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A better financial rescue plan for the US

by Alexander Sat Sep 27th, 2008 at 10:50:03 PM EST

The Johns Hopkins economist Christopher Carroll has an interesting blog entry describing rescue plan which has been proposed by economists  which is better than Paulson's, and expressing puzzlement about why this alternate plan has been completely ignored in Washington. This plan involves temporary nationalization, something that was done by Sweden when it had a financial crisis in 1992.

In talking to people involved in the inside-baseball political side of the discussion on Capitol Hill, I get the impression that they are very unhappy about being asked to sign on to this bill, but are planning to do it because they have been told that if they don't sign on the dotted line then the apocalypse is around the corner.

The KEY point that I think is not penetrating from the economists to the Congress is that what sticks in our craw is ONE SPECIFIC ASPECT of the Paulson/Frank plan: Its focus on having the government buy up the toxic subprime securities. This is close to a pure bailout for Wall Street, and there is NO REASON that any of us sees that this has to be the core of the rescue plan. I think you could get near-unanimity from economists, from across the political spectrum, in FAVOR of a simple, easy-to-do alternative that would be both more economically sound and more politically palatable: The Federal government should do, with respect to the banking sector as a whole, what Warren Buffett did last week in his investment in Goldman Sachs.


Buffett did not become the richest man in the world by making bad investments. The money he provided to Goldman was emphatically NOT a bailout. It was a prudent investment - he thinks he will make his money back, and much more. The taxpayer should follow his lead and take a similar stake in the financial industry.

This is the essence of the concrete plans that conservative, moderate, and liberal economists have been proposing (cf. Zingales and deLong). I think the reason these ideas have not made more headway on Capitol Hill is simply that the proposals are written in terms that are too technical for members to realize that they are all basically saying the same thing: The right way to recapitalize the financial system is by investing money in the system as a whole, so that the taxpayer benefits when the economy recovers. This is not a new idea; it is basically what Sweden did in 1992 when it faced a financial meltdown, and it worked out OK in the end for the Swedish taxpayer (at least compared with the alternatives). Just like Warren Buffett, the taxpayer might even ultimately make money on the deal.

At the risk of making eyes glaze over, let me sketch one way of doing this (which is basically similar to the more concrete and detailed proposals of others): The taxpayer could approach each financial institution that is in trouble and offer them a take-it-or-leave it deal: You need capital and we have capital. We'll either lend you the money you need (in exchange for being first in line for repayment out of any future profits, and in exchange for your cutting your dividends to zero until your capital is restored), or we'll buy preferred shares in you in an amount directly proportional to shareholder equity from your last audited financial statement (again, you must cut dividends to zero until you are healthy again). This solution is not perfect, but I am assured by people who should know that it is something that could be organized very quickly and would provide the needed capital. The plan would need to specify, in an ironclad way, that the taxpayer's stake would be sold off (at a profit) when the system regains its footing.

Carroll offers an explanation for why this plan is not getting any traction in Washington (the Republicans proposed an alternative plan, but not the Democrats!):

What is mystifying to me and many other economists is why there seems to be such resistance to the Zingales/deLong/Buffett plan by people who do not seem to be able to offer a coherent rational argument for why it would not work, and an insistence instead that the taxpayer should buy the toxic assets directly. I can think of only one potential explanation: A rigid ideological opposition on the part of Henry Paulson to taxpayer ownership of even one dime of the financial sector. If this is the right explanation, it is scarily reminiscent of the rigid ideologies that led to catastrophic errors of policy judgment during the Great Depression. A lot of conservative economists, who share Paulson's presumed predilictions in this regard, have seen the light and now feel that the Zingales/deLong/Buffett plan is the best of a bad set of options. Why doesn't Henry Paulson agree?

(I should note, in fairness, that Paulson has moved somewhat in this direction; the latest versions of his plan involve taxpayers getting some ownership stake in exchange for their purchases of the toxic assets. But if he is willing to compromise in that regard, it is all the more mysterious that there is still an insistence on buying the toxic assets).

