Arnold Kling  

Wishful Thinking

An Open Letter to Ben Bernanke... Why Only Bush Could Bring Soci...

Concerning the $700 billion bailout proposal, Brad DeLong writes,

I beg the Democrats in congress: write a bill that makes sense.

I probably should have warned you to put your coffee down first.

Now that you're finished guffawing, here's my take. Like Brad, and like Paul Krugman, I think that this bill gives awesome power to the Treasury Secretary. Unlike Brad and Paul, I wouldn't take the deal even if it came with a guarantee that the secretary of the Treasury would be someone they could trust.

Think about what $700 billion could buy, if you weren't using it to bail out the financial industry. I can't talk about mosquito nets and anti-malaria drugs for Africans, health care for the uninsured, and stuff like that, or they'll take away my libertarian union card. Let's stick to the purpose of doing something about the housing and mortgage markets.

Let's say we decided to give the money to households in order to put into equity into their homes. If you figure roughly 140 million households, then that's $5000 per household. If everyone added $5000 to their housing equity, there would be fewer defaults.

But that's silly. Most people already have plenty of housing equity. Only a few people are what I call "home borrowers." A home borrower, as opposed to a home owner, is someone who bought a house with less than a 10 percent down payment. If you did that, you are not a home owner. You are living in a borrowed home. I'm not judging you or criticizing what you did, just putting your situation in perspective.

Anyway, suppose there are 10 million home borrowers out there. Now we give $700 billion to them to use as home equity supplements, meaning that they put the money into their mortgages. That's $70,000 of housing equity per household, and $70,000 less mortgage debt per household. I think we could safely declare the mortgage crisis over. In fact, if you look at it that way, it's clear that we could solve the mortgage crisis for a lot less than $700 billion.

A couple of points.

1. We are not "giving" people anything. We are taking money from taxpayers and spending it on other taxpayers. Again, I feel like I need to say that to keep my libertarian union card.

2. Bernanke and Paulson don't think of what they are doing as charity. It's more like an entrepreneurial business, where they intend to buy what they think are undervalued mortgages assets, which they believe they can finance profitably.

They may be right, but if they took their business plan as written to any bank or VC, they'd be laughed out of the office. The plan is utterly vague, untested, and there is no proof that they have or can find the executive talent needed to run a pilot program of this kind, much less scale it up to $700 billion.

I tend to think that voters are really, really stupid. But I am optimistic that they will sense that the Paulson plan is not in their best interest. My guess is that if Congress goes home and faces the voters before they pass the bill, rather than the other way around, the plan will die a well-deserved death.

UPDATE: Yves Smith is, like me, a plan-basher. Pointer from Greg Mankiw, which suggests that Greg is at least skeptical.

Tyler Cowen says,

Count me in too, among those screaming "no!"

Tyler and I have talked a lot about financial doomsday scenarios and systemic risk. Both of us have taken a relatively favorable view of government intervention to date. But this proposal has pushed each of us over the edge.

On the other hand, The New York Times reports that

there is wide agreement that a broad intervention like the one Treasury is proposing is necessary.

The article proceeds to cite Alan Blinder among other supporters.

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The author at Dean's World in a related article titled The $700 billion Bush proposal to bail out lenders writes:
    Since my belated realization that this was a serious policy proposal and not merely a trial balloon, I’ve been meaning to write a post criticising it. But it appears that Arnold Kling has saved me the trouble. In addition to Kling’s objecti... [Tracked on September 21, 2008 8:54 PM]
COMMENTS (22 to date)
Tgriffin writes:

Sunlight is the best disinfectant. Paulson should be required to fully reveal what he has done after the fact and the processes he will use before the fact.

A business model is a technology. And that technology evolves just like "real technology." Sometimes people create technology (e.g., derivatives) that can create massive negative externalities for society as whole. And regulators fail to understand that technology- until things happen that are very painful. When you go understand it, you need to react-- but not fool yourself that you will see it before the fact next time. To help with this "technology moving faster than regulators problem" you need to create transparency via regulation. Not just transparency to regulators like the people in the government agency who failed to regulate Fannie and Freddie, but the public.

If you take a complex adaptive system, and central banks flood the system with money to make it more stable when a problem happens (repeat this time after time) you may just be setting yourself up for the really big shock (you are deferring adjustments and making them cumulative not eliminating them). As Taleb talks about, "fewer but massive shocks".

