Bank bailout - risky plan - macroeconomic scanarios

I number of commentators have called for the temporary nationalisation of insolvent banks rather than the current approach. These include those who saw the crisis coming such as Robinini and Soros. The people that said there wasn't a problem (Paulsen, Bernake and now Geithner) now say the problem can be fixed but without radical changes in approach to the ones that have so far failed to address the underlying issues. I believe this approach is to risky to be the one relied upon. Too risky for the for the US and world economy in the medium term.

At the moment the plan is basically to:
- provide government, loans and capital but keep banks in private hands,
- facilitate mergers as more solvent banks buy less solvent ones (often with government of Fed guarantees against losses),
- try and encourage private investors to buy the risky bad assets off banks by limiting the downside by providing government guarantees if things get worse etc.
Basically socialising the losses.

There are a number of other parties that could be bought to the table to assist before the government is required to tip[ in more capital. At the very least pressure needs to be bought on other relevant parties: management, creditors, stockholders and employees to come to the party before funds are provided. This is the usual approach when a company is insolvent and this is what banks do to their customers all the time. They need a stick to do this - usually this stick is bankruptcy. This appears too risky in this situation so the stick needs to be nationalisation.

The financial stress test that decides nationalisation is supposed to be forward looking. If so it would need to take into account:
- housing prices are going to continue to go down in the foreseeable future and then in 1 year all those ARM's reset and there's another 2 years of foreclosures based on that
- companies are going to start going into Chapter 11 as the recession goes for longer
- unemployment is likely to be higher rather than lower

It seems unlikely that many banks would pass such a stress test so presumably the banks will be pressing for a less stressful and transparent stress test that they can pass. Then when things get worse they can say it wasn't our fault the government checked us out we were just unlucky that things got worse, and can we have some more money please.

The big risk of the current approach is that if things continue to get worse despite this plan the government is in a much weaker position to go the nationalization route. You then risk the loss of US dollar safe haven status. This means a drying up of loans for treasuries and either mass insolvency for the banking system or the Fed having to print money. As presumably the Fed would print money we would then have high inflation and high interest rates to go with the high inflation. The impact of high interest rates would drive down already depressed asset prices and weakened corporations etc. It's a whole other reflexive (ie. self reinforcing) cycle) down. Then we do have something like great depression II.

Taking too much risk is what got everyone into this mess. Temporary nationalization of US banks might be less palatable in the short term but it takes much of this big risk away.

Gold prices have rallied strongly on the current Geithner plan suggesting other also see loss of US dollar reserve status is real risk in the medium term. So what are the broad macro economic scenarios going forward.

1. Best case. The plan works well (or they bit the bullet and go down the nationalisation path)along with other stimulus and banking bailout plans worldwide. The world resumes solid growth in 12-18 months. Obviously the banking systems still got some issues and governments have large debts but nothing some gradual inflation and fairly low real interest rates can't fix over 5-10 years. Presumably China and India come out of this stronger than US and Europe and the opportunities are more in developing countries as the US and Europe have to stop leveraging up.

2. Deflation case. After the US come out of negative growth there's Japan 1990's style 8-12 years of slow growth, continued asset price deflation and high unemployment.

3. Inflation case. Scarier option of high inflation, double dip severe recession and loss of confidence in US dollar if the US dollar looses safe haven status and Fed has to print money and so inflates. A lot of turmoil in currency markets as countries unpeg from dollar.

As far as what this means for asset prices.
A. Stock prices
- Best case is OK but probably no turnaround within 6 months so no hurry to be in the market. Worth watching to see which countries markets/sectors look stronger as if there is a new bull market in the next few years its' dynamic will be very different to the last one.
- Deflation case is bad for stock prices.
- Inflation case - gold stocks the obvious pick

B. Commodity prices
- Best case OK for commodity prices particularly if China and India are the stronger economies
- Deflation case - bad for commodity prices
- Inflation case - good for commodity prices

C. Gold
- Best case - bad
- Deflation case - bad
- Inflation case - very good

So no change to my general conclusion that it still makes sense to be short stocks and to have plenty of cash and to watch how things play out. Each scanario leads to radically different conclusions.