Why Washington wants to buy the toxic assets even though this is not required to get the financial sector back in order is obvious to anyone but an economist. Economists, like other American social scientists, do not as a rule progress beyond the view of the role of the US government that we get taught in grade school: that its purpose is to serve the American public. As we have seen all too well in the last eight years, its real role is to plunder other people's wealth to transfer it to the very wealthy (see Free Lunch). And this is precisely what the Paulson plan does, on a massive scale (without solving either the problem of the undercapitalization of banks or that many houses are now worth less than the mortgages taken out to buy them).

The purpose of the Paulson plan is not to rescue the financial sector—a later plan developed by the next administration will have to do that—but to rescue the paper gains that very wealthy investors had made which have recently disappeared.

It's possible that Carroll is using snark when he says it is "mysterious" that there is "an insistence on buying the toxic assets", but I don't think he is. Also, he doesn't mention that Buffett supports Paulson's plan. Evidently, Buffett doesn't find that what's good for Buffett is good for the American people.

It's also interesting that in an interview with the progressive radio talk show host Amy Goodman, Paul Krugman says that "temporary nationalization in a financial emergency is always the way to go, but the word "nationalization" nowhere appears in his column of the same day. Krugman is a bit more specific in his latest blog post:

Nouriel Roubini has a characteristically scathing takedown of the Paulson plan, and here's the thing: language aside, his economic analysis is similar to mine. The fundamental problem in the financial system is too little capital; bizarrely, the Treasury chose not to address that problem directly, by (say) purchasing preferred shares in financial institutions. Instead, the plan is premised on the belief that toxic mortgage-related waste is underpriced, and that the Treasury can recapitalize banks on the cheap by fixing the markets' error.

The Dodd-Frank changes make the plan less awful, mainly by creating an equity stake. Essentially, this makes it possible for the plan to do the right thing through the back door: use toxic-waste purchases to acquire equity, and hence inject capital after all. Also, the oversight means that Treasury can be prevented from making the plan a pure gift to financial evildoers. But it's still not a good plan.

Carroll finds it "mystifying"; Krugman finds it "bizarre". Mentioning the obvious explanation is out of the question if you write for a corporate news outlet or have an academic job.

Update [2008-9-28 16:14:0 by Alexander]: Now that a deal's been reached, Krugman finally says what other economists have been saying:

Brad DeLong says that Swedish-style temporary nationalization is the right answer to a financial crisis; heís right. I havenít been clear enough about this, it seems, but itís where my basic diagnosis leads: the problem is insufficient capital, you want to inject capital, but you donít want it to be a windfall to existing stockholders ó hence, take over and recapitalize the failing firms. By the way, thatís what we did with AIG 10 years days ago. So thatís the good solution. The Paulson plan, which is some combination of sheer giveaway and mystic faith that a slap in the marketís face will make everything OK, is a bad solution (and probably no solution at all.)

And note that he writes "Brad DeLong says". It's not just DeLong: it's virtually all economists. But Krugman is afraid to point that out, because then his readers would start wondering why Congress would approve of a plan that essentially all economists agree is bad and probably won't work. By making it seem that it's just he and DeLong who think it's a bad plan, Krugman sticks to the media's postmodern narrative mode according to which there are just differing points of view.

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Cross-posted from The Booman Tribune.

The blog at which Carroll posted his entry has a bunch of interesting responses by economists to Paulson's plan. I don't know if ETribbers' attention has been directed to it already.

A bomb, H bomb, Minuteman / The names get more attractive / The decisions are made by NATO / The press call it British opinion -- The Three Johns

by Alexander on Sat Sep 27th, 2008 at 11:00:10 PM EST
Three or four decades of a concerted ideological misinformation campaign sure count for something.

