Perhaps I’m being smug, but I think that the financial crisis is clouded in enormous mystery, when the problems are not actually that complex. And perhaps it’s because I’m not as smart as I think and don’t understand the situation. So, at the risk of being patronizing and/or revealing myself as a fool, let me outline the financial situation as I understand it. And I look forward to being corrected. Andy’s post is worth visiting on the political fallout. And I my colleague’s blog is helpful (he knows more than I about this stuff). In what follows I outline what I understand the problems to be, and what the solutions might look like.
(1) The problem is that mortgage securities have dropped in value because of the extension of bad loans and the decreasing likelihood of these loans getting paid back. In English, banks gave out bad loans. Those loans aren’t getting paid back. So the money given out is less than the money coming in.
(2) Banks and other financial institutions now have a higher than desirable debt load (in some instances more debt than capital).
(3) The pervasiveness of this problem of debit to capital means that there are few left in the financial industry to provide capital.
(4) It is this capital that the economy requires (hence the Paulson plan, and many “taxpayer check” models). So where is the capital to come from?
(5) The market solution has been for banks and financial institutions to sell off their debts.
(6) Insodoing they have made matters worse, as the flooding of the market with (bad) debt has lowered the price of such debts, and even other debts. So institutions find that while selling their debt, they’re actually loosing more money. They may be getting some capital, but perversely, the debt:capital ration can get worse.
The solution is quite clear: the state has to provide the capital required for the economy. No one else is in a position right now to extend money. The debate is over how this can/should be done.
The Paulson plan is basically that the US government buys up the bad debts. The advantages are clear:
(a) The value of such debts does not decrease the value of other, not so bad debts (the market is no longer flooded). So the debt:capital ratio goes down in two ways: (1) some debt is actually purchased, (2) the price of debts stops falling.
(b) And more importantly, there is now capital in the markets. Which is what is required.
But I agree that this plan is idiotic. It basically means the state buys the bad debt, creates incentives for poor financial decision making, and gives Wall street a pass. The state can have little expectation of getting paid back anything close to what it purchases the debt for. Hence, this is a “blank check” to the rich.
The (simple) solution is quite similar to the Paulson plan, but does something different (and this is in no way MY idea. I think a lot of folks are basically on board). Rather than buying the debt of institutions, it buys part of the institutions. This has several advantages:
(a) The gets capital into markets. This is part of what’s needed.
(b) Rather than buying up bad debt, the state buys up shares in institutions that incurred such debts.
(c) The state can have a reasonable expectation of return on its investment
(d) Oversight of financial practices can happen not just from outside, but from within firms (a long term advantage).
(e) Firms are not given incentives to act poorly.
There is one big disadvantage. At least as far as I can tell, it will be more expensive. The bad debts will still be there. And it will take more capital within the markets to solve the problem they create. But this plan will infuse markets with capital (reducing the debit:capital ratio). It will give the state wider oversight. And it will give the taxpayer not just the responsibility of writing a check and seeing the money disappear, but rather an not-so-unreasonable expectation of seeing a return on their bailout of the rich.
Paulson’s plan is basically a bail out. Main street gives money to wall street and hopes that it will eventually “trickle down” – the markets are saved and the people benefit from a better economy. Every ounce of understanding and intuition I have suggests that it won’t work out well for Main Street. The alternate plan is that Main street buys out Wall Street. I’m optimistic about this.
I think we should make signs. No Bail Outs! Only Buy Outs!