Friday, September 26, 2008

the bailout

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Everything about this bailout sucks. Like most people, I’m pissed off.

But, on balance, I support it. Barely. (“It” being something along the lines of the bill Chris Dodd and Barney Frank have worked out, not what Paulson originally proposed.)

WTF? How could I support this monstrosity? Well, “support” might be too strong a word. Somewhere between "support" and “on the fence” might be more like it.

Let’s get a few things straight first.

I don’t trust anything this administration does or says. The likelihood that I would agree with the Bush administration on any matter of policy is less than random. Much, much less. Indeed, it would be an extraordinary coincidence were I to agree with George Bush about anything.

The manner in which this proposal was sprung on Congress and the American people would cause any sane person to assume it should be rejected out of hand without any further consideration. On the Friday a week before Congress is about to adjourn for a presidential election we’re told a massive bailout for Wall Street must be passed right now—after the administration has been telling us for months that everything is OK. On top of that, a White House spokesman
insisted earlier this week that the Poulson plan was not slapped together at the last minute but “had been drawn up as a contingency over previous months and weeks by administration officials.”

We’ve seen this picture before. In the immediate aftermath of 9-11 we had the monstrous “USA PATRIOT Act” foisted on an obedient Congress eager to demonstrate bipartisanship and national unity. That 342-page law enforcement wish list, which had obviously been in the works long before 9-11, was passed with virtually no debate. (It passed 98-1 in the Senate with only Feingold voting against it. It passed 357-66 in the House.)

Despite that bipartisan unity, Rove announced that the Republicans would use the “War on Terror” as a wedge issue for partisan gain in the 2002 midterm elections, which they did -- ruthlessly. In that spirit, in October of 2002, the Bush administration forced a vote on the “Authorization for Use of Force” in Iraq. After all, we wouldn’t want national unity at a time of war when there is partisan advantage to be gained. Republicans controlled Congress, but Democrats cowered in the face of accusations of weakness and insufficient patriotism. We know how that one turned out.

And, again, before the 2006 election, George Bush insisted to the American people that everything was going great in Iraq and we were “winning” – only to fire Donald Rumsfeld the day after the election.

Now, again, a national crisis demands immediate action before an election with no time for deliberation or consideration of alternatives. We have to trust them and act immediately. With no review of subsequent Treasury actions by any other agency or court of law and no Congressional oversight. A two and a half page grant of virtually unlimited discretion.

When Congressional Democrats insisted that any bailout plan include limits on executive compensation at participating firms and that the federal government get equity stakes in those firms,
we were told that those things would be bad. Insisting on an equity stake, “would limit participation in the program. Only failing banks would be willing to give the government stock in exchange for buying up their bad assets.” Huh??!! Why would we want to help banks that are not failing? Don’t take my word for it. Here is a direct quote from a White House spokesman:

With respect to executive pay, again, I'm not going to get into specific, point-by-point details on what our views are on that, other than the Secretary of Treasury said it would make more difficult to make this plan work and effective if you provide disincentives for companies and firms out there who are holding mortgage-backed securities and other securities from participating in the program. You have to remember, these are not all weak or troubled firms that own mortgage-backed securities. A lot of them are very successful banks and investment houses that have done very well, have been responsible, are holding performing assets that have value. They were not necessarily irresponsible players, and so you have to be careful about how you deal with them.

We “have to be careful how we deal with them”? How about NOT dealing with them? If they are “not weak or troubled” and are “very successful” then obviously let them fend for themselves. On the other hand, if they really need a bailout, then they can take whatever Congress decides to give them, including restrictions on executive compensation and an equity stake for the taxpayers putting up the money.

If we are going to socialize the downside, we need to socialize the upside, too.

Really, the logic of the bailout, as proposed by Paulson, has been puzzling from the start. As
I’ve noted before, Paul Krugman has done a good job critiquing that logic. I won’t repeat it here.

But Krugman now seems to be
coming around
to supporting the bailout as it has evolved through negotiations with Congress:

Many people on both the right and the left are outraged at the idea of using taxpayer money to bail out America’s financial system. They’re right to be outraged, but doing nothing isn’t a serious option. Right now, players throughout the system are refusing to lend and hoarding cash.

