Mr. Geithner upped the confusion index with his speech on Tuesday outlining the ‘details’ of the administration’s plan to rescue the ailing financial sector. The fact is that for the most part, there is no plan, or at least one which can be deciphered by just about anyone.  All we have are some vague outlines which seem to lay the broad strokes for much of the same old thing; more government capital infusions into the banks, buying the banks’ toxic assets (this time via some sort of public/private partnership) and expanded Fed lending. 

There is one part of the plan which is intriguing—the part about forcing twenty of the nation’s largest banks to undergo a “stress test” to see how they look in a worst-case scenario. It’s good that the government well be doing this, but what’s the end game here? What are the government’s pass-fail criteria in these tests? What happens if a bank fails the test? Is the stress test process a prelude to shutting down that particular institution? No details regarding this were supplied by Mr. Geithner yesterday, so no one knows.

As usual, Nouriel Roubini is way out in front of the curve regarding this. I can’t understand why the government doesn’t ask him to advise them, but the only reason I can think of that is that they know very well what he is going to say and have determined that his answers will not be politically palatable at this time

The facts are that throwing more money at troubled banks isn’t going to work because their losses (now estimated to reach $2.1 trillion by the IMF and $3.6 trillion by Nouriel Roubini) on bad debts are going to exceed what the government will inject, leaving them technically insolvent. Buying their toxic assets isn’t going to work because there’s no way to price them either without putting taxpayers at severe risk by overpaying or by putting the institution at severe risk by paying what they truly are worth . Additional lending by the Fed isn’t going to work because lenders will not lend to overburdened entities and such entities are in no mood to borrow while their balance sheets are in such disarray. And the biggest thing which isn’t going to work is implementing a fiscal stimulus in the middle of a solvency crisis. At this point, the only thing that will work is to seriously start the process of cleaning out the mess.

The system needs to be cleared of its excesses. Certain institutions need to be allowed (or forced) to fail, have their toxic assets placed in the government’s control (at no cost to the taxpayer) and then have their viable assets sold off to interested parties in the private sector if what remains cannot be reorganized.

So why isn’t this happening now? Because doing what is necessary means that things are going to get worse before they get better as far as the real economy is concerned, and government officials are frightened of that. They really needn’t be, because this is the solution that has worked before.

Russia had a debt crisis, Asia had a debt crisis and Sweden had a debt crisis. All had to go through the same process; clear out the failed institutions and sell their viable assets to the private sector.  All came out of the situation stronger and had years of healthy economic growth, until they were overtaken by today’s Western debt crisis and by imbalances in their own economies, i.e. Asian over-dependence on exports.

The one economy that did it “our” way was Japan. Japan spent years propping up its failed (zombie) institutions with government support, which led to a lost decade of economic growth. Even worse, because Japan saddled itself with so much debt, it now faces some of the worst prospects of any nation, except perhaps the U.K. The Nikkei is still way below the level where it was before the Japanese real estate bubble burst.

There’s no question the real economy will worsen as the process of cleaning out the excesses goes forward, but the situation will be far more severe if the process is not allowed to take place as the government continues to allow insolvent institutions to remain upright. The U.S. is at severe risk of a prolonged, near-depression event if the government does not chop the heads off the zombie institutions and burn the bodies. The longer that they are allowed to walk around, the more infection they will spread.

Perhaps the part of the plan regarding the stress-testing of the banks is a prelude to the government doing the necessary thing. If it is, all well and good but the problem is that no one knows exactly what is going on because no transparency has been provided regarding this. Right now, all we’re left with is a lot of speculation.