Warren Buffett may not agree with all of this below, but the statements in bold in particular seem like they would resonate with him.

Below is a Statement of Principles for the Treasury Proposal from Senator Barack Obama:

No blank check. If we grant the Treasury broad authority to address the immediate crisis, we must insist on independent accountability and oversight. Given the breach of trust we have seen and the magnitude of the taxpayer money involved, there can be no blank check.

Rescue requires mutual responsibility. As taxpayers are asked to take extraordinary steps to protect our financial system, it is only appropriate to expect those institutions that benefit to help protect American homeowners and the American economy. We cannot underwrite continued irresponsibility, where CEOs cash in and our regulators look the other way. We cannot abet and reward the unconscionable practices that triggered this crisis. We have to end them.

Taxpayers should be protected. This should not be a handout to Wall Street. It should be structured in a way that maximizes the ability of taxpayers to recoup their investment. Going forward, we need to make sure that the institutions that benefit from financial insurance also bear the cost of that insurance.
Help homeowners stay in their homes. This crisis started with homeowners and they bear the brunt of the nearly unprecedented collapse in housing prices. We cannot have a plan for Wall Street banks that does not help homeowners stay in their homes and help distressed communities.

A global response. As I said on Friday, this is a global financial crisis and it requires a global solution. The United States must lead, but we must also insist that other nations, who have a huge stake in the outcome, join us in helping to secure the financial markets.

Main Street, not just Wall Street. The American people need to know that we feel as great a sense of urgency about the emergency on Main Street as we do the emergency on Wall Street. That is why I call on Senator McCain, President Bush, Republicans and Democrats to join me in supporting an emergency economic plan for working families – a plan that would help folks cope with rising gas and food prices, save one million jobs through rebuilding our schools and roads, help states and cities avoid painful budget cuts and tax increases, help homeowners stay in their homes, and provide retooling assistance to help ensure that the fuel-efficient cars of the future are built in America.

Build a regulatory structure for the 21st Century. While there is not time in a week to remake our regulatory structure to prevent abuses in the future, we should commit ourselves to the kind of reforms I have been advocating for several years. We need new rules of the road for the 21st Century economy, together with the means and willingness to enforce them.

PJens writes:

I completely agree that the 700B proposal is a bad idea. I am not waiting until my reps get home, I have already sent them letters.

My main objection is that once the federal government owns the bad loans, there will be very little incentive for the borrowers to make good on their end of the contract. The government will not be able to sort out, much less enforce, that many contracts. I foresee future political pressure for the government to forgive the loans and start fresh.

What really scares me though and it has been pointed out several times in this blog, is the looming Medicare crisis.

How many weeks are left to educate voters?

ErikR writes:

Warren Buffett may not agree with all of this below, but the statements in bold in particular seem like they would resonate with him.

I doubt Warren Buffett would want his name associated with anything about the plan. Buffett does not buy what he cannot understand and put a valuation on. Even if someone did manage to put a value on some of the paper and somehow forced Buffett to buy, I'd bet Buffett would insist on a huge margin of safety (i.e., purchase price far below the estimated value) -- something I doubt the government would insist on.

Flip writes:

The current proposal reminds me of a quote from Gary North earlier this year:

"I am in favor of tax-free rebates from the Federal government -- any time, any place, any amount. Just send out the checks. The taxpayers can do better things with their money than the Federal government can.

So, I am in favor of Federal deficits, if the alternative is higher taxes. I am in favor of lower taxes, even if these lead to higher deficits. I think the Federal government will not cut spending for any reason but one: bankruptcy. So, as long as the beast is going to spend
money, it might as well raise it by borrowing. Let the people who trust the government wind up as creditors to the government. When the government defaults, one way or the other, those hurt most will be those who trusted politicians the most. This is as it should be. There is a kind of raw justice in the arrangement."

E. Barandiaran writes:

I'm afraid you're becoming too hysterical. First, you refer to BDL and PK, two dishonest economists who are only interested in having someone they like in charge of the program (with the same broad authority that Paulson may get). Second, you assume that Paulson's proposal will be a huge bailout of financial institutions but then you acknowledge two points that may imply a small bailout. Third, the problem is how to stop politicians not how to persuade "stupid" voters: since we know that politicians will not face voters before passing the bill, rather than "wishfully" thinking about how to stop them, you should attempt to give them good suggestions on the terms and conditions to purchase the assets.

josh writes:

Where can I get my hands on one of those libertarian union cards?

