Preview

As of this morning, Congress has pretty much decided to move forward with the largest rescue plan of the financial system in U.S. history. The plan, in its current form, involves the government buying up to $700B of illiquid securities from Wall Street at above market prices.

Let me say, for the record, that I oppose this plan or any plan that involves such massive government intervention in the credit crisis. Essentially, I view this plan and the bailouts more generally as unfair and ineffective: unfair because losses caused by poor lending decisions should not be socialized to all taxpayers collectively, and ineffective because intervention does not allow asset prices to correct to levels where lending makes more sense.

A more appropriate course of action is to let the market correct and allow the financial sector to shrink if necessary. I see no reason to prop up a financial system that drove itself into bankruptcy. The adjustment process may be painful, but it is necessary if we want the finance industry to change for the better.

How did we get here?

Credit expansion in the last decade has been tremendous. One consequence is that home prices have been rising at increasingly rapid rates since 1997. In 2005-2006, most markets reached levels which were unsustainable, and home prices have been falling ever since.

During the housing boom, Wall Street got rich securitizing mortgages and other debt obligations which were easy to pay back when home prices were rising by 5-10% per year. But once home prices stopped rising, Wall Street got caught holding billions of dollars of mortgage debt and consumer debt that will not be paid back.

Since a typical Wall Street bank balance sheet contained less than 5% equity, these losses ended up wiping out shareholders completely. As things got worse, investors started pulling money out of the credit markets, causing a credit squeeze for municipalities, banks, and even money market funds.

Now we are in a situation where the short-term credit has essentially frozen up, so that borrowing money to fund short-term liabilities is extremely expensive. In response, Congress is about to infuse Wall Street with $700B of capital purchases to address the problem.

The bailout proposal

As I understand it, the proposed Wall Street bailout boils down to this: the Treasury gets $700B to purchase commercial paper and mortgage-backed securities at above market prices. There would be no need for intervention if they were buying at the market price since firms can sell to the market already (though at a substantial discount from par value).

Readers can see the plan described in detail in the following two news articles:

• NYTimes: "Party Leaders Back Revised Plan for Bailout"
• Washington Post: "Lawmakers Reach Accord on Huge Financial Rescue"

The first issue is figuring out how much the bill will ultimately cost taxpayers. One main argument for buying these securities above the market prices is that the market is functioning so poorly that prices are way below fundamental value. Bernanke and Paulson argue that taxpayers will eventually benefit from the plan since the government will be buying the assets below their long-term value.

Even Warren Buffett has weighed in and thinks that the U.S. government might come out ahead if the bailout is properly executed:

[Buffett] said a positive return was feasible if the government ignores the book value of instruments or the original cost to banks and instead pays the prevailing market rates for the bombed out assets.

"They'll pay back the $700bn and make a considerable amount of money if they approach it like that," said Buffett. "I would love to have $700bn at Treasury rates to buy fixed-income securities - there's a lot of money to be made."

- "Banking crisis: Warren Buffett sees US bailout as a golden opportunity", The Guardian

But stop and think about this: does it really make sense for the government to take risks with taxpayer money when private investors won't take the same risks themselves? I'm sorry, but the U.S. Treasury is not Hank Paulson's private hedge fund of taxpayer capital. I don't care what Paulson thinks the securities are worth. The government should not be in the business of financial speculation with taxpayer money. Taxpayers do not need the government to do this for them.

So I don't think it's a valid argument that the government speculation might payoff for the taxpayer. Even so, I find it hard to believe that the plan will come out ahead in the end. If it's so easy to make money in these markets, why aren't private investors buying these distressed assets already?

Let's assume (safely, I think) that the plan comes with at least some taxpayer cost. It would be possible to convince me to spend some amount of collective taxpayer money to avoid a financial crisis, but I would want to consider two fundamental issues: (1) efficacy and (2) fairness.

In terms of efficacy, I don't have a lot of faith that the current plan will do any good. How many bailouts have we had already that have helped us "avoid" this crisis? Bear Stearns, Fannie Mae, Freddie Mac, AIG, need I go on? I don't see how the next round of government money solves the massive imbalances that exist in the credit market. I'm also afraid that this bailout won't be the last one.

As for fairness, any direct transfer of wealth from the general population to the finance industry is a disgrace. This is the same industry that gave outrageous bonuses to CEOs and managers from 1996-2007. At least some portion of this industry will get a huge windfall from selling their junk securities to the government at above market prices, and this is unacceptable.

I would tolerate a small amount of unfairness for a large amount of efficacy, but this is not the trade-off I am seeing. All of the bailouts so far seem largely ineffective in preventing the credit crisis from worsening. And given the extreme wealth generated by the finance industry during the credit expansion in the last 10 years, I'm not feeling obligated to help them out during the credit contraction.

I am not alone in opposition to the plan. Almost 200 academic economists from over 25 highly respected universities have signed a petition against the current plan (see Bloomberg: "Hundreds of Economists Urge Congress Not to Rush on Rescue Plan"). The petition reads:

September 25, 2008:

To the Speaker of the House of Representatives and the President pro tempore of the Senate:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed 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.

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.

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.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.

