Greg Mankiw defends the Paulson plan (from a distance)

by on September 25, 2008 at 3:12 pm in Economics | Permalink

Read the whole thing, which is full of economics.  I think the bottom line is this part:

…that’s [capital injection] a complement to an asset purchase plan, not a substitute — and it’s one allowed by the Treasury proposal and indeed envisaged in some cases. But that will take much longer to implement than an asset purchase. That’s why it’s a complement not a substitute — Treasury needs to act now.

In other words, we are going to get both the Paulson plan and the Dodd plan, or some modified versions thereof.  It was never either/or.  Note that if Greg’s arguments are correct things are very bad indeed.  The outstanding open question is why markets don’t now, pre-plan, successfully trade the toxic assets in sufficient quantities.  But they don’t.

y81 September 25, 2008 at 3:18 pm

What has struck me about economic commentary, including that here, is how little academic economists actually know about the workings of the capital markets. Also how little law professors know. I’m curious about why there is such a gulf between finance professionals and scholars of the relevant academic disciplines.

BoscoH September 25, 2008 at 3:24 pm

At ground level in the real estate market, it’s because the banks won’t take significant enough losses on foreclosed homes. I’m always stopping at open houses on the weekends. Last weekend, I saw a new listing for $390,000. 3BR/2BA small back yard, nice enough to move in. I also saw a foreclosure that had been on the market for 3 months, asking price $439K. 3BR/2.5BA, a real dump, would need $25K to make it livable and who knows about termites, gas, water, etc. I felt bad for the agent baby-sitting that place because it won’t sell for more than $350K and the bank isn’t interested in selling at that price. When the banks figure out the true value of what they have, it will drag the values of everything else down, creating more problems.

Samir Nurmohamed September 25, 2008 at 3:28 pm

Never mind, my blog reader cut off the title…I see now.

J Scott September 25, 2008 at 3:31 pm

One does not need an economics degree to deduce that the federal government created this mess and that a reduction or elimination of federal laws that drove the crisis critical. Further, call it what we may; our federal government will own home mortgages, which will essentially take our constitutional republic even closer to than it already is to socialism. Mind you, most actors in this drama have good intentions and are simply trying to cover their behinds—but to suggest any “profit” will find it’s way into debt reduction or, God forbid in the American taxpayers pocket is absurd. The Feds will take the money and expand the role of government.
We should reduce/eliminate the capital gains tax, corporate taxes, and repeal Sarbanes-Oxley—and while we’re at it eliminate Fannie and Freddie by putting them on the market. Most of the paper they hold is legit—the paper that is not will be foreclosed.
The government needs to get the hell out of the way—there’s plenty of money in the private sector that would rush in if capital gains alone were eliminated/reduced drastically—that would be a start and it would not cost the taxpayer a nickel. Change we can believe in; a smaller, less restrictive federal government.

Dan September 25, 2008 at 3:35 pm

Just to clarify my comment above, if the auction was perfectly designed, we wouldn’t need the warrants per MM. But it will be badly designed (in my mind with p>.9), so we need the warrants.

The Epicurean Dealmaker September 25, 2008 at 3:56 pm

Oh, and by the way, I hope no-one tries to foist the old canard on us that the current (depressed) market prices of the securities at issue are in fact the “correct” or “fair” prices. (Because, whatever the price, they are set in arms-length transactions …)

The entire [blank]ing point of TARP is to bridge us over a period in which multiple non-self-correcting market disruptions and breakdowns have in fact severed the connection between market prices and fair value. If you do not believe the market has failed in this way, you can have no reason to suggest we need TARP (or anything like it) in the first place.

QED.

Jeff September 25, 2008 at 4:05 pm

I for one am getting really tired of economists with no faith in markets. The idea that current “fire sale” prices must be less than the intrinsic worth of the assets is pure conjecture, supported by nothing. This is not economics, its just assertions.

Bernard Yomtov September 25, 2008 at 4:19 pm

I think Dan and T.E.D. are right about the warrants. Mankiw’s argument against them does seem to depend on thenotion that the MBS price will be accurate, but confuison about that price seems to be at the root of much of the trouble. The warrant penalty, it seems to me, will induce security holders to accept lower prices than otherwise, not to demand higher ones.

gabe September 25, 2008 at 4:48 pm

ya those securities are such a good deal that Buffet and Jack Welch have bought zero of them at the bargain basement prices.

Instead