Monday, September 29, 2008

The revised bailout package is awful

The revised bailout package is terrible. It should not pass. Yves put it best: "turning Hank Paulson's three pager into a 110 page draft made for a nice fig leaf but made virtually no substantive difference." Those, like Paul Krugman, who said "no equity, no deal" should be rejecting this, but as you would expect from a good Progressive, he's backing the civil service plan.

The Paulson Plan was better than the current plan in that it was easy to understand. It would have been even better if it read "Give me $700B so I can give it to firms as I see fit". After Summer's terrible faux pas that got him thrown out of Harvard ("men are different from women, and this difference might be biological") it's not surprising to see him grovel to get back into the good graces of the permanent civil service, but his FT op-ed is drivel.

At heart, I think the problem is the utter failure of academic macro-economics. This is the best Arnold could dredge up
In a comment on my Where are the Macro Theorists? post, G. Martinez says that he teaches the current crisis as a surge in money demand, with Treasuries playing the role of money. Everyone else's borrowing rate goes up, and the rest happens according to a textbook.

That's a good analytical approach.
UPDATE: I'm going to put my original continuation below the fold. I've thought more since.

OK, so now we have a story that we can put into a textbook macro framework (I'll play that game for now). We've had an increase in liquidity preference. Why, if we don't act this weekend, will we get the Great Depression? I don't think that what has happened so far is going to do it. Do we really think that the lagged response of spending to the increase in liquidity preference that has already taken place will be that large? I don't.
What does "increase in liquidity preference" mean? Is a bank run an "increase in liquidity preference?" Can one distinguish between an "increase in liquidity preference" and an "increase in solvency preference", or even an "increase in not wanting to see all my money vanish preference?" Muddled language reflects muddled thinking.

One clear description comes from U Chicago's Bob Shimer. He acknowledges the potential of information assymetry being a potential problem in the MBS market (I don't agree that this is a big issue) and points out that TARP does not fix that:
This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. (Of course, it cannot increase too much, or no one would sell to the government. They would wait to sell at the higher market price. I have not worked out the equilibrium of an auction with an option to resell later. It seems complicated.) But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.
He also points out, albeit in passing, the key problem
What else can the government do? First, it can establish stable rules and play by them. Holding out the possibility of distributing vast sums of money in an unspecified manner does not help market participants value the securities or value the firms. Second, it can prevent panics, i.e. Diamond-Dybvig bank runs. This is what it did when it offered insurance for money market mutual funds, an important source of funding in the commercial paper market. So far, that market appears to be holding up. Third, it can reduce the risk that its current actions encourage future misbehavior. We have already seen evidence of moral hazard in these markets, for example in AIG's decision to turn down a $8 billion offer from J.C. Flowers during the weekend before AIG collapsed.
The informality of the Paulson plan is toxic, and it is why I prefer outright nationalization. If we extend FDIC to non-commercial banks, then it's easy just to get rid of fractional reserve banking altogether, keep deposits in vaults, and just have the US Government lend to firms directly. There is, in fact, one stable equilibrium in the Diamond-Dybvig model and it is the bank run state. Prices, if left to their own devices, will settle at their term matched state.

Looks like the plan is dead. I hope it stays that way.


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