We Need the Bailout

We Need the Bailout September 29, 2008

Quite simply, the whole financial system is headed for a meltdown. While many will gleefully cheer the fall of those whose greed brought them to the precipice, we must keep in mind that ordinary people will ultimately suffer here. Nobody can obtain credit. Investment plummets. Unemployment skyrockets. Remember the Great Depression: 25 percent unemployment and massive poverty, with few social safety nets. Yes, it’s that serious. We need to hold our noses and take action now, making sure we deal with the more structural issues (making sure this does not happen again) at a later stage.

Having looked at some of the proposals, I side with Paul Krugman and Brad De Long: since the core problem is less a liquidity issue than a lack of capital, and since the private sector is unwilling to pump in funds, the first best solution would simply be nationalization, putting large insolvent banks with insufficient capital into conservatorship. This has the benefit of wiping out shareholders and giving the taxpayer a stake in the upside. At the moment, though, we need to stay focused on what is realistic, and large-scale nationalization is simply not realistic. A version of this plan proved highly successful during the major early-1990s banking crisis in Sweden, and the taxpayer did not end up losing money. Some form of public re-capitalization might ultimately be needed.

So what of the Paulson-Bernanke plan of creating a taxpayer-funded vehicle to remove toxic mortgage assets from banks’ balance sheets? Again, not ideal, as it benefits shareholders. But although nationalization would probably be a better deal for taxpayers, it is not certain that taxpayers would lose, and quite possible that they would gain. Bernanke’s reasoning on this front has been attacked, but it has some merit. Because of the widespread fear and loathing of these assets right now, nobody will touch them with a ten-foot pole. Everybody is trying to dump them, which of course makes the price collapse– this creates further losses and compounds the solvency problem. This “firesale” price is well below their true value. These assets still have value. Put it another way: most people are not defaulting on their mortgages, and the widespread sell-off assumes they are. The problem is one of information: nobody knows where the bodies are buried. If, therefore, they are purchased at a price that is above the firesale price and yet below their true “hold-to-maturity” price, then banks will be willing to participate and taxpayers will actually make money.

Sounds too good to be true? The problem is that nobody reallys knows how to value these extremely complicated assets, making it highly uncertain that the government will indeed get a good deal. Which is why it is important that taxpayers be protected from loss, in the form of equity warrants (though, in the compromise agreement, this protection is not as strong as it could be).

It is also important to look at the budgetary implications, as noted by Larry Summers. It’s frustrating that people focus only on spending 700 billion dollars of taxpayer’s money, failing to note that they are getting assets (which still have value) in return. Indeed, as noted above, the taxpayer could still come out of this on top. Another point noted by Summers is that the usual argument of large government deficits sucking up funds that would otherwise be used for investment (“Rubinomics”) doesn’t really apply here, as the government is just issuing debt to purchase asset-backed securities. In other words, Jim Lehrer notwithstanding, there is little reason to think that fiscal priorities such as health care reform should be scaled back to pay for this bailout, especially since cutting the deficit in the midst of a recession makes things worse. Of course, bad spending and tax proposals that cause the deficit to balloon should be scaled back anyway…

So, all in all, the plan is imperfect, but we need it. And we need it now, as the meltdown might well be imminent. What makes it all so frustrating is that some politicians– Republicans in particular–seem willing to destroy an economy to further their electoral ambitions.

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