So says Ricardo Caballero, here is more:
First, a private sector solution to the current crisis requires fresh capital injections into financial institutions. However, in an environment of widespread uncertainty where the instinctive reaction is to run away from risk-taking, private capital is likely to remain on the side for much too long. Thus, the optimal policy response is to encourage and leverage private risk-taking, not to discourage it with a pending threat of exemplary punishment were a fragile situation turn worse, regardless of cause. Economic policy risk is compounding the private sector’s reluctance to capitalize financial institutions…
Second, during periods of high uncertainty and the potential for runs, large or coordinated shortsellers are more likely to succeed in triggering socially inefficient panic-selling. Rumor-mongering and persistent selling pressure eventually weaken wary investors and depositors. Unfortunately, by choosing to punish shareholders, Secretary Paulson has rewarded shortsellers and raised their ammunition to cause further financial instability. Again, while shortselling plays a very useful role during normal times, it can turn into a source of instability during periods of high uncertainty.
Two points: first, if we are going to nationalize this argument implies we should do it quickly to avoid further hemorrhaging. Yet the mortgage agencies are not quite proven to be unsalvageable failures (much as I opposed their initial creation that does not imply immediate obliteration as the proper current response). Second, even if nationalization is the right response this time, it might not be the next time a financial institution gets into fiscal trouble. Yet in that subsequent case nationalization will be that much harder to avoid, given the understandable fears of private capital if nationalization happens this time. Every time you nationalize and wipe out shareholders, you create a dangerous precedent and scare away private capital for a long time.
You are probably reading lots of absolutist recommendations around the blogosphere but these are truly difficult issues and the correct policy responses are not obvious.
Caballero’s argument seems to be to save the stockholders. This is fine if you are a stockholder; otherwise it is rubbish. Paulson’s at least attempting to keep some moral hazard.
[disclosure: mutual funds I own, hold FM)
We pretty much have to save the bondholders (i.e. not default on the bonds). But if we save ALL the big financial guys while letting individual mortgagees hang out there with half-measures (because they aren’t small individual people who aren’t organized) then we are risking the mortgagee equivalent of food riots.
I am, quite frankly, and against my own financial interests, enjoying seeing the trouble a New Deal institution is falling into. I have never thought home-ownership should be privileged by a “Government Sponsored Institution” which we now know is an insured institution. Lately, more and more institutions are “too big to fail.” I foresee more institutions and programs invented by the New Deal Brain Trust getting into trouble in the future.
Callero’s argument against the shortsellers is pure handwaving. ‘socially inefficient panic-selling’? ‘raised their ammunition to cause further financial instability’? Someone isn’t maintaining a neutral viewpoint on short selling. The shortsellers in this case (as with speculators generally) are speeding the reaction time of the entire financial system – they’re giving us advance notice that these entities are bound for failure.
I’m surprised that Tyler would claim there is a “correct policy response” given his previous humility in epistemology. What are we aiming at that there should be a response at all? Beware the ugly incentives of central planning; their roots are in the belief in “correct” policy responses.
P. Blank writes: “Are there “inverse-Pareto efficiencies†, where you cannot make someone worse off without making someone else better off?”
Certainly, provided the basic fabric doesn’t tear (few opportunities in the Great Depression).
As I’ve posted before, unless housing prices go down, millions of people (my daughter who teaches elementary school among them) won’t find anything affordable. But the process of lowering real housing prices is going to be painful. So she, and you, will benefit from housing price declines.
Short sellers like vultures are a key part of an good ecosystem, and do a hard days work for their meals.
Comments on this entry are closed.