Academic Economists vs Paulson

A very long list of economists has signed a letter critical of Hank Paulson’s bank bailout plan.

I’m not a huge fan of the Paulson version of the plan myself, but the arguments given in the letter are, I think, pretty weak. There are three grounds on which the letter criticizes the plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

This starts out well: the government should certainly do its best to ensure that the plan doesn’t unfairly benefit investors. But it’s worth rememering that investors have already taken very large losses, and their investments are now approaching (or even, in some cases, below) the minimum value they would have just so long as the US doesn’t enter a macroeconomic tailspin.

More to the point, the idea that "the government can ensure a well-functioning financial industry… without bailing out particular investors and institutions whose choices proved unwise" — well, that sounds really good until you try to get into specifics. I very much doubt that the signatories to the letter could even begin to agree on any way of doing that, but if they could, it would have been really helpful for them to add a footnote, at least.

To be fair, at least one of the signatories, Luigi Zingales, has come up with a skeleton of such a plan; there are others out there. But most such plans involve hurting bondholders a little and stockholders a lot, and there can be unintended consequences to that, as we saw after Lehman collapsed, such as money-market funds breaking the buck, and a vicious stock-price cycle in what seemed to be otherwise-healthy companies. I’m all in favor of salutary losses for stock investors, but the fact is that there is a vital connection between a bank’s stock price and its ability to lend, which means that it’s not a great idea for all financial companies to go to zero simultaneously.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

Again, this starts out well: the mission and oversight of the new agency must be clear. I’m pretty sure Paulson would agree. But I utterly disagree with the more substantive second part. The bailout plan needs constructive ambiguity, or else it will be gamed.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

Do you think that we’re living in a country of unparalleled prosperity? I don’t, and a glance at the poverty statistics would I think back me up. The "unparalleled" bit is definitely wrong: I’m sure that all of us can think of quite a few countries which are just as prosperous as the US but which have very little in the way of "dynamic and innovative private capital markets". How about Ireland, say?

Justin Wolfers says that this letter "summarizes what I think of as the emerging consensus from academic economists". I’d note that Ben Bernanke is, by trade, an academic economist — I wonder whether he might have been tempted to sign it had he remained at Princeton rather than moving to the Fed. I hope not.

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