Academic Economists vs. Paulson

A very long list of economists has signed a letter critical of Hank Paulson's bank bailout plan.

I'm not a huge fan of the Paulson version of the plan myself, but the arguments given in the letter are, I think, pretty weak. There are three grounds on which the letter criticizes the plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers' expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

This starts out well: the government should certainly do its best to ensure that the plan doesn't unfairly benefit investors. But it's worth remembering that investors have already taken very large losses, and their investments are now approaching (or even, in some cases, below) the minimum value they would have just so long as the US doesn't enter a macroeconomic tailspin.

More to the point, the idea that "the government can ensure a well-functioning financial industry... without bailing out particular investors and institutions whose choices proved unwise" -- well, that sounds really good until you try to get into specifics. I very much doubt that the signatories to the letter could even begin to agree on any way of doing that, but if they could, it would have been really helpful for them to add a footnote, at least.

To be fair, at least one of the signatories, Luigi Zingales, has come up with a skeleton of such a plan; there are others out there. But most such plans involve hurting bondholders a little and stockholders a lot, and there can be unintended consequences to that, as we saw after Lehman collapsed, such as money-market funds breaking the buck, and a vicious stock-price cycle in what seemed to be otherwise-healthy companies. I'm all in favor of salutary losses for stock investors, but the fact is that there is a vital connection between a bank's stock price and its ability to lend, which means that it's not a great idea for all financial companies to go to zero simultaneously.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

Again, this starts out well:The mission and oversight of the new agency must be clear. I'm pretty sure Paulson would agree. But I utterly disagree with the more substantive second part. The bailout plan needs constructive ambiguity, or else it will be gamed.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America's dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

Do you think that we're living in a country of unparalleled prosperity? I don't, and a glance at the poverty statistics would I think back me up. The "unparalleled" bit is definitely wrong: I'm sure that all of us can think of quite a few countries which are just as prosperous as the US but which have very little in the way of "dynamic and innovative private capital markets". How about Ireland, say?

Justin Wolfers says that this letter "summarizes what I think of as the emerging consensus from academic economists". I'd note that Ben Bernanke is, by trade, an academic economist -- I wonder whether he might have been tempted to sign it had he remained at Princeton rather than moving to the Fed. I hope not.

Comments

[freeAgent:]

I suspect it's worded weakly and is overly vague because the authors wanted to attract as many signatories as possible. I'm sure that many of these academics have much more to say on the subject but kept it to a general disapproval of the current plan in order to magnify their voice. Seeing how Bernanke and Paulson are attempting to ram this through Congress, I can understand why they would want to release this as quickly as possible.

2008 Sep 24 12:56 PM

[debtacid:]

Here is my draconian but Constitutional solution: Decentralize power.

Bail out only the individual and married/joint U.S. tax payer. Only tax payer bank accounts, 401k, and pensions. Freeze U.S. tax payer losses immediately.
The IRS will be abolished and over 20 years, every dime of income tax they have collected since 1920 will be refunded.
Abolish the Federal Reserve.
Abolish fractional reserve banking.
Re-establish the gold standard.
There is no reason why banks should be any more profitable than your local car wash. Bank depositors will voluntarily make their deposits available for lending from 5% to 7%. The depositor will collect the monthly interest and pay the bank a fee. Max mortgage life will be 10 years, No interest greater than 7% on anything.
The major goal of this plan is to stop the plundering of Main street by Wall street, Washington and international bankers.

2008 Sep 24 01:15 PM

[MarvinMBA:]

The bailout plan will do nothing for the average guy...actually inflationary and costly jepordizing funding for education, health and social programs.
Alternately the Fed could help the bank by guaranteeing new loans only which seems to be the major immediate problem. Let those that have gambled for higher rates with the subprime mortgages claim the underlying assets like everyone else has to do that has invested in a securitized bond. There are no guarantees in this world for anyone...why for the select few that are detached from our real working man economy anyway...the average guy is broke and your going to add this to his back...come on its just not fair and will do NOTHING for the average guy except burden him..MarvinMBA

2008 Sep 24 01:21 PM

[whidbey:]

As a retired academic I assure you that this tiresome set of comments can be safely as nitpicking. The man is business trying to deal with Congress which is utterly impossible, so he must let the children paint the bailout many colors and put bows and ribbons on it, if he wants to get it through. What most of us are missing is that is some urgency in his efforts since he knows things we can only guess at, like several more banks are bleeding internally and need transfusions before their demises. I suspect the sudden taste for truth is driven by their discovery that this crisis has spread overseas, and outside the financial sector. Shocking they did not guess that was going to happen, but look at who they are, just ordinary men who have never taken broad strokes until recently. The academics and corporate officers are poor field generals and worse leaders, so naturally they are getting bad press and lots of heckles from their former colleagues.
The bad mouthing should be ignored, but not the central question: what doe those two know that we do not. Think the worse and I bet you will be short of the truth.

2008 Sep 24 02:07 PM

[markg:]

Felix, where are the facts to back up one point you made? The main problems with the Paulson plan are:

We are taking tax payer dollars to make the same institutions more solvent that lost their solvency through mis-management, doesn't anyone else see a problem with this?

The premise of the Paulson plan is that liquidity is needed for financing growth, and I agree with this, but idea the plan proposed to implement this is faulty. Why not funnel liquidity into the economy through paths that have demonstrated success? Where is the economic growth path? Paulson has yet to elaborate on that little detail.

Bernanke stated at his confirmation hearings that we were not in a housing bubble. Do you thrust his judgement now? I sure as hell don't.

2008 Sep 24 03:17 PM

[GaryB:]

Maybe they should just give everyone $10k, leave the money market protection in place and call it good.

2008 Sep 24 06:33 PM

[carey_jim:]

There is unparalleled prosperity in America combined with unparalleled inequality which produces the illusion that America's GDP is declining.

America leads the world in creativity and inventiveness and the freedom to create wealth through free enterprise (and not monopolies.)

America also leads the first world in financial inequality.

America's motto: Let the talented and privileged prosper and let the stupid and unfortunate starve.

The problem we face is, how can we reduce the "inequality effect" of free enterprise capitalism without reducing the incentive of the talented and talented well-born to create wealth and distribute it using markets and price mechanisms.

I believe an attack on monopoly capitalism is the answer, not a bailout of failed "free" enterprise ventures that can't produce wealth and/or provide profitable methods to distribute goods such as real estate and other services such as health and legal services.

Good luck making this happen without the incentive of severe crises such as the present one. But the simple existence of a crisis doesn't assure that a good solution will be found as the present bailout proves, IMO of course.

2008 Sep 25 11:00 AM