The Reagan/Bush/Clinton/Bush economy has been good for one class of people and one class of people only - the very wealthy. Without credit-fueled bubbled, no one else profited. And, when the bubble burst, only those whose interests are really being looked out for, by the GOP AND by Democrats, in Washington, are the plutocrats.

Trickle down is bipartisan, as this new 'bailout' bill will show...

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Sun Sep 28th, 2008 at 06:32:51 AM EST
Adding, that one thing economists do not usually get is that the greater good is not, all other things being equal, necessarily the goal of policy, although it, generally speaking, undergirds the economist's naive weltenshauung.

Plato didn't call economics the Master Science, he called politics the master science, and he had good reason to do so. Economists, on the other hand, have spent the last half century undermining folks in the exertion of their political interests, and now are surprised to see they have been used by the Wealthy, the Powerful, the Absolutists, as in previous periods other useful idiots have been used.

I understand they want to be heard, and that Krugman still has a following among the "left" in the US and elsewhere. But the trade they practise has undermined our classes at most every turn, and so, I'm not going to necessarily rue the fact, in and of itself, that they've been cut out of the discourse.

Long term, that's probably a good thing.

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Sun Sep 28th, 2008 at 06:44:50 AM EST
[ Parent ]
In the USA,for someone in the financial services industry or academia and for most politicians, seriously raising the issue of nationalization is career suicide.  Right now I suspect that even validating workable alternatives to Paulson's proposed bailout that don't involve nationalization could pose risks.  

With the current system of campaign finance not too many in Congress can afford to oppose this bailout.  Wealth has closed ranks.  When they obviously start turning on one another there may be more opportunity for truth to out.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 28th, 2008 at 09:43:35 AM EST
Yes certainly, that Congressmen are dependent upon campaign contributions explains why this is happening. The American political system is structurally set up to serve the interests of the wealthy.

As for your other point that in the US raising nationalization is career suicide, the people who post at that blog I quoted from are academics or in the financial services industry. Here is a new post:

Bailout: It's About Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis

Where have I heard that the problem isn't liquidity but solvency before?

A bomb, H bomb, Minuteman / The names get more attractive / The decisions are made by NATO / The press call it British opinion -- The Three Johns

by Alexander on Sun Sep 28th, 2008 at 02:26:00 PM EST
[ Parent ]
... Republican Senator from a relatively safe state, its not career suicide for a university academic.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Sun Sep 28th, 2008 at 03:58:08 PM EST
[ Parent ]
... be expressed in a way that sounds like something other than temporary nationalization. Temporary nationalization is a non-starter ... for one thing, there would be a lot of Democratic voters who, after eight years of Bush, would be nervous to have the banking system potentially within reach of Republican control. Talk about opportunities for politicizing government institutions for partisan advantage!


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Sun Sep 28th, 2008 at 02:20:37 PM EST
The article I linked to in my previous post quotes two people at the American Enterprise Institute (!) as writing this:

A better model for a fair solution to the incipient solvency problem is the Reconstruction Finance Corporation, or RFC, of the 1930s. This was one of the most powerful and effective of the agencies created to cope with the greatest U.S. financial crisis ever. When financial losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when uncertainty is extreme and risk premia therefore elevated, what the firms involved need is not more debt, but more equity capital."

The article describes the RFC thus:

Consider two models for government assistance. The first is the Resolution Trust Corporation ("RTC") model of the 1980s, which was used to buy up bad assets following the S&L crisis of the 1980s. The older model comes from the 1930s and the Reconstruction Finance Corporation ("RFC"), the most authoritarian federal agency that has ever existed in the United States. Directed by Jesse R. Jones, the RFC used its vast legal powers to test the solvency of banks and commercial companies and, when those institutions were proven solvent, they were allowed to re-open. Those financial institutions that were determined not to be solvent were closed by the FDIC and either sold whole or in pieces to other institutions.