Methinks writes:

First, I didn't know that Paul and Brad were still considered economists. I thought they gave that up to write comedy long ago.


1.) we are taking money from taxpayers and mostly giving it to non-taxpayers.

2.) Ben and Hank are freaking out, praying and trying desperately to seem relevant. Cox is trying to keep up by taking his lead from Pakistan and attempting to kill one of the only still functioning markets we have left. Somehow, I prefer to disagree with you and imagine that Hank and Ben don't honestly think that they can more accurately value these mortgages than the countless market participants.

I agree with professor Kling that voters are incredibly stupid and I had a friend call and screech on the phone for about half an hour about just how stupid they are only today. However, somebody isn't buying this bag of manure because ever since the spus (S&P 500 futures) opened for trading this evening, they've been falling - currently down 1.26%.

Les writes:

If you say things only to keep your libertarian union card, are you sure you really are a libertarian?

E. Barandiaran writes:


This is about your update. From reading Tyler's posts on the crisis, I conclude that you have chosen the wrong person to discuss it. I'm not surprised that he screams. But screaming is not substitute for analysis. At a time in which many people are confused about the consequences of the proposal, I assume that some analysis and in particular recommendations about the terms and conditions of the purchase of assets are welcome. If you're interested in a serious discussion of the proposal I suggest that you make clear the specific instrumental objectives for which incentives are needed. Given the basic idea of the proposal, the terms and conditions of the purchase of assets should provide incentives (a) to limit the purchase of assets to those financial institutions that because of liquidity problems may be forced into liquidation, and (b) to facilitate a quick restructuring of these institutions. For both objectives sellers must repurchase the assets with the prohibition of distributing profits and with restrictions on compensation until all assets are repurchased.

ErikR writes:

John Hussman makes an excellent point:

The appropriate solution is not for the government to replace the bad assets with public money, but rather for the government to execute a receivership of the failed institution and immediately conduct a "whole bank" sale -- selling the bank's assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.

The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost.

For example, consider Morgan Stanley's balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?

stylized.fact writes:

Handing over $70K per head to the bottom percentile of those cursed by self-deception and hyperbolic discounting sounds like a pretty big hole digging exercise to me. Besides, I don't think the Chinese govt would allow for it.

Why not nationalize the credit rating agencies (consumer and secondary market raters) and impose some sort of psychological coaching on those with money problems and status envy (that highly sought after school district where they borrow their house). The current system of personal bankruptcy credit counseling is in bad need of reform.

E. Barandiaran writes:


Thanks for referring to Hussman's post. There is a much easier way to achieve what Hussman proposes. Further to my previous comment, assuming the seller's obligation to repurchase the assets, the seller should be required not to distribute profits, not to pay interest on any outstanding senior bonds, and to limit compensation to senior management to less than 50% of the average compensation paid in the past 5 years until all assets are repurchased.

silvermine writes:

As a person who pays tons of taxes and cannot afford a house (yea, I live in CA), I would be really really really really pissed off if I end up with the government taking thousands of dollars from me that I worked for and giving it to people so that their company they screwed up and their house they can't afford can still be okay.

No, I have no better plan. No I have no idea what to do. But I was responsible. I didn't do this. Well, I probably own a fund that helped do this, which pisses me off. But I don't think I'll be able to *ever* get past the emotional response I have to having my money taken to give homes to people who can't afford them. People I told they shouldn't do it, and they laughed and did it anyway, because out here in silicon valley "homes never lose value". Because we have magic house fairies, apparently.

I will never get past this evil trillion dollar socialization crap.

M. Sean Webster writes:

What is $700 Billion dollars right now? At the rate of decline of the value of the dollar, even if AIG gets back onto their feet, they are going to be sitting in the same pool as every other Insurance corporation, mortgage lender, etc. At rock bottom, with the economy falling behind them. Compare the situation to a mythological serpent. Once the head is removed, the body becomes useless.

Frejus writes:

Libertarians and conservatives seem to be working overtime now to "demonstrate" and "prove" how the current crisis is the result of regulation, not the result of lax regulation. The best one I've seen: it's the fault of all them poor people.

Markets are exuberant. That's a fact. They sometimes explode or implode. And network effects--or coupled risks--can easily allow the exuberance to harm innocent bystanders.

Hence building codes. Driving laws. And market regulation.

Conservatism and libertarianism themselves have suffered a spate of irrational exuberance, starting with Reagan and building from there. It's over.

