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March 24, 2009

Economist's View - 8 new articles

Sachs: Will Geithner and Summers Succeed in Raiding the FDIC and Fed?

Chris Carroll supports the Geithner plan, but I don't think we can say the same about Jeff Sachs:

Will Geithner and Summers Succeed in Raiding the FDIC and Fed?, by Jeffrey Sachs, Vox EU: Geithner and Summers have now announced their plan to raid the Federal Deposit Insurance Corporation (FDIC) and Federal Reserve (Fed) to subsidize investors to buy toxic assets from the banks at inflated prices. If carried out, the result will be a massive transfer of wealth -- of perhaps hundreds of billions of dollars -- to bank shareholders from the taxpayers (who will absorb losses at the FDIC and Fed). Soaring bank share prices on the morning of the announcement, and in the week of leaks and hints that preceded it, are an indication of the mass bailout at work. There are much fairer and more effective ways to accomplish the goal of cleaning the bank balance sheets.

Here's how it works

A major part of the plan works as follows. One or more giant investment funds will be created to buy up toxic assets from the commercial banks. The investment funds will have the following balance sheet. For every $1 of toxic assets that they buy from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the remaining balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the toxic assets purchased by private investors fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the toxic assets.

Taxpayer giveaway explained with a numerical example

To understand the essence of the giveaway to bank shareholders, it's useful to use a numerical illustration. Consider a portfolio of toxic assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The market value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, which sums to $360 billion. The assets therefore currently trade at 36 percent of face value.

Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC loan. The FDIC is giving a "heads you win, tails the taxpayer loses" offer to the private investors.

Specifically, the FDIC is lending money at a low interest rate and on a non-recourse basis even though the FDIC is likely to experience a massive default on its loans to the investment funds. The FDIC subsidy shows up as a bid price for the toxic assets that is far above $360 billion. In essence, the FDIC is transferring hundreds of billions of dollars of taxpayer wealth to the banks.

Back of envelope calculation: $276 billion

With a little arithmetic, we can calculate the size of that transfer. In this scenario, the private investors (who manage the investment fund) will actually be willing to bid $636 billion for the $360 billion of real market value of the toxic assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders! Here's why.

Under the rule of the Geithner-Summers Plan, the investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion. The FDIC will loan $546 billion. (All numbers are rounded). If the toxic assets actually pay out the full $1 trillion, there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.

Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP's expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.

The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the toxic assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is "underwater" (holding more in FDIC debt than in payouts on the toxic assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.

You know it's a bank shareholder bailout when …

Soaring bank stock prices during the last week, and then again on the day of the announcement, demonstrate the bailout in action. From March 9 to March 20, the KBW bank index rose by 33 percent, while the overall Dow Industrials rose by only 11 percent, indicating how the rumors were especially good for the banks. This morning, bank shares across the board soared in value. Citibank has tripled in value since its low in early March. The value of the bailout dwarfs the AIG and Merrill bonuses, but since the bailout is much less obvious than the bonuses, the public's reactions have been muted, at least at the start.

A better plan

The plan should not go forward on such unfair terms. Under the law, Congress should apply the Federal Credit Reform Act of 1990, which requires budget appropriations to cover expected losses on government loans programs, which would presumably include the expected losses on FDIC and Treasury loans under the Geithner-Summers Plan. With proper credit accounting, the entire operation in our little illustration would require a budget appropriation of $276 billion, equal to the expected losses of the FDIC and Treasury. If the Administration goes to Congress for such an appropriation it will be shot out of the water. The public will not accept overpaying for the toxic assets at taxpayers' expense. Thus, it is very likely that the Administration will attempt to avoid Congressional oversight of the plan, and to count on confusion and the evident "good news" of soaring stock market prices to justify their actions.

The Geithner-Summers plans for the FDIC are not the only off-budget transfers to bank shareholders taking place. Other parts of the plan support subsidized loans from the Treasury and, even more, from the Fed. The Fed is already buying up hundreds of billions of dollars of toxic assets with little if any oversight or offsetting appropriations. Since the Federal Reserve profits and losses eventually show up on the budget, the Fed's purchases of toxic assets also should fall under the Federal Credit Reform Act and should be explicitly budgeted.

