He writes, this morning:
Cash for Trash: The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis? Well, it might.... [But] even if the vicious circle is limited, the financial system will still be crippled by inadequate capital. Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?...
This is analogous to the argument that the Hayekians always made against central bank stabilization policy carried out by open market operations. The problem, the Hayekians said, that the Keynesian central bankers saw was that the prices of safe bonds were too low to bring full employment. The solution the Keynesian central bankers pursued, the Hayekians said, was to print cash and buy safe bonds and so push safe bond prices up and interest rates down until businesses were confident enough that they could make a profit to employ all the workers who wanted jobs. But, the Hayekians said, this worked only because the Keynesian central bankers were buying the bonds for more than their real true value. Eventually the bonds would have to fall back in price to their true value. And when they did, you would find that all the extra investment undertaken during the false Keynesian boom had further increased the overhang of unproductive and useless capital, and that you were in a situation in which the gap between the market equilibrium interest rate and the interest rate consistent with full employment is better than ever.
This Hayekian argument was, of course, dead wrong. Its problem was that it mistook value for being a fact of nature rather than a social relationship among people. The value of something is what people are willing to pay for it. If there is extra liquidity--extra real money balances--in the economy then the value of commodities in terms of nominal yardsticks will be higher and the value of liquidity will be lower--which means that the value of bonds will be higher. There is no "fall back in price to their true value."
Similarly, financial institutions will be grossly undercapitalized if bond prices don't recover and will be well capitalized if bond prices do recover. The way to make bond prices recover--and housing prices as well--is to boost the economy's risk tolerance by raising demand for risky assets and reducing the burden of risk that the private sector needs to hold by reducing the supply of risky assets on the private market. You reduce the supply of risky assets by having the government buy them up. You expand the demand for risky assets by restoring confidence and by providing capital injections. You do both of these at fair prices--at current values--and you find that values have changed *without the governent having to overpay for anything.
This is, I think, what Olivier Blanchard was trying to teach me in the spring of my sophomore year with his disquisitions on the "Metzler model." But I did not understand it at the time...
