Transactions: May 18, 2009

In the cloistered world of bankruptcy, there are hierarchies, like orders of angels in heaven: there are shareholders (low), unsecured creditors (higher), secured creditors (highest), and, if you're a debtor-in-possession lender, you get a luxury box at the new Yankee Stadium. This is the way it is. This is what has evolved over decades of bankruptcy infighting, brass knuckles, legal decisions, rules beyond measure. It's true that in the Chrysler episode, the federal government reached in and plucked a junior unsecured creditor, the United Auto Workers union, and placed it ahead of senior creditors, a handful of hedge funds. And when they objected, the feds shoved the mess into bankruptcy, and the president excoriated them as "speculators." It's hard to see what made these hedge funds angrier: that they got turfed out or that Obama called them speculators. (If he called them mutual fund investors, would they be happier?) Whatever the case, the lesson was driven home: Political exigencies supersede bankruptcy convention.

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All this brings us to stress tests, which were not just a way of telling whether banks could survive, but a test of administration bank policy. They are illustrative of the way Obama operates. He's apparently a fan of the political utility, even power, of examinations, contests, deadlines. Tests seem fair; they seem transparent; they appear metaphorically comprehensible. It's as if the world were an episode of "American Idol." Institutions seeking government largess can pass or fail in ways the public understands. Chrysler gets a deadline to do a deal with Fiat. If it fails, it ends up bankrupt. The deadline applies pressure to all interests. And while the government intervened, it fed off the mood of the populi: Workers matter more than speculators. When the hedge funds dug in, Chrysler failed (so did they). Stress tests were constructed the same way. The tests could never produce a "real" result, in the sense that we would really know whether there was adequate capital to cover future losses. Even beyond whether banks cheated or Treasury set the bar too low, truly quantitative forecasts of a dynamic future are illusory. Instead, they were less about stress and more about tests. They created a perception of uniformity, like SATs. Arguably, the negotiations that occurred, which critics said "proved" banks are too uppity, gave the appearance of fair play to the few who tuned in.

The mistake many critics made was to confuse substance with theater. This was particularly the case with advocates of aggressive federal intervention in banking: the nationalization crowd (one of its sharpest proponents, Simon Johnson, believes "nationalization" caricatures the position, but, like junk bonds, it's too late now). Nationalization began with hard numbers: estimated losses on assets versus capital outstanding. The gap yawned, thus the belief that "all banks were insolvent." But nationalization represented a shift from economics to political economy. Its advocates boasted economic expertise (Joseph Stiglitz, Paul Krugman, Nouriel Roubini and Johnson are highly credentialed economists), experience in analogous situations ('90s Japan, emerging markets), and core beliefs that the slump was a depression, not a recession, and that banks were the primo culprits. Insolvency and depression were symbiotic: If we're in a depression, insolvency must follow, and vice versa. But the most important feature of the critique was that economics shapes politics. For all their criticism of free-market deregulators, the nationalizers, like '90s adherents of the Washington Consensus (whom they ritually deride), view the U.S. as primarily an economic mechanism. Thus, the technocratic solution was to seize banks, recapitalize them, break them up, sell them off. Clean, fast, efficient, fair. They downplayed political difficulties; legal hurdles; historical antipathies; expense; the danger of overreach.

The nationalization crowd was a little like the hedge funds in Chrysler: They thought they knew the rules, but it turned out, once the government showed up, new rules prevailed. Obama does not view the world as pure economic construct or banks as oligarchic institutions in need of reinvention. Where Krugman declares sweeping certainties, the White House fears peril, panic, complexity. Where Johnson envisions zombie banks, Obama sees market breakdowns. No one can know yet what party in this debate is "right" or "wrong." What's clear is that Obama, Geithner et al., through luck or through political skill (compare them to Paulson), designed tests to create an appearance of success and legitimacy to bank policy. Krugman still believes zombie-like failure looms, but he also argues we should return to the '60s. The real lesson of the tests is obvious: Effective politics, at least over the short term, gets a better seat than economics. Now we'll see if the home team wins.

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