Is it too late to turn this ship around?
I'm becoming more and more unsettled at the prospect of spending $700 billion to bail out the financial system. I have very little confidence that the terms of the bailout will be sufficiently painful for the bailees or that this bailout will not have to be followed by similar bailouts of other parts of the financial system. I'm uncomfortable with the idea of the U.S. government taking an equity stake in major financial institutions - as if our government and the finance industry did not already have an unhealthily incestuous relationship.
So what's the alternative? Let's get back to basics. Read through Krugman's four-point analysis of how we get into this mess below. He says the Paulson plan intervenes at step 4 - where falling asset prices force firms to deleverage - whereas it would be best for public intervention to occur at step 2, where firms are undercapitalized. I suggested that intervention at step 1 - where households begin defaulting on their mortgages - would also be helpful.
But Krugman is missing step 5 - where the deleveraging of financial institutions dries up credit to households and businesses, forcing a reduction in spending and pushing the economy into a recession. The only reason we care about steps 1-4 is because step 5 naturally follows; if there was no effect on the real economy we would happily sit back and watch the carnage from the sidelines.
So I propose that public intervention come at step 5. The government has already made steps in this direction when it took over (or took back) Freddie Mac and Fannie Mae. The U.S. government is now the ultimate home mortgage lender, and consequently mortgage rates have fallen. The government has lending facilities for student loans, farm loans, small business loans, and myriad others. The task now is to pick up the pace. The Treasury and the Federal Reserve have been quite creative in setting up new lending facilities for the benefit of investment banks and broker-dealers. How about a lending facility for businesses to replace the commercial paper market? How about a lending facility for consumers to ease the pinch from credit card debt? How about an expansion of the small business lending program to provide small businesses with the financing they are having trouble getting from their banks? Government could also provide deposit facilities, allowing individuals to buy Treasury securities in small amounts if private money market funds cannot be trusted not to put depositors' money into unsafe short-term securities. Does financial turmoil threaten pension funds? Create facilities to bail out the pensioners, not the pension companies. I'm not smart enough to think through all the details, but surely someone out there is.
The idea is to provide islands of credit availability independent of the for-profit financial system so that turmoil in the financial system can be allowed to run its course with a minimal impact on the real economy. The inspiration is Keynes, who argued that because investors seeking profit are prone to wild swings between optimism and pessimism, the aggregate level of investment cannot safely be left in private hands. Today it is not the investors whose swings from optimism to pessimism are to blame, but the providers of finance. Having the government replace private institutions as provider of credit in large swaths of the financial system will help stabilize the economy.
Are there problems with this approach? Sure. In general we'd prefer rational investors to make lending decisions rather than the government. Unfortunately rational investors are in short supply these days. We probably don't trust government to direct flows of capital for long-term investment - imagine the auto plants divvied up among key Congressional districts, the biofuels plants dotting the landscape of farm states with early primaries. These problems can be avoided by restricting the government's intervention primarily to money markets rather than capital markets. Nevertheless there are surely some inefficiencies in this approach - but it's hard to imagine that they are worse than what we'll get from the Paulson or Dodd plans.
So what's the alternative? Let's get back to basics. Read through Krugman's four-point analysis of how we get into this mess below. He says the Paulson plan intervenes at step 4 - where falling asset prices force firms to deleverage - whereas it would be best for public intervention to occur at step 2, where firms are undercapitalized. I suggested that intervention at step 1 - where households begin defaulting on their mortgages - would also be helpful.
But Krugman is missing step 5 - where the deleveraging of financial institutions dries up credit to households and businesses, forcing a reduction in spending and pushing the economy into a recession. The only reason we care about steps 1-4 is because step 5 naturally follows; if there was no effect on the real economy we would happily sit back and watch the carnage from the sidelines.
So I propose that public intervention come at step 5. The government has already made steps in this direction when it took over (or took back) Freddie Mac and Fannie Mae. The U.S. government is now the ultimate home mortgage lender, and consequently mortgage rates have fallen. The government has lending facilities for student loans, farm loans, small business loans, and myriad others. The task now is to pick up the pace. The Treasury and the Federal Reserve have been quite creative in setting up new lending facilities for the benefit of investment banks and broker-dealers. How about a lending facility for businesses to replace the commercial paper market? How about a lending facility for consumers to ease the pinch from credit card debt? How about an expansion of the small business lending program to provide small businesses with the financing they are having trouble getting from their banks? Government could also provide deposit facilities, allowing individuals to buy Treasury securities in small amounts if private money market funds cannot be trusted not to put depositors' money into unsafe short-term securities. Does financial turmoil threaten pension funds? Create facilities to bail out the pensioners, not the pension companies. I'm not smart enough to think through all the details, but surely someone out there is.
The idea is to provide islands of credit availability independent of the for-profit financial system so that turmoil in the financial system can be allowed to run its course with a minimal impact on the real economy. The inspiration is Keynes, who argued that because investors seeking profit are prone to wild swings between optimism and pessimism, the aggregate level of investment cannot safely be left in private hands. Today it is not the investors whose swings from optimism to pessimism are to blame, but the providers of finance. Having the government replace private institutions as provider of credit in large swaths of the financial system will help stabilize the economy.
Are there problems with this approach? Sure. In general we'd prefer rational investors to make lending decisions rather than the government. Unfortunately rational investors are in short supply these days. We probably don't trust government to direct flows of capital for long-term investment - imagine the auto plants divvied up among key Congressional districts, the biofuels plants dotting the landscape of farm states with early primaries. These problems can be avoided by restricting the government's intervention primarily to money markets rather than capital markets. Nevertheless there are surely some inefficiencies in this approach - but it's hard to imagine that they are worse than what we'll get from the Paulson or Dodd plans.
posted by Maynard at 9:56 AM
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