There are countless preferable and more transparent courses of action. The toxic assets could be sold at market prices, not inflated prices, making the bank shareholders bear the costs of the losses of the toxic assets. If the banks then need more capital, the government could invest directly into bank shares. This would bail out the banking system without bailing out the bank shareholders. The process would be much fairer, less costly, and more transparent to the taxpayer.

Take insolvent banks into receivership instead: a bailout needs a workout plan

Banks that are already insolvent should be intervened directly by the FDIC, that is temporarily taken into receivership. The shareholder value would be wiped out, except perhaps for some residual claims in the event that the toxic assets vastly outperform their current market expectations.

As I've written before, the allocation of bank shares between the taxpayers and the current bank shareholders could be make contingent on the eventual value of the toxic assets, ensuring fairness between the shareholders and the taxpayers.


"Why are we Bailing Out Foreigners?"

Ben Bernanke, via Andrew Leonard, explains why U.S. tax dollars were used to bail out foreign banks:

Why are we bailing out foreigners?, by Andrew Leonard: Why did American taxpayer money help AIG pay its debt to foreign counterparties? Representatives from both parties raised the question during Tuesday's House Financial Services committee hearing on AIG. On the surface, the question seems perfectly reasonable. Why are American taxpayers bailing out foreign companies? Shouldn't their own governments be taking responsibility for their welfare? ...

Few people seem inclined to accept that as far as the global financial system is concerned, there's really not that much difference between foreign and domestic financial institutions -- the web of interconnections tying all the big players together is so tangled and intricate that if one link in the chain goes down, everyone stands a chance of collapsing. (And yes, that's a bug, not a feature.) If the goal is preventing systemic collapse, then everybody gets bailed out, regardless of jurisdiction. But Bernanke followed up an answer along those lines with an even more effective riposte: Hey, Europe has been bailing us out too!

BERNANKE: ...The critical issue was, was AIG going to default and create enormous chaos in the financial markets, or was it going to meet all of its obligations, including those to foreign counterparties?

I would point out that the Europeans have also saved a number of major financial institutions. And the issue of whether those institutions owed American companies money has not come up. So I think that there is a sense that we all have the obligation to address the problems of companies in our own jurisdictions.

In particular, the Europeans could appropriately point out that it was under U.S. regulation or lack of regulation and U.S. law that AIG failed. And in their sense, we do bear some responsibility.

Good answer. ... All in all, I thought Ben Bernanke had a pretty good day on Monday -- he's clearly gotten more comfortable dealing with rampant Congressional irrationality over the last two years. ... And when he claimed that after learning of the AIG bonuses he wanted to file suit to stop the payments, he sounded believable.

This is another case (DeLong response) where having procedures worked out in advance can help with both the politics and the economics. It's best if we don't have to waste time bickering over who should pay for what while the economies of both countries are going down in flames, and policies made in the heat of the moment aren't always the best policies, particularly when they are made in combative political environments. But all of that can be avoided if the polices are thought through carefully and dispassionately in advance, and have the approval of the appropriate authorities.


Dissent on "Which Plan is Best": Why a Second Best Plan May not be Good Enough

Sach Mukherjee disagrees with my mild support of the Geithner plan. He's worried that if we let this window of opportunity for reform go by without making major changes - and going with the Geithner plan is, he believes, a step in that direction - then we are headed for an even bigger disaster than we have now at some point in the future:

Why a second best bailout may not be good enough, by The Compulsive Theorist: It's not often I find myself disagreeing with Mark Thoma, but on the issue of the Geithner bailout plan I think I do. Thoma is a careful and reasoned writer, so what comes below I say cautiously, but nonetheless with some conviction.

