Sunday, September 21, 2008

Bailout Notes

I'm a little skeptical of the new proposed bailout. It may work, and Bernanke and Paulsen obviously understand the situation much better than I do, but it seems as though going to the "heart of the problem" may not be what's required in this situation.

The rationale behind the bailout is pretty straightforward: the financial system has been teetering on the brink of disaster because it's ultimately tied to these risky loans and securities that were worth less than people thought. If the government buys up all those loans, it should reduce uncertainty, since they will get a fixed price, and reduce the overall strain on the system.

However, the government doesn't pretend it can buy up all the bad debt, and the basic weakness of the plan is that it assumes that the heart of the problem is its source. An analogy here would be a set of dominos. If you figured out that the first domino to fall would probably be in the first 20, you could cut off those from the rest. Your whole structure of dominos would certainly be safer, but it wouldn't exactly be "safe".

It's the same way with the financial crisis. Our current financial system has created a surprising number of ways for money to get from "securities" (things like houses, the collateral behind the rest of the system) to "loans" (basically the exit of the money from the system). Part of the problem is that these elaborate systems were built on top of very small pieces of real value. It's clear that those systems need to be slimmed down now. The question is how to shrink them without collapsing the entire structure. At the moment, the Fed/Treasury are playing a large game of jenga where they decide which pieces would bring the whole thing tumbling down (i.e. the elimination of AIGs credit swaps).

Paulsen and Bernanke's gamble is that artificially restoring the value of the stuff at the bottom (i.e. houses) is the best hope for maintaining the rest of the structure. In other words, giving "bad loans" a stable value will restore some measure of confidence, and alleviate the current "credit crunch". As number economist bloggers have pointed out, this largely means buying these loans/securities at above market value. But the plan seems a little too reactionary, and has the wrong goals and objectives in mind.

The most straightforward problem with the plan is that Bernanke and Paulsen don't appear to have a firm grasp of the situation, and without a solid understanding they are likely to use most of the money they've been given ineffectively. First off, it seems strange to ask for money but no real legislation. However, given that legislation can shape the entire industry, while money can merely offer much-needed infusions at certain points, it seems that a combined approach would be much more effective.

The plan seems to be addressing the wrong problem. As I mentioned before, the plan is trying to stabilize a financial infrastructure that has already largely collapsed. However, it doesn't do much to insulate "main street" from "wall street". But it seems to me that the latter goal is more important at the moment. The basic functions of the financial markets are to distribute capital and allow borrowing/saving. Additional downsizing of the finance industry seems inevitable, no matter what the treasury does. In fact, it may be healthy in the long term for the weaker elements of the system to collapse. But the danger to the rest of the economic system is that people and companies will find it harder to borrow or save (although obviously there will also be a negative impact from people getting laid off and spending less). What's needed is a combination of legislation and funding that will accomplish this goal while avoiding more bad loans.

The last issue may at first seem to be a moral one: the plan seems to be helping the people who most contributed to this mess, rather than punishing them. Rescuing the economy is more important than trying to selectively punish people, but it does seem as though this plan is helping out the wrong groups. The crisis is going to lead to a reordering of the financial system, and this move by the Fed is going to impact what will stay constant and what will change. The Fed/Treasury's actions will probably have an unpredictable effect, and may do more harm than good in the long run. Or course, as public enemy #1 stated, "in the long term we are all dead".