Secondly, even if both strategies -- bailing out the banks and re-regulation of the financial sector -- are implemented reasonably well, neither resolves the "Second Wave" problem:
The banking system will get caught in a vicious circle of credit contraction that invariably accompanies the massive de-leveraging that will be needed. Depending on how the re-regulation is implemented, it may actually inhibit banks from providing the finances needed for a reasonably fast recovery of the real economy.
In any case, given the size of the losses to be recovered, it will take many years, in the order of a decade, certainly more than enough time to bring the real economy into real trouble.
In practice, this means we are only at the beginning of a long, drawn-out economic unraveling. The social and political implications for such a scenario are hard to fathom.
The last time we faced a problem of this size and scope was in the 1930's, and that event resulted in social and economic problems that ended up manifesting violently in a wave of fascism and ultimately World War II
The first objection to nationalizing banks or their toxic assets is the well known "moral hazard" problem.
If banks know that they will be saved when in trouble, they may be tempted to take higher risks than otherwise would be prudent. When these risks pay off, the profits are held privately and translated into generous dividends for the banks' shareholders and extraordinary bonuses to management.
But when they fail, the losses end up being absorbed by the taxpayers. The current salvage programs confirm that this problem hasn't gone away and is unavoidably further strengthened by new bailouts.
Christine Lagarde, Minister of the Economy, Industry and Employment in the current Sarkozy government in France, stated "Moral hazard has to be dealt with later... Maintaining the functioning of our markets is the top priority." This is exactly the argument that pops up at every systemic crisis...
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