Conservatives and libertarians should have regulated themselves. Now they will pay the price. They've lost the argument and will increasingly become irrelevant. Their time has come and gone--at least for a a decade or two. And by that time, peak oil will have set in for real.

Nathanael Nerode writes:

You are wrong about what thing. Paulson is *not* planning to "buy what they think are undervalued mortgages assets, which they believe they can finance profitably".

In fact, every evidence, including leaks from Congressmen, indicates that he is planning to buy them at OVERVALUED prices in order to shovel money into 'preferred' companies, essentially recapitalizing them directly at taxpayer expense. Lehman can fail, but Goldman Sachs, Paulson's old company, will be given cash by the truckload.

peter jackson writes:

So Arnold,

Am I ignorant to think that the Federal government, especially now that it owns Fannie and Freddie, can simply promise to re-tranche these mortgage backed securities by reissuing them after replacing the crap paper in them with higher rated paper? I imagine that would cost less than 700b and it would directly address the problem that started it all, wouldn't it?


Less Antman writes:


Libertarians are not blaming this on poor people. We are primarily blaming it on those rich people who have gotten rich by an arrangement in which profits are privatized but losses are socialized. The problem is moral hazard among lenders, and the solution they've offered is more of it. We're objecting to the Treasury department creating a charitable foundation whose beneficiaries will be multi-millionaires.

If we care about the ability of poor people to afford housing, we ought to look at all the land use restrictions that have, for example, made it a criminal offense to build housing on more than 80% of the land in the San Francisco Bay Area. We should also realize that subsidizing low interest loans benefits bankers, realtors, and construction contractors much more than it does buyers, who would be better off actually having the purchase price of houses be lower, which would be the case without all the policies artificially lowering the interest rates on mortgages (the same problem applies to higher education: all these low interest student loan programs have allowed universities to jack up their prices and help students graduate with massive debts).

Housing is relatively affordable in Texas, including areas that have boomed financially, because they haven't been able to attract support for significant land use restrictions. Housing was affordable in California, including areas that were booming financially, as recently as 1970, before the infamous Petaluma case allowed all these restrictions to be imposed in areas that are more than 4/5ths undeveloped. Housing would be more affordable throughout the country without interventions designed to encourage massive lending.

Collapsing housing prices, like collapsing personal computer prices, would be wonderful.

Lee Haslup writes:

Bernake's and Paulson's assertion that the $700 billion is an investment that may show a positive return is highly likely to be optimistic but it is not risible. Even the riskiest mortgage-backed securities represent at least some real value. They are not worth their book value but they are not worthless. They are merely insanely difficult to correctly value and, with the financial markets thoroughly spooked, may well be under-priced compared to their unknowable value.

I don't point this out to argue in favor of the plan (although it may well be the best of the bad choices available) but to suggest that if you are going to complain about the plan you should do so fairly. When you speculated about other things the fed could do with 700 gigabucks you listed expenditures where the money was simply spent. To fairly compare the bailout with outright spending you should reduce the cost to some guess of the amount the Fed will actually end up losing on the deal.

Jim Ancona writes:

My son passed along this link, where Chicago GSB professor Luigi Zingales suggests an alternative [pdf], , a government-imposed debt-for-equity swap. I'm no finance expert, but it at least seems to put the costs in the right place.

I'd be interested in others' takes.


floccina writes:

I can't talk about mosquito nets and anti-malaria drugs for Africans, health care for the uninsured, and stuff like that, or they'll take away my libertarian union card.

True, but your card does enitle you can talk about DDT for for Africans.

The Libertarian Union

floccina writes:

We are not "giving" people anything. We are taking money from taxpayers and spending it on other taxpayers. Again, I feel like I need to say that to keep my libertarian union card.

Yes and who are they taking the money from? Well some it will come from the responsible people who saw the ridiculous house prices and stayed n cash waiting for prices to fall. Some will come from responsible lenders who did not make bad loans. And will they give the money to? The irresponsible.

BTW my business partner joked that we should let the IRS have and collect on the mortgages. The IRS would get the mortgagee’s his employer to pay before the employee gets to touch the money. If additional payment is due and the mortgagee is late one month, the IRS would ht him with a $1,000 file. The IRS would make the mortgagee report how much they owe and if they make a mistake $1,000 fine. If the mortgagee is out of work and refuses to pay the IRS will put him in jail.

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