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The problem is political; it will take strong leadership to explain why it is necessary to resist the demands of the losers, especially if, as in America, they may well form the majority. I totally reject your flag day solution. It will simply lead to another, possibly bigger, crisis down the road.

You’re right, of course. I was writing too casually. The firm’s market cap cannot reach zero until some bankruptcy process has actually declared the equity defunct.

I agree completely with your conclusion. My only caveat is that the solvency of all banks is in doubt, because the mark-to-market interest rate of their long-term assets is rising and can rise more or less indefinitely, and the market price of the assets that collateralize these loans is sinking and can sink more or less indefinitely.

There is just no conceivable bank which is strong enough to resist these forces indefinitely. Therefore, they should all be nationalized.

Again, I do not see the motivation in the rule that the shareholders should receive nothing. I think the “seizure” should be a normal acquisition. Even from a practical political standpoint here, I don’t see why you’re trying to generate a set of losers here. Surely in an ideal structural fix, there are no winners and no losers.

Not true. The equity of the firm, as Merton described, is like a call option on the value of the firm’s assets. Its market value cannot reach zero. It is impossible to tell whether a bank is insolvent or not without knowing the full details of its assets and liabilities, and if it is insolvent, the shareholders have an incentive to gamble with what is left for the creditors in the hope of making back their losses.

That is why I would argue that, to end the uncertainty that is paralysing the money markets, the government should seize any bank whose solvency is in doubt, with the presumption that the shareholders should receive nothing (with the possibility of compensation after the government has recapitalised and disposed of the bank).

There is no point in developing ideas about what should be done, except as a way to analyze an opponent’s policy space.

We live in democracies and that implies that only projects with sufficient political energy are adopted. Political energy differs from economic feasibility or desirability from a welfare perspective. It is what politicians can use to expand their base, which includes measures that please important backers. Ultimately, voter interests count too but only if they re sufficiently articulated and concentrated. In our media democracy, that is increasinlgy problematic. Sorry if this sounds cryptic.

The bottom line is that economics matters up to a point, but very indirectly, and only if politicians and media ll agree to educate the public “objectively”. In all other cases, the crude notions that exist among voters are massaged by superficial media and manipulated by both politicians and media, resulting in a volatile and patchy set of expectations and values that act as a framework in which politcal messages (”promises”, “threats” and “assessments”) are broadcast. Economics is a particularly dangerous theme for politicians (compared to social and moral issues, because of much greater (and less predictable) variability of economic conditions. Politicians campaigning on positive economic policy issues (to be distinguished from “economic” topics like criticizing an incumbent’s lack of success in…etc) tend to be dsperate or reckless. I guess political investment mnagers like Rove would agree with this view. Economics has too many moving parts for sound politics.

Of course, having ideas about what should be done (better) is very useful from a personal therapeutic perspective, and great conversation material. Or academic content.