hoenig, said policymakers must allow troubled firms to fail rather than propping them up, a la AIG (AIG, Fortune 500). He said banks must be treated consistently, regardless of their size or connections, for the sake of restoring confidence to markets and normal function to the economy.

"Rather than letting the market system objectively discipline the firms through failure and stockholder loss," Hoenig said of the current approach to bailouts, "we tend to micromanage the institutions and punish those within reach."

The hearing comes as Congress prepares to consider an Obama administration proposal to give regulators the authority to take over systemically important institutions. Treasury Secretary Tim Geithner has said such a plan is crucial if the U.S. is to avoid a recurrence of the current crisis.

Meanwhile, regulators led by the Treasury and the Federal Reserve are conducting so-called stress tests on 19 big banks, in an effort to demonstrate that the banks are well capitalized.

Big bank stocks have risen sharply over the past month, amid hope that government-subsidized lending and toxic-loan disposal programs will help restore the vitality of struggling financial institutions.

Shares of the most troubled banks -- Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500), which together have received hundreds of billions of dollars of federal capital and asset-guarantee aid -- were among the biggest winners in that rally.

All three panelists said they believe the Bush and Obama administrations have misspent taxpayer funds in their zeal to stabilize the financial system -- and they warned that taxpayer money will continue to circle the drain if the Obama administration doesn't change course soon.

Along those lines, the International Monetary Fund estimated Tuesday that financial institution writedowns tied to toxic assets could reach $4 trillion globally.

Hoenig said authorities must set up a procedure that would allow big nonbank financial firms to be temporarily taken over by the government. Regulators would then replace management, wipe out shareholders and seek to sell the cleansed institution back into private ownership.

Stiglitz, formerly an aide in the Clinton administration, said the process of briefly taking over banks then selling them back to investors would be much less costly for taxpayers.

Both he and Johnson, a former IMF chief economist, added that the structure Hoenig sketched out would be good to have now - though it would have been better before last year's implosions at Bear Stearns and Lehman Brothers.

Instead, the government rescued Bear and let Lehman collapse - then got $700 billion from Congress that many argue was distributed willy-nilly to good and bad banks alike, as well as automakers and others.

The Lehman decision also froze credit markets and pushed AIG to the brink of insolvency. In response, the government extended an $85 billion emergency loan to the insurer. The cost of that rescue has since more than doubled.

The short-sighted responses to crises last year highlight the need to take bold steps now, Stiglitz said. "We really now ought to draw the line and say where we want to go from here," he said.  To top of page

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