"Wishful thinking syndrome"

Back from a few days of travel. Much has been going on, of course, and this blog will catch up on stuff as the week unfolds and as we move towards the G-20 on Thursday

But let's start with Robert Shiller, who's on CNBC this morning. As ever, he's concerned about 'animal spirits' and market psychology, and doesn't like what he's seeing and hearing. He sums things up by saying that the Obama administration is suffering from the title of this posting. I agree. So many of their initiatives have assumed near-ideal market outcomes and macroeconomic developments, rather than worst-case. And if we've learned anything, it's to expect, and plan for, the worst, unfortunately. Shiller's very worried that if the latest round of government rescues - esp the new Geithner plan and the stimulus bill - fail (and, like Krugman, he's afraid they're too timid) then market psychology spiral downward, making further recovery efforts even more difficult. In 6 months we could be looking at another phase of the crisis - one which is accelerating and for which few policy options would have political support.

Best to get all the pain over with sooner rather than later, and the nationalization of banks with toxic assets still makes most sense. Absent nationalization, the Achilles heel of all bank rescue plans - how to value toxic assets - remains. Here's an assessment from Doug Roberts at bloggingstocks.com:

Paul Krugman, the liberal Noble Prize winner, wrote an editorial in The New York Times attacking the plan as "Cash for Trash." Subsequently, Newt Gingrich, the former Republican Speaker of the House, announced on Fox News that he agreed with Professor Krugman. When senior figures on both left and right agree, it may be wise to look past the euphoria.

The problem with the purchase of toxic assets has always been one issue:price! Banks claim that this is a liquidity issue and that these assets are worth much more in the long run. Outside investors disagree and think that these assets are worth far less. However, if banks sell at these prices, many may be insolvent. This would require receivership under current FDIC rules. In some circles, this is called nationalization, something the government desperately wants to avoid.

Therefore, the government appears ready to create substantial incentives for these private investors to purchase at higher prices, possibly including non-recourse loans and government guarantees. This assumes that the banks are right, and these assets will eventually return to higher values.

However, suppose that the investors are right, and these assets are worth very little. We are merely paying private investors and banks with taxpayer funds to postpone the inevitable write-down of these assets. As we saw in Japan, postponing these write-downs does not change the situation. You cannot re-inflate the bubble!

This will simply result in huge tax bill for the American public sometime in the future. The cure may be truly worse than the disease.

After the G-20 this week (at which it now appears certain that no coordinated response will emerge) the next big reality check will be the (secret) results of those bank stress tests in late April. Reuters has a good peek into what that might look like: Bank stress tests could broadly hurt corporate debt

As ever, it's best to avoid wishful thinking....