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Why I am Skeptical of the Paulson Plan

October 3, 2008

With less than 24 hours to go before the House of Representatives is supposed to vote on the version of the Paulson rescue/bailout plan adopted by the US Senate, I thought I would say a few things which I have not heard elsewhere.

The potential financial meltdown strikes me as a very interesting and complicated story. The quality of the information available in blogs has been far superior to anything available in the mainstream press. In part this is probably because there is so much relevant information that it is impossible for the mainstream press to present it all within the space constraints that they face. In part it is due to the fact that the mainstream press is populated by journalists not economists and understanding and presenting this story requires analytical skills that most members of the press don’t possess. In contrast, there are many great economics blogs written by people who do possess such skills.

I am sure there are others, but here are some of the blogs I have found particularly helpful in understanding what is going on and possible steps to ameliorate the problem:

  • Will Wilkinson’s interview with Arnold Kling on BloggingHeads.tv. (I find Will’s interviews really good, perhaps because I find myself thinking like Will with somewhat disturbing frequency!)
  • Arnold Kling’s blog posts at EconLog.
  • Tyler Cowen’s blog posts at Marginal Revolution.
  • NakedCapitalism also passes on some pretty interesting information.

Here are some of the reasons I am skeptical:

  1. $700 billion is a lot of money.
  2. Under the Paulson plan, this money is to be spent to acquire so-called "toxic" assets consisting of various varieties or mortgages and mortgage backed securities. If the government pays more than fair market value (i.e. what one would pay in a well functioning market, not the lockup we have now) then this is a direct transfer of wealth from the US taxpayers to the holders of those mortgage assets. If these were loans of preferred stock investments, at least the Treasury would get its money back if the firm survived. With asset purchases there is a big chance that the government will be taken to the cleaners by holders of these assets.
  3. The "plan" that passed the US Senate is festooned with a collection of market-distorting tax breaks and other programs that are bad for the country.
  4. In the shadow of the bailout, $25 billion in loan guarantees for US automakers sailed through Congress and will be signed into law by the President. No tell me again about how the Paulson Plan does not create any bad precedents for future actions.
  5. I believe that the credit markets are more resilient and faster moving than Hank Paulson. I believe that participants in those markets will be able to organize around new market realities faster than ever before. Just as information technology has made other economic adjustments faster, it will do the same for the credit markets.
  6. I am not convinced that everyone should have seen the housing bubble for what it was. Bubbles are only bubbles in retrospect. Sometimes there really are extraordinary changes which are not bubbles. Was the runup in the price of oil a bubble, or the Canadian dollar, or Dell stock?
  7. I fear a successful Paulson Plan would just prolong the pain of making some big adjustments in the way the credit markets work. Attempts to preserve many existing players would just prolong those changes. Given the amount of liquidity the Fed is putting into the system (circa $600 billion) doesn’t the credit lockup in the face of that suggest that the problem is one of (i) too little capital at financial institutions for the system to continue as it was, and (ii) maybe that is a good thing if there was too much credit available before.
  8. The possibility of the Paulson Plan passing (or other government responses to high mortgage default rates) may be what is preventing markets from being able to price mortgage backed securities, leading those market to freeze up.
  9. If there were more transparency about financial firms, parties to transactions could do a better job of addressing counterparty risks, including those associated with leverage. The Paulson Plan does nothing to address this.
  10. Couldn’t some form of accelerated bankruptcy work better?
  11. Would net worth certificates for financial institutions be better?

Here are some doubts about my positions above:

  1. I don’t know as much about financial markets as Hank Paulson and Ben Bernanke.
  2. I don’t have a good explanation of why mortgage backed securities are not trading. Markets price uncertainties all the time, why would uncertainly prevent this market from working?
  3. There may be technical aspects of the regulations and laws that govern credit markets and their players that would make some of my alternatives counterproductive and my observations incorrect.
  4. Most financial crises are the result of people suddenly realizing that a society’s assets were not efficiently allocated. (After all, financial assets ultimately represent claims on tangible assets.) Beyond the deployment of too many assets into residential real estate, are there other misallocations that need to be corrected? I don’t know.
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