More of Why the Paulson Plan is Bad

This time from Sebastian Mallaby. His views are similar to those I and others have noted before, namely the government going around and buying up toxic assets from financial insitutions. There are people who would buy these assets, but there is a problem. The financial insitutions don’t want to sell them at the price these buyers are willing to pay. This indicates that these assets aren’t worth what the banks claim they are, and if the government shows up to buy them they will likely pay too much. And what they are paying with are taxpayers dollars.

The first is whether the bailout is necessary. In 1989, there was no choice. The federal government insured the thrifts, so when they failed, the feds were left holding their loans; the RTC’s job was simply to get rid of them. But in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice. It would spend billions of dollars on the theory that preemption will avert the mass destruction of banks. There are cheaper ways to stabilize the system.

A commenter quipped, “Why not just print $700 billion in cash and give that out.” Why indeed? If you recoil in horror at this notion then in my view you should be doing the same to the Paulson plan. Printing more money is inflationary and is very much like a tax. It takes a little bit of value for money already in circulation and transfers it to the government in the form of the newly printed dollars. Then give it to the financial insitutions that are in trouble and there you go…a stable financial system once again, but with a somewhat higher inflation rate (no we aren’t talking hyper-inflation levels here). This is pretty much what Paulson et. al. are suggesting but with the added benefit of getting all these toxic assets.

So what are some of the alternatives?

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don’t do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don’t want to signal weakness and they don’t want to dilute existing shareholders. A government order could cut through these obstacles.

In other words the government is going to cloud the issue of which banks are closer to the brink than others in the interest of getting banks on healthier footing.

Another suggestion,

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks’ bad loans but by buying equity stakes in the banks themselves. Whereas it’s horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

These are indeed government interfering with the market, but they could mitigate if not even solve the crisis thus keeping the government from intervening in financial markets in even more invasive ways. These also would minimize the impact on the taxpayer which is a good thing. After all, consumer expenditures are one of the things that has often kept the economy going in recent years. Telling taxpayers they are going to be on the hook for trillions of dollars could have the effect of making taxpayers hunker down and spend alot less. And last but not least Paulson’s plan is just plain bad.

FILED UNDER: Economics and Business, US Politics, , , , , , ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.


  1. The government buying into the banks seems like a really bad idea, much worse than my suggestion of printing $700B :).

    Does the government get a seat on the boards of these banks since they will be significant stakeholders? Just think of the cans of worms that could open up.