Thoma writes:

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Let me start by nailing my colours to the mast: I am not convinced the Geithner plan is a good one, and would greatly prefer to see a much more thorough reform of the financial sector, including a bankruptcy-like reorganization of insolvent firms. I understand that this sort of "solution" is much easier to consider in the abstract than implement in the real world and that such a plan would encounter formidable political obstacles at a time when the policy response needs to be rapid. So my argument below against Geithner-type plans is made neither lightly, nor simply to play devil's advocate to optimists. My opposition to the Geithner plan stems not primarily from outrage, concerns about equity, or even book losses borne by taxpayers, but from major concerns about future economic output and stability. The other issues are important and certainly things I care about, but my feeling is that even these are of secondary concern next to the signal issue of how today's bailout will affect tomorrow's broader economy. For the moment, let's categorize bailout plans into those which seek to recapitalize the banks while maintaining the current system in roughly its present form and those which go the route of bankruptcy-type proceedings and (given the breadth of the current crisis) would involve a much more thorough overhaul of the financial system. The Geithner and Paulson plans are of the first kind, and the "Swedish" plan (and its many variants) of the second kind. I'll call these "bailout" and "restructuring" plans respectively. Clearly this nomenclature hides a lot of detail, but I think captures a key axis of difference between the various plans. Two things about the aetiology of the crisis stand out. First, perverse incentives for agents within the financial sector played a central role in bringing about the crisis. Second, there were (and remain) issues of poor system design in the financial sector: even perverse incentives might have had limited consequences in a robust system. The problem with the Geithner plan is that even it works in terms of stabilizing the economy in the short-term, it does relatively little (the uncharitable would say almost nothing) to correct either incentives or system design. But the business and cultural norms and system-wide conflicts of interest which form the backdrop to the crisis run deep, and will not change without substantial impetus. It is precisely these deeper issues that we must address if we are to reduce the risk of a re-run of the crisis, probably on a larger scale, in a few years time. I sympathize with the point of view which says that the political window of opportunity is narrow and the need for action urgent, so let's accept the bailout plan for now, and deal with these wider issues later on. But the very fact that political momentum is limited means that if these wider changes are to be brought about, the process has to begin in earnest at once. Does anyone seriously believe that in a years time, if following massive government support the banks are stable - or can be made to appear stable – there will be any political will to break up very large institutions, or any real change to underlying norms in the financial sector? However, absent these deeper changes, it is entirely possible that we will see a replay of the crisis - but on a larger scale - in a few years time. Naturally, one cannot say with certainty that such a cataclysm (and if it were much larger than the current crisis, it really would be a cataclysm) will occur. But if it does, the resulting costs will be huge. Martin Wolf has written persuasively about the costs of major economic dislocation. Net of unemployment, political instability and even wars, the human costs of a sequel could dwarf even the current crisis. Then, the choice in the present between the "bailout" and "restructuring" plans hinges on whether expected cost (in the broadest sense), conditioned on the "bailout" strategy is higher than expected cost conditioned on "restructuring". One could formalize this argument as a decision problem, but it comes down to a judgement call on the relative probability of such a cataclysm under the two strategies and the magnitude of the dislocation. My feeling, admittedly subjective, is that the gloomy cataclysm scenario is substantially more likely under the "bailout" than "restructuring", and that the costs would be immense. This case can be put very simply: if we do not use current political momentum to fundamentally reform a system which has shown itself to be unstable and even dangerous, a second opportunity may come at a very high price. And this is not a gamble I wish to see our leaders make.


"Will the Geithner Plan Work?"

The question is, "Will the Geithner plan work?" There are responses from Paul Krugman, Brad DeLong, Simon Johnson, and me:

How to Tell It's Working, by Mark Thoma, Room for Debate, NY Times Blogs: A bailout plan must do two things to be effective. It must remove toxic assets from bank balance sheets, and it must recapitalize banks in a politically acceptable manner. I believe the Geithner plan has a chance of doing both of these things, but it's by no means a sure bet that it will.

How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem. If the free insurance against downside risk that comes with the non-recourse loans the government is offering doesn't induce sufficient private sector participation, then it will be time to end the Geithner bank bailout. Even if increasing the insurance giveaway would help, legislative approval would be unlikely and the political fight that would ensue would hurt the chances for nationalization.

The second factor to watch is the percentage of bad loans the government makes as part of the program. These non-recourse loans are the source of the free insurance against downside risk. Borrowers can walk away if there are large losses, and if the number of bad loans is unacceptably high (a potential political nightmare), then policymakers will need to act quickly and pull the plug on the program.

Unfortunately, however, the loan terms make it unlikely that we'll have timely information on the percentage of bad loans. But there is something else we can watch to assess the health of the loans: the price of the toxic assets purchased with the loans. If the price of these assets is increasing sufficiently fast, then the loans will be safe. But if the prices do not respond to the program, then the loans will be in trouble.