While this opposition may have been more directed towards the initial Paulson plan (which, according to economist Alan Blinder, was either "a joke or a disgrace"), the objections still pretty much hold for the revised version.

Addressing the problems more directly

What are the real, negative economic outcomes we are trying to avoid with a credit meltdown? Here's one: businesses, individuals, municipalities, and entrepreneurs who want to borrow money for productive purposes now face a higher price of credit. But is this really so bad?

Certainly fewer businesses will expand and take risks if the price of credit goes up, but who am I to say or who is the government to say whether the risk-taking is too high or too low? That is what the market is for. Just because a small business could expand by acquiring a loan doesn't mean that it should. The cost of borrowing is going up since too many risks were taken when credit was cheap.

Most finance companies need to change the way they do business. Making loans to capitalize on rising asset prices turned out not to work. Many weak businesses need to fail, and the stronger companies need to adapt. But propping up a financial system that drove itself into bankruptcy makes no sense.

Here's another negative outcome to which I'm more sympathetic: unemployment caused by the business contraction. Consider the following excerpt from the NYTimes:

In a brief speech on the Senate floor, Senator Kent Conrad, Democrat of North Dakota, said: "It’s not just going to be Wall Street. The chairman of the Federal Reserve has told us if the credit lockup continues, three million to four million Americans will lose their jobs in the next six months."

- NYTimes: "Party Leaders Back Revised Plan for Bailout"

Unemployment is perhaps worth addressing, but I'd rather do so directly. It makes more sense to me to alleviate this problem by increasing short-run unemployment benefits rather than pumping money into a financial system that doesn't work. And I bet that it would be cheaper in the long-run.

Finally, I don't see how taking money from taxpayers (directly or through inflation) and pumping it into the credit markets makes us collectively better off. Every dollar that is taken away from you and me is one less dollar that can be spent for alternative consumption or investment. If the marginal benefit of putting the money to work in the credit markets were truly so high, why would we need the government to do it for us?

Do we truly believe that the economy will "implode" if the price of credit is higher than it is now? Companies can still borrow, just not as cheaply as before. The business model based on cheap credit does not work anymore, and the longer we ignore this reality, the longer the adjustment process will take. But even if you could convince me that government intervention were absolutely necessary, I'd rather see the government providing cheaper credit for new debt instead of buying debt that already exists.

Fed Watch 2008

Nobody wants the Fed to raise rates into this recession. The consequences of doing so would be horrific for housing and for the credit markets more generally. But they can't really lower rates either now that inflation at a 17-year high, and well above the Fed's target inflation rate of 1-2%:

Think about Washington's response to the last financial crisis: the popping of the Internet Bubble. President Bush and Congress pushed through massive tax cuts and the Federal Reserve held the target Fed Funds rate below 2% for 3 full years:

Essentially, the U.S. ran huge fiscal deficits and made credit extremely cheap in the interest of short-run prosperity. With the benefit of hindsight, we know that cheap credit helped fuel a Housing Bubble which misallocated an enormous amount of resources from productive economic activity to homebuilding and excess consumption. Would someone please tell me how the plans to stimulate the economy this time around are any different?

It's possible that this economic stimulus will help create a third bubble to follow the Internet Bubble and the Housing Bubble. This is the investment thesis of bubble guru Eric Janszen of iTulip.com, who published a superb piece on this issue in Harper's Magazine in February: "The next bubble: Priming the markets for tomorrow's big crash."

But I think hardly anyone would argue that the Housing Bubble "saved" our economy from the 2001-2002 recession. So much of the economic "growth" in the last 5 years was due to artificially rising home prices. Does anybody actually believe that the Housing Bubble has made us better off?

Here's the point: Washington's efforts may avert a short-term crisis, but what crisis can we expect in the future as a consequence? If it's a currency crisis with the U.S. dollar, count me out. The dollar has lost 40% of its value since our efforts to prop up the economy since 2001. Is it really worth going down this path all over again? I'd rather take the medicine now than face the future unknown consequences of our actions, which could be much, much worse.

Let the market correct

At the end of the day, my preferred course of action is to let the market correct itself. I certainly think this would be better than the current plan. But as I mentioned, even if you could convince me that short-term intervention were necessary, I'd like to see it much smaller and targeted towards different objectives. Here's one of the best ideas I've read so far:

"Conversation with Mr. Practical", Minyanville

Mr. Practical: The way to eventually heal the system is to let bad banks fail and just protect the savings at those banks. The dollar, ironically, would remain stronger in the long run if we let the right amount of debt be destroyed without supporting equities of insolvent institutions.

Toddo: So you’re saying we should basically “hit tilt” and start over.

Mr. Practical: Don’t support worthless equity and print only enough dollars to protect savings. This is the only way to eventually attract private capital back into the market.

They keep talking about instilling confidence, but the only way to instill confidence for investors is to not print money/create more debt to solve a debt problem. If not, private capital will remain on the sidelines and the only liquidity will be from borrowing from the future. [emphasis mine]

Credit markets will not be normal again until asset prices correct to levels where lending is much less risky. Until that happens, expect slow growth moving forward. I'd prefer policies which let the market correct sooner rather than later so that this crisis lasts years and not decades. The process may be painful, but not as painful as it will be if we refuse to let the private markets purge the quantity and keep the quality.