Doug Elmendorf for Treasury Secretary

He writes:

Concerns about the Treasury Rescue Plan: One approach is to purchase mortgage-related debt or other troubled securities.... Yet this approach has significant disadvantages.... First, the affected debt instruments are quite heterogeneous, which makes setting appropriate prices and quantities very difficult.... A second problem with buying troubled debt is that it provides the most help to the financial institutions that made what are, in retrospect, the worst investment decisions.... Third, this approach saddles taxpayers with significant downside risk but limited potential upside gain....

An alternative... is for the government to make equity investments in a wide cross-section of such institutions. For concreteness, suppose that the government offered to make an equity investment in every firm regulated by a federal or state banking regulator equal to 10 percent of the market value of the company as of September 1st in exchange for a 10 percent equity stake in the company. (The 10 percent figure is illustrative. As with the first approach, a judgment about the appropriate total amount of government funds would need to be made.)... [T]he government would not need to determine the appropriate prices and quantities of individual mortgage-related securities, it would not be providing a greater reward to companies that have made the worst investments, and it would gain the opportunity for taxpayers to receive a higher return if the financial system recovers more strongly. Still, objections can be raised.

First, the even-handedness of these investments means that they would not focus on the firms facing the greatest stress, which might damp the immediate bang-for-the-buck.... A second difficulty would be choosing the companies that would be eligible for this offer.... Third, firms that were optimistic about their future prospects without government assistance would likely decline this offer. But shareholders would be unlikely to hold out in expectation of a better deal from the government in light of the losses suffered by shareholders in the Federal Reserve and Treasury rescue operations this year.

A fourth objection is that the government would be a minority shareholder and could not control the institutions in which it invested. Therefore, this approach could not be used to help struggling mortgage borrowers directly; any additional assistance to borrowers would need to be channeled through the Federal Housing Administration or some other entity. In addition, the government could not dictate corporate strategies regarding asset accumulation or liquidation. This passive shareholder position creates some risks, but it avoids substantial risks associated with the government attempting to control and manage the entire financial system.

Whichever of these broad alternatives the government pursued—buying mortgage-related debt and other troubled securities, or investing in a wide range of financial institutions—the assets acquired would need to be divested over time. After the financial crisis has passed, the government would sell its holdings to private investors on a gradual basis over a period of years.

Luigi Zingales for Deputy Secretary:

The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.... Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision. My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices, but bond prices as well, soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equityholders, but also the debtholders....

Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

Comments

[Justin Rietz]

From which capitalists are we saving capitalism? The crooks on Wall Street who are in bed with the crooks in the U.S. Congress and White House?

They are not capitalists. They are mercantilists, or more aptly, supporters of socialism for the wealthy.

The Federal Reserve members such as Ben Bernanke, Alan Greenspan, Janet Yellen and their loose money friends?

They are not capitalists. They are technocrats who believe their doctorate degrees and economic acumen have granted them the ability to single-handedly manage the world economy. They could be mistaken for a communist central planning agency, except that they set the price of perhaps the most important good in the world economy: the U.S. dollar.

To summarize the bailout:
1. Easy credit leads to a bubble in the stock market and real estate.
2. Financial institutions leverage to the hilt due to lax fractional reserve banking requirements.
3. The asset bubble bursts.
4. Financial institutions look to Washington D.C. for bailouts an receive warm welcomes from ex-bankers turned politicians.
5. "Voluntary" committees of powerful business leaders are brought together by the government to "coordinate" a solution.
6. Members of the U.S. Congress call for a halt to mortgage foreclosures.
7. Under stress and short of time, the federal government hacks together a multi-billion dollar bailout program to be footed by the taxpayer.

This is a description of the 1930's bailout under Hoover. Did you think I was describing the present? True, hard to tell the difference....

[Frank Dean]

While I'm sure things would have gone better with Rubin and DeLong at Treasury from 2000-2008, surely the time to save capitalism from the capitalists was back in the 1990s. The Clinton administration was not exactly skeptical, conservative, or resistant when Wall St. was pushing for the further deregulation of financial markets. Where were the initiatives to coherently and comprehensively regulate financial innovations? Was there any resistance to Greenspan's magical thinking about a new era of productivity? Instead, Clinton signed Phil Gramm's "do whatever you want" bill. Unfortunately for the American taxpayer, the foxes are still in charge of the chicken coop.

[JoeKool]

An economist I am not, but my layman understanding of the Fed's mandate is that it includes a responsibility to ensure that credit bubbles don't develop. If so, the 'Maestro' Greenspan is where the buck stops. His life in retirement must be a nightmare with no end.

[W. Raymond Mills]

Any solution beats no solution. To stop the Paulson express, an alternative solution must be advanced by creditable people - like Brad DeLong and his friends and colleagues.

Try this as a starter:

Congressional leaders were said to be dismayed when confronted with the depth of the problem. They were also said to be dismayed that no one other than Paulson had a solution. Shouldn't more than one solution be considered?

For example, try viewing the problem as an accounting problem. These toxic contracts are not hurting anybody directly. If they were removed from the market by some other means other than Federal purchase, would that not be a solution?

I propose quarentine. Remove these toxic contracts from the market temporarily and then restore them later, after the current owners have positioned their firms that they are able to take them back on their books without problems.

Establish a Federal agency to receive, store and manage these toxic contracts temporarily, with the original owners able to repossess their contract any time they choose.

The proposed legislation would specify that the agency would only accept contracts voluntarily stored with them. While these contracts are stored off the market, they cannot be bought or sold and any hypothetical change in their value would not be refected in the books of the owners. The value of these toxic contracts would be held constant, by law, at the level they were estimated to have at the time they were stored. When recovered, their value would be reassessed at the market level at that time.

I encourage Economist to come up with other alternatives. This one is radically different from the massive bailout. Will it do the job?
What do you think? A major advantage of this proposal is that it can be tried first and if the problem persists, the bailout can be considered.

[The fastest growing municipality was Las Vegas]

"Any solution beats no solution," which is the type of thinking that made in acceptable for Greenspan to play ball with Bush, the politicized Fed. Later in his never ending career Greenie went to Pimco the firm that gamed the Fannie/Freddie bail-out.

[david]

It's not at all clear what you mean by the "free market system" you support.

Profits are private now, and losses are being socialized now. If that cow's out the barn, what does it mean to support the system? Seems to me the key is, keep the Republicans from running this show, they're the most likely to socialize the costs. I'm not optimistic.

[bakho]

http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf

Zingales wrote the last paragraph, too.

[Brue Moomaw]

For whatever it's worth, Sebastian Mallaby is also backing your two guys -- for the same reasons: http://www.washingtonpost.com/wp-dyn/content/article/2008/09/20/AR2008092001059.html