In that case, we will need to end the program as quickly as possible and minimize losses. The next step will have to be bank nationalization, though the political climate will be difficult. Sticking with the plan until it completely crashes and burns on the hope that a little more time is all that is needed will make nationalization much more difficult.

[The discussion is supposed to continue through today.]

Update: I made similar points in a discussion at Foreign Policy (which is based upon this post):

There were three plans to choose from: the original Paulson plan in which the government buys bad paper directly, the Geithner plan in which the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, and outright nationalization.

So which plan is best? Any plan that does two things -- removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner -- has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has the two necessary features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. This option also comes with its own set of political problems -- problems that will worsen if the loans to private sector "partners" turn out to be as bad as some fear. Finally, the plan for nationalization also includes these two features, but it suffers from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives (though not everyone agrees with this assertion).

I am not wedded to a particular plan. Each has its good and bad points. Sure, some seem better than others, but none is so off the mark that I am filled with despair because we are following a particular course of action.

Thus, I am willing to get behind this plan and to try to make it work. It wasn't my first choice; I still think nationalization is better overall. But trying to change the plan now would delay the rescue for too long, and more delay is not something we dare risk at this point.

Update: A second entry at the NY Times blog:

Random Actions on Failing Banks, by Mark Thoma: Mark Thoma responds to Simon Johnson:

One of Simon Johnson's points is very much worth emphasizing. When this crisis hit, we did not have the procedures in place for an orderly resolution for banks that were failing. Thus, because there were no well known procedures to follow, the actions that the government took when faced with a failing bank appeared ad hoc, almost random, because they were constructed on the fly to deal with problems at individual banks.

The first thing we need to do is to change the regulatory structure so that banks cannot get too big and too interconnected to fail. When they are too big, their failure puts policymakers and the public in a position where there is no resolution that can confine the costs to those who were responsible for the problem. The dynamic is bad both ways: If the bank is allowed to fail, people who did nothing to cause the crisis are hurt. But if the bank is saved the people responsible are let off the hook at taxpayer expense, at least to some degree, and that brings up issues of both moral hazard and equity.

But despite our best efforts, banks may become too large or too interconnected anyway, particularly if the interconnections are not transparent until trouble hits, and that's where we need to do much, much better than we did in the present crisis. We need to have procedures available to resolve problems that are backed with a credible enforcement threat so that everyone understands in advance exactly what will happen to institutions that are deemed insolvent. We simply cannot repeat the uncertainty generating ad hoc, case by case approach that was used in the present case.

[And Brad DeLong has a second entry responding to Paul Krugman.]


Fed Watch: Fed-Treasury Accord

Tim Duy on the Fed's efforts to maintain its independence:

Fed Treasury Accord, by Tim Duy: The Fed and Treasury released a joint statement yesterday afternoon that was lost amid the official release of the Geithner Plan (hat tip Across the Curve). Clearly, it reveals the concerns of the Federal Reserve that its expansive role in the crisis will eventually threaten monetary independence, and thus wants that right/privilege reasserted:

The Federal Reserve's independence with regard to monetary policy is critical for ensuring that monetary policy decisions are made with regard only to the long-term economic welfare of the nation.

The need for such a statement was heightened by last week's FOMC decision to expand the balance sheet via outright purchases of Treasury securities (in addition to mortgage backed securities). Considering the massive amount of red ink fiscal authorities are expected to spill for the foreseeable future, the Fed's action could be interpreted as the first salvo in a campaign to monetize deficit spending. I do not believe that this is the interpretation the Fed intends. Indeed, I believe this is one reason the Fed has shied away from the term "quantitative easing." Note Bernanke & Co. always place the expansion of the balance sheet in terms of the improving the functioning of private capital markets. See Federal Reserve Chairman Ben Bernanke's speech last Friday:

These purchases are intended to improve conditions in private credit markets. In particular, they are helping to reduce the interest rates that the GSEs require on the mortgages that they purchase or securitize, thereby lowering the rate at which lenders, including community banks, can fund new mortgages.

