Tuesday, September 23, 2008

Krugman on Treasury Proposal: "The more I think about this, the more skeptical I get"

Princeton economist Paul Krugman thinks the bailout through and doubts it will be effective:
What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.

First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.
Senator Chris Dodd now has a competing bailout proposal. Krugman likes Dodd's proposal better:
I’ve had more time to read the Dodd proposal — and it is a big improvement over the Paulson plan. The key feature, I believe, is the equity participation: if Treasury buys assets, it gets warrants that can be converted into equity if the price of the purchased assets falls. This both guarantees against a pure bailout of the financial firms, and opens the door to a real infusion of capital, if that becomes necessary — and I think it will.

Can this be done? Can the Paulson juggernaut be stopped? I’m starting to think yes. Paulson displayed a lot of arrogance here — he basically marched in and said Daddy knows best, don’t worry your pretty little heads about the details. He offered no, zero, zilch explanation of how the plan was supposed to work — just “it’s a crisis and we need to act now.” And he overreached, especially with that demand for immunity from any review.

Now we’ve had a lot of pushback from economists and financial analysts, and the realization has sunk in that this particular daddy has shown very little sign of knowing best. So there’s a real chance to do something quite different.
Update: It appears that Paulson has agreed to the Dodd plan.

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