Below are two very simplified numerical illustrations to highlight the failings of the current plan in Washington by way of a comparison between (1) the RTC/Paulson model and (2) the 1930s RFC model, which is conveniently illustrated by the purchase of WaMu by JPMorgan Chase (NYSE:JPM). Of note, in the WaMu resolution, equity and bond holders of the parent holding company were effectively wiped out - a significant landmark for bank investors that probably kills the private market for bank equity for the foreseeable future.



A bomb, H bomb, Minuteman / The names get more attractive / The decisions are made by NATO / The press call it British opinion -- The Three Johns
by Alexander on Sun Sep 28th, 2008 at 02:39:42 PM EST
[ Parent ]
Temporary nationalization is a non-starter ...

Maybe the difference is in the spelling, but temporary nationalisation is exactly what Her Majesty's Treasury appears intent on doing this week with Bradford & Bingley....

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sun Sep 28th, 2008 at 02:44:02 PM EST
[ Parent ]
Also, AIG was effectively nationalized, wasn't it?

A bomb, H bomb, Minuteman / The names get more attractive / The decisions are made by NATO / The press call it British opinion -- The Three Johns
by Alexander on Sun Sep 28th, 2008 at 03:12:49 PM EST
[ Parent ]
... made it through the Senate if it had required additional Congressional authority?


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Sun Sep 28th, 2008 at 03:56:08 PM EST
[ Parent ]
If the Democrats had the interests of the country at heart and not those of the wealthy, they would have give the Republicans the choice between a Swedish/RFC type plan and no plan. Instead of coming up with their own plan, they work with a Republican bill, as usual.

A bomb, H bomb, Minuteman / The names get more attractive / The decisions are made by NATO / The press call it British opinion -- The Three Johns
by Alexander on Sun Sep 28th, 2008 at 04:25:43 PM EST
[ Parent ]
... group. At least 40% of the House Democrats do primarily represent the wealthy ... its not like it could be otherwise with our campaign funding system ... and its not likely that many can completely ignore the interests of the wealthy. Its just that they represent a Whig variety of wealthy rather than a Dry Tory variety of wealthy.

Add to that the fact that the corporate wing gets legislation and the veneer of expertise handed to them by their corporate backers, and House progressives are mostly forced to come up with things on their own, and the outside advice they do get includes things as politically dead on arrival as temporary nationalization of banks, and its not wonder that the progressive wing of the House Democrats do not have a horse in the race.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Sep 28th, 2008 at 04:37:04 PM EST
[ Parent ]
... gone into insanity as the US ...

... but by all appearances the Bush administration was perfectly happy with nationalizing businesses to bail them out ... the opposition would be in the Senate, and somehow I do not imagine the House of Lords presenting such a hurdle for a UK government to get over.

The problem is certainly not that the policy is guaranteed to fail if enacted ... while the devil is in the details, its one of the main lines of approach for a government addressing a solvency crisis.

If an academic wants to make the point, "this is a solution that can work, and look how its being ignored", that's a fine lesson on the limits of the political discourse in American today ... but that's different from making a policy proposal that you hope to see adopted.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Sep 28th, 2008 at 04:18:57 PM EST
[ Parent ]
Only an economist could be puzzled over why the Paulson Plan (aka TARP, Taxpayer Anal Rape Plan) is on the table and the Swedish is not.  The bailout has nothing to do with economics and everything to do with politics.  It is the last piece of a machine intended to create and perpetuate an oligarchic plutocracy for the benefit of about 5% of the population at the expense of the other 95%.  Taxpayers are not there to be protected.  They are there to be used and used up.
by rifek on Sun Sep 28th, 2008 at 02:39:14 PM EST
There's a diary up at dKos about a draft of the bailout bill:
This deal sucks!

A bomb, H bomb, Minuteman / The names get more attractive / The decisions are made by NATO / The press call it British opinion -- The Three Johns
by Alexander on Sun Sep 28th, 2008 at 07:02:38 PM EST


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