The stated intent is not supporting fiscal stimulus, creating inflationary expectations, nor even fighting deflation. The Fed expects they will withdraw their extraordinary liquidity operations when financial conditions stabilize (see Monday's Wall Street Journal). They expect they will have the political freedom to do so; but the deeper they delve into financial markets, the more politicized their activities become.

The broad points, with my comments:

1. Treasury-Federal Reserve cooperation in improving the functioning of credit markets and fostering financial stability The Federal Reserve's expertise and powers are indispensable for preventing and managing financial crises. The programs it has initiated since the onset of this crisis have played a critical role in helping to contain the damage to the broader economy. As long as unusual and exigent circumstances persist, the Federal Reserve will continue to use all its tools working closely and cooperatively with the Treasury and other agencies as needed to improve the functioning of credit markets, help prevent the failure of institutions that could cause systemic damage, and to foster the stabilization and repair of the financial system.

2. The Federal Reserve to avoid credit risk and credit allocation The Federal Reserve's lender-of-last-resort responsibilities involve lending against collateral, secured to the satisfaction of the responsible Federal Reserve Bank. Actions taken by the Federal Reserve should also aim to improve financial or credit conditions broadly, not to allocate credit to narrowly-defined sectors or classes of borrowers. Government decisions to influence the allocation of credit are the province of the fiscal authorities.

This Fed understands its role is to provide substantial support for the economy. But that support is not intended to be directed toward a particular sector. Of course, it can be argued that the Fed is targeting the housing sector, but they would argue that this is justified given the depth and magnitude of that sector's role in the current crisis. They do not want to be pressured into supporting the auto industry, for example, absent a overriding concern for the economy as a whole. Understandably, they want to deflect criticism that they are pursuing fiscal policy (and subverting the democratic process by doing so). And they do not want to be politically pressured to continue to support any sector - even housing - should they need to withdraw from the financial markets.

3. Need to preserve monetary stability Actions that the Federal Reserve takes, during this period of unusual and exigent circumstances, in the pursuit of financial stability, such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy as needed to foster maximum sustainable employment and price stability. Treasury has in place a special financing mechanism called the Supplementary Financing Program, which helps the Federal Reserve manage its balance sheet. In addition, the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.

The Fed does not want the expansion of the balance sheet to be interpreted as a deliberate effort to devalue the US dollar - a natural concern of financial market participants, as failure to protect the purchasing power of the dollar is virtually the same as a default. Our foreign creditors would not be amused. Again, I believe this is why the Fed shies away from the term quantitative easing, despite its widespread acceptance by commentators. I believe that term, in their minds, refers to a targeting of the growth of the balance sheet with the intention of generating a particular inflation rate. This is not consistent with the language the Fed uses to describe its actions. (Of course, the danger is that the Fed triggers some collapse of confidence in the US Dollar regardless of policymakers best intentions).

4. Need for a comprehensive resolution regime for systemically critical financial institutions The Treasury and the Federal Reserve remain fully committed to preventing the disorderly failure of systemically critical financial institutions. To reduce the risk of future crises, the Treasury and the Federal Reserve will work with the Congress to develop a regime that will allow the U.S. government to address effectively at an early stage the potential failure of any systemically critical financial institution. As part of the framework set forth, the legislation should spell out to the extent possible the expected role of the Federal Reserve and other U.S. government agencies in such resolutions.

The Fed would like to make its future role in crisis management clear so that it is not again forced into a job that arguably exceeds its legal authority and threatens its institutional independence. Sounds reasonable. Finally:

In the longer term and as its authorities permit, the Treasury will seek to remove from the Federal Reserve's balance sheet, or to liquidate, the so-called Maiden Lane facilities made by the Federal Reserve as part of efforts to stabilize systemically critical financial institutions.

It appears the Fed is unhappy with its holding of Bear Stern's toxic debt, and wants the taxpayer liability out of its hands ASAP.

Bottom Line: The Fed is aware that its actions over the past eighteen months has put its independence in danger. They are hoping this agreement helps ensure that independence when the crisis is over. Note also that the Fed is reiterating its policy intentions regarding the balance sheet - and, as aggressive as those intentions are, they are not as aggressive as is commonly believed.


