Bad bailout (22 Sept 2008)

Since returning from vacation, I've read little other than posts about the banking industry's continued implosion and the various bailouts meant to rescue it. The most recent issue is Treasury secretary Hank Paulson's plan to spend unlimited billions without any oversight buying up banks' bad assets in a contemporary version of the Resolution Trust Company, which was deployed during the 1980s savings-and-loan bailout. Paulson's idea seems to be to stop the financial crisis by fixing banks' balance sheets once and for all, through the magic process of letting banks replace failing, ill-considered, or impossible-to-price items on it with what the banks want them to be worth in government (aka taxpayer) cash. With the toxic assets -- strange how toxic has moved from a business journalism cliche to a virtual term of art -- cleansed from the system, banks can resume borrowing short and lending long again as their business model demands. As Mark Thoma points out, this will work if the problem is illiquidity. If the banks are actually insolvent, what's needed to bail them out is a massive capital infusion -- money for nothing. Given the nature of the assets the government would acquire under the Paulson plan, it's not clear if there is a difference.

Most experts and pundits and economists who have commented on Paulson's plan seem to hate it. (Steven Waldman has a good roundup here.) Some question it because it rewards an industry for its failure to effectively perform its most basic function -- evaluate credit risk so that it can make loans to make money. Some are skeptical because it gives Paulson unchecked power to help his former compatriots on Wall Street. (The proposal features this banana-republic-appropriate codicil: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.") Some wonder why it uses taxpayer money to prop up an industry that has doled out to itself millions in bonus money while doing nothing to help the wage-earning classes directly. Some are curious about why the banks should be able to get away with selling assets no one else wants to the government at sweetheart prices. Many note that this is risk-free socialism for the rich -- the gains of entrepreneurship are privatized while the losses are socialized. Accordingly, most commentators want to see a taxpayer stake added to the plan, under which the government gets to own part of the firms it helps out -- a debt-for-equity arrangement of some sort. But such an arrangement would threaten to nationalize the banking industry.

Would that be a terrible thing? It could, in economist Luigi Zingales's phrase, "save capitalism from the capitalists." Of course, bankers don't like such a thing, and as Zingales points out, it is much easier for those few bankers to coordinate and argue their side to Congress then the many taxpayers who would get nothing under the Paulson plan. So it seems unlikely that the plan will be modified too much in our favor. But hey, we got a lot of overpriced and inefficient houses in the exurbs out of this whole mess.