It’s true that we don’t know for sure that the parallel is a fair one. Maybe we can
let Wall Street implode and Main Street would escape largely unscathed. But that’s not a chance we want to take.

So the grown-up thing is to do something to rescue the financial system. …

[T]he bipartisan “agreement on principles” released on Thursday looks a lot better than the original Paulson plan. In fact, it puts Mr. Paulson himself under much-needed adult supervision, calling for an oversight board “with cease and desist authority.” It also limits Mr. Paulson’s allowance: he only (only!) gets to use $250 billion right away.

Meanwhile, the agreement calls for limits on executive pay at firms that get
federal money. Most important, it “requires that any transaction include equity

As I’ve said before, I’m highly skeptical of anything I can’t understand at least at a high level of abstraction. I still don’t understand why Paulson and Bernanke proposed to buy troubled assets rather than inject equity into troubled financial institutions. Eventually, in Congressional testimony, Paulson suggested that the goal is “price discovery.” As I understand it, the argument is that there is insufficient liquidity in the markets to establish a true “market price” for a large volume of trouble assets. The Treasury, by buying up some of those assets, would establish a market price, everyone can mark their assets to market, confidence will be restored, financial institutions will trust again in the solvency of their counterparties, and everyone will start lending and borrowing again. That seems like quite a leap of faith to me.

Krugman shares that skepticism:

The fundamental problem with our financial system is that the fallout from the housing bust has left financial institutions with too little capital. When he finally deigned to offer an explanation of his plan, Mr. Paulson argued that he could solve this problem through “price discovery” — that once taxpayer funds had created a market for mortgage-related toxic waste, everyone would realize that the toxic waste is actually worth much more than it currently sells for, solving the capital problem. Never say never, I guess — but you don’t want to bet $700 billion on wishful thinking.

The odds are, instead, that the U.S. government will end up having to do what governments always do in financial crises: use taxpayers’ money to pump capital into the financial system. Under the original Paulson plan, the Treasury would probably
have done this by buying toxic waste for much more than it was worth — and gotten nothing in return. What taxpayers should get is what people who provide capital are entitled to: a share in ownership. And that’s what the equity sharing is about.

The Congressional plan, then, looks a lot better — a lot more adult — than the Paulson plan did. That said, it’s very short on detail, and the details are crucial. What prices will taxpayers pay to take over some of that toxic waste? How much equity will they get in return? Those numbers will make all the difference.

I still believe there are better approaches than the one on the table now. For example, James Galbraith laid out a
good alternative in a Washington Post op-ed yesterday. Simply put, Galbraith would just beef up the FDIC, raise the limits on the size of accounts that are insured by FDIC, and leave things to well-established procedures for dealing with troubled banks. This approach has been made more practical by the fact that all five major investment banks have now disappeared or been morphed into regular banks. Makes sense to me.

I’m sure there are other approaches that also make sense. But, alas, the option on the table seems to be the Dodd/Frank modification of the Paulson proposal.

How important is it that we act immediately? Again, I am skeptical. I would rather wait 40 days until after the election and review matters then. Different approaches could be developed and negotiated in the meantime so the new president-elect has some more say in the matter. Tragically, the sums involved, after squandering a trillion or two on the Iraq war, pretty much ensure that any other national priority will be starved of funding for a generation or more. And this is the most radical intervention in the financial markets since the Great Depression. The process could certainly benefit from greater deliberation.

This is where one has to take a leap of faith, one way or the other. Given the stakes involved, I’d rather wait and see. But if we get it wrong, and there is a real need to act immediately, we could face a financial meltdown that would hurt everyone, not just those who deserve it. It is a sad state of affairs when the insistence on the need for urgency expressed by president of the United States is actually a strong factor against taking urgent action. But there are people I trust in this process.
First and foremost, I trust Warren Buffett. He has already committed to giving his vast wealth to the Gates Foundation (without even his name on some venerable institution as his legacy). He is practical, lives relatively simply in Omaha, and is an Obama supporter. He is also the wisest counsel on financial matters I know and has been warning against exactly this scenario for years. He has called this an “economic Pearl Harbor.” That carries a lot of weight with me.

The world’s best bond manager, Bill Gross, in a Washington Post
op-ed on Wednesday, also expressed his view that this plan is needed. His lack of self-interest is much less apparent than with Buffett, but I have been reading his monthly Outlook pieces for years and I trust his values and judgment. He knows what he is talking about. (He is also an Obama supporter.)

Yesterday, I heard a long radio interview with Yale economist Robert Shiller who predicted both the dot-com meltdown (in his book “Irrational Exuberance”) and the current crisis. He, too, expressed the need for a bailout (and explictly endorses the term “bailout” as opposed to any other less inflammatory euphemisms). And, of course, I have previously cited Krugman’s reluctant path toward acceptance of some plan along the lines of the one currently on the table.

I think we are as a nation fortunate to have Ben Bernanke at the helm at the Fed right now. He is probably the pre-eminent academic scholar on the subject of the Great Depression and credit crises and he has had enough experience in the world of actual policy, both at the White House and at the Fed, to temper his academic background. Indeed, he is probably the only economist to survive contact with the Bush administration with his professional reputation and integrity intact. I hate to even think where we would be with Greenspan (perhaps the greatest culprit in this whole disaster) and John Snow (a political hack) at the helm right now. I am ambivalent about Paulson. He is unquestionably smart and knows this stuff. But he hasn’t shown particularly good judgment as Treasury secretary and his Wall Street background is a mixed blessing. We certainly need someone in charge right now who knows the financial markets intimately. But I fear his lifelong Wall Street affiliation creates too strong an institutional bias toward the needs of the financial community. In short, his experience is valuable but suspect.

Similarly, Chris Dodd is smart and experienced. In general, I like him, but he is too close to big financial interests for me to follow his lead without question. Barney Frank, on the other hand, I trust and I’m glad he is taking the lead in these negotiations in Congress.

So when I look for guidance from those I trust and respect on these matters, I (very reluctantly) come down on the side of accepting the need for quick action. I absolutely understand those who disagree – and disagree vehemently. Emotionally, that is where I am, too. How quick do we have to act? The failure of Washington Mutual yesterday – the biggest bank failure in US history – nudged me further toward accepting the need for action sooner rather than later.

To be clear, while the need for liquidity and confidence in the markets is the immediate crisis, I don’t believe liquidity and confidence are at the root of the problem. Fundamentally, the problem is one of valuation and solvency.
As I have written before, we have perhaps trillions of dollars in bad “assets” in the system that are going to have to be written down or written off over time. As that happens, a lot of firms and individuals are going to find that they are insolvent. And across every sector of our economy, we have a massive debt problem. The process of de-leveraging, assuming we get out of this crisis intact, is going to be a decades-long process and is going to involve a lot of pain. I fear the only way that de-leveraging is going to occur in an orderly manner is through a slow process of inflating our way out of it. And it will be a HUGE drag on growth in this country (and the world). The result is likely to be some form of stagflation (or, at the very least, stagnant economic growth).

This is all tragic. As I wrote above, the trillions squandered on this crisis and the Iraq war, as well as the trillions in debt resulting from Bush’s tax cuts, will ensure that every other national priority is starved of funds for a generation or more. President Obama will inherit a financial system in ruins, two wars, and massive debt, while also facing the urgent need to address the climate crisis, a dysfunctional health care “system” and a large number of other difficult and urgent needs. He will need our strong support, even if he stumbles at times along the way. Just as in Iraq, where we face no good options, the same can be said of the economy and many other challenges. As in this current crisis, there will be lot of choosing among bad options.

Finally, any bailout will result in some people and some firms being rescued from their own greed and stupidity. There will be bad actors – a lot of bad actors – who deserve to be punished harshly by the market who will instead benefit from the need to keep the economy functioning. But I learned a long time ago that, in life, you sometimes have to simply accept imperfect justice if the desire to see bad people and bad deeds punished would inflict greater harm on others who don’t deserve it. Or the flip side: Sometimes in pursuing a good thing for good people, bad people will also benefit. Perfect justice is not always attainable and sometimes attempts to pursue it only result in more harm or lost opportunities. This may be one of those instances where the actions required to prevent harm to many undeserving people with have the unavoidable “externality” of benefiting bad actors, too. I don’t like it. But I also understand that sometimes it is unavoidable except at a greater cost.

Bush deserves to preside over the full consequences of his disastrous policies. But the rest of us don’t.

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