Dissent on "Which Plan is Best?": Dark Musings

This is from Steve Waldman at Interfluidity. I have a few comments at the end:

Dark musings, by Steve Waldman: I often wish I were Mark Thoma. If I were Mark Thoma, I could be smart and paying attention without being bitter.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Unfortunately, I have a darker temperament, a spirit less generous and optimistic than Mark's. I am filled with despair, not because what we are doing cannot "work", but because it is too unjust. This is not my country.

The news of today is the Geithner plan. I think this plan might work very well in terms of repairing bank balance sheets.

Of course the whole notion of repairing bank balance sheet is a lie and misdirection.

The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by legacy bankers.

I think that critics of the Geithner plan are missing some of its tactical brilliance. My guess is that behind the scenes, Geithner has arranged a kind of J.P. Morgan moment. You know the story. During the Panic of 1907, J.P. Morgan locked a bunch of bankers in a room and insisted they lend to stave a panic. We've already seen one twisted parody of this event, when Henry Paulson locked a bunch of bankers in a room and insisted they borrow money from the Treasury. This second one is more clever. I don't think the scandal of the Geithner plan is going to turn out to be the subsidy to well-connected investors embedded in the non-recourse loan put option. On the contrary, I think that Treasury has already lined up participants for the "Legacy Securities Public-Private Investment Fund" and persuaded them to offer prices so high that despite the put, investors will expect to take a major loss. My little conspiracy theory is that the Blackrocks and PIMCOs of the world, the asset managers who do well by "shaking hands with the government", will agree to take a hit on relatively small investments in order first to help make banks smell solvent, and then to compel and provide "good optics" for a maximal transfer from government to key financial institutions. ...

I liked this post today by Matt Yglesias:

My biggest concern about the PPIP approach to the banking system is that even if it works, what it does essentially is return us to the pre-crisis status quo — banks that are so large that they're too politically powerful to regulate effective and too systemically important to be allowed to fail. That's a recipe for dishonest transactions that produce short-term profits at the cost of blowups. One appealing element of nationalization is that it can easily be made to end in a world in which there is no institution named "Bank of America" or "Citi" and no such gigantic institution.

On the bright side, I'm thankful that we have people like Paul Krugman, Simon Johnson, and Willem Buiter, who fight the good fight while being too eminent to ignore.

On the dark side, try here, here, and here.

When I talked about the plans working, I was referring to their ability to repair the financial system while abstracting from their equity properties. But when discussing the relative merits of the plans, I noted that political problems - meaning mainly the equity properties associated with the plans - precluded the Paulson plan altogether and led me to prefer nationalization. So I didn't ignore the equity issue. However, with that said, Steve's right that my outcry against the equity properties of the Geithner plan - where the term "equity properties" is used (perhaps too) broadly to include the kinds of behavior he has in mind - was not as nearly as loud as he thought it should have been.


"Neoclassical Economics: Mad, Bad, and Dangerous to Know"

I can't say I agree with every word of this, but given what just happened to the economy and our general failure to see the signs that it was coming, it's a good time to hear alternative viewpoints about the state of the discipline:

Neoclassical Economics: mad, bad, and dangerous to know, by Steven Keen: The whole of the most recent Real World Economics Review (formerly known as the Post-Autistic Economics Review) is devoted to the question of "How should the collapse of the world financial system affect economics?". My paper, which led volume 49, is reproduced below. ...

The most important thing that global financial crisis has done for economic theory is to show that neoclassical economics is not merely wrong, but dangerous, by Steven Keen: Neoclassical economics contributed directly to this crisis by promoting a faith in the innate stability of a market economy, in a manner which in fact increased the tendency to instability of the financial system. With its false belief that all instability in the system can be traced to interventions in the market, rather than the market itself, it championed the deregulation of finance and a dramatic increase in income inequality. Its equilibrium vision of the functioning of finance markets led to the development of the very financial products that are now threatening the continued existence of capitalism itself.

Simultaneously it distracted economists from the obvious signs of an impending crisis—the asset market bubbles, and above all the rising private debt that was financing them. Paradoxically, as capitalism's "perfect storm" approached, neoclassical macroeconomists were absorbed in smug self-congratulation over their apparent success in taming inflation and the trade cycle, in what they termed "The Great Moderation"... [...continue reading...]


links for 2009-03-24

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