Stiglitz: A Better Bailout

This is a critique of the Paulson plan by a well know economist. Stiglitz has turned out to be wrong about politicians not being willing to vote against the plan however. But this was probably a temporary move. It has meant that there are now some changes to the plan. The new plan seems to replace government ownership of the toxic assets by some type of insurance plan. Perhaps this will mollify those who claim the plan is some sort of socialist enterprise! So weird is discourse about socialism now that bailing out capitalism is called socialist by some! Socialism is socialisation of the major means of production distribution and exchange and production on the basis of need not profit. It replaces capitalism rather than rescuing it.

Better BailoutBy Joseph E. Stiglitz26 September, 2008The NationThe champagne bottle corks were popping as Treasury Secretary HenryPaulson announced his trillion-dollar bailout for the banks, buying uptheir toxic mortgages. To a skeptic, Paulson's proposal looks likeanother of those shell games that Wall Street has honed to a fineart. Wall Street has always made money by slicing, dicing, andrecombining risk. This "cure" is another one of these rearrangements:somehow, by stripping out the bad assets from the banks and payingfair market value for them, the value of the banks will soar.There is, however, an alternative explanation for Wall Street'scelebration: the banks realized that they were about to get a freeride at taxpayers' expense. No private firm was willing to buy thesetoxic mortgages at what the seller thought was a reasonable price;they finally had found a sucker who would take them off theirhands--called the American taxpayer.The administration attempts to assure us that they will protect theAmerican people by insisting on buying the mortgages at the lowestprice at auction. Evidently, Paulson didn't learn the lessons ofinformation asymmetry which played such a large role in getting usinto this mess. The banks will pass on their lousiestmortgages. Paulson may try to assure us that we will hire the best andbrightest of Wall Street to make sure that this doesn't happen. (WallStreet firms are already licking their lips at the prospect of a newsource of revenues: fees from the US Treasury.) But even Wall Street'sbest and brightest do not exactly have a credible record in assetvaluation; if they had done better, we wouldn't be where we are. Andthat assumes that they are really working for the American people, nottheir long-term employers in financial markets. Even if they do usesome fancy mathematical model to value different mortgages, those inWall Street have long made money by gaming against these models. Wewill then wind up not with the absolutely lousiest mortgages, but withthose in which Treasury's models most underpriced risk. Either way, wethe taxpayers lose, and Wall Street gains.And for what? In the S&L bailout, taxpayers were already on the hook,with their deposit guarantee. Part of the question then was how tominimize taxpayers' exposure. But not so this time. The objective ofthe bailout should not be to protect the banks' shareholders, or eventheir creditors, who facilitated this bad lending. The objectiveshould be to maintain the flow of credit, especially to mortgages. Butwasn't that what the Fannie Mae/Freddie Mac bailout was suppose toassure us?There are four fundamental problems with our financial system, and thePaulson proposal addresses only one. The first is that the financialinstitutions have all these toxic products--which they created--andsince no one trusts anyone about their value, no one is willing tolend to anyone else. The Paulson approach solves this by passing therisk to us, the taxpayer--and for no return. The second problem isthat there is a big and increasing hole in bank balance sheets--bankslent money to people beyond their ability to repay--and no financialalchemy will fix that. If, as Paulson claims, banks get paid fairlyfor their lousy mortgages and the complex products in which they areembedded, the hole in their balance sheet will remain. What is neededis a transparent equity injection, not the non-transparent ruse thatthe administration is proposing.The third problem is that our economy has been supercharged by ahousing bubble which has now burst. The best experts believe thatprices still have a way to fall before the return to normal, and thatmeans there will be more foreclosures. No amount of talking up themarket is going to change that. The hidden agenda here may be takinglarge amounts of real estate off the market--and letting itdeteriorate at taxpayers' expense.The fourth problem is a lack of trust, a credibility gap. Regrettably,the way the entire financial crisis has been handled has only madethat gap larger.Paulson and others in Wall Street are claiming that the bailout isnecessary and that we are in deep trouble. Not long ago, they weretelling us that we had turned a corner. The administration even turneddown an effective stimulus package last February--one that would haveincluded increased unemployment benefits and aid to states andlocalities--and they still say we don't need another stimulus. To befrank, the administration has a credibility and trust gap as big asthat of Wall Street. If the crisis was as severe as they claim, whydidn't they propose a more credible plan? With lack of oversight andtransparency the cause of the current problem, how could they make aproposal so short in both? If a quick consensus is required, why notinclude provisions to stop the source of bleeding, the millions ofAmericans that are losing their homes? Why not spend as much on themas on Wall Street? Do they still believe in trickle down economics,when for the past eight years money has been trickling up to thewizards of Wall Street? Why not enact bankruptcy reform, to helpAmericans write down the value of the mortgage on their overvaluedhome? No one benefits from these costly foreclosures.The administration is once again holding a gun at our head, saying,"My way or the highway." We have been bamboozled before by thistactic. We should not let it happen to us again. There arealternatives. Warren Buffet showed the way, in providing equity toGoldman Sachs. The Scandinavian countries showed the way, almost twodecades ago. By issuing preferred shares with warrants (options), onereduces the public's downside risk and insures that they participatein some of the upside potential. This approach is not only proven, itprovides both incentives and wherewithal to resume lending. Itfurthermore avoids the hopeless task of trying to value millions ofcomplex mortgages and even more complex products in which they areembedded, and it deals with the "lemons" problem--the governmentgetting stuck with the worst or most overpriced assets.Finally, we need to impose a special financial sector tax to pay forthe bailouts conducted so far. We also need to create a reserve fundso that poor taxpayers won't have to be called upon again to financeWall Street's foolishness.If we design the right bailout, it won't lead to an increase in ourlong term debt--we might even make a profit. But if we implement thewrong strategy, there is a serious risk that our nationaldebt--already overburdened from a failed war and eight years of fiscalprofligacy--will soar, and future living standards will becompromised. The president seemed to think that his new shell gamewill arrest the decline in house prices, and we won't be faced holdinga lot of bad mortgages. I hope he's right, but I wouldn't count on it:it's not what most housing experts say. The president's economiccredentials are hardly stellar. Our national debt has already climbedfrom $5.7 trillion to over $9 trillion in eight years, and thedeficits for 2008 and 2009--not including the bailouts--are expectedto reach new heights. There is no such thing as a free war--and nosuch thing as a free bailout. The bill will be paid, in one way oranother.Perhaps by the time this article is published, the administration andCongress will have reached an agreement. No politician wants to beaccused of being responsible for the next Great Depression by blockingkey legislation. By all accounts, the compromise will be far betterthan the bill originally proposed by Paulson but still far short ofwhat I have outlined should be done. No one expects them to addressthe underlying causes of the problem: the spirit of excessivederegulation that the Bush Administration so promoted. Almost surely,there will be plenty of work to be done by the next president and thenext Congress. It would be better if we got it right the first time,but that is expecting too much of this president and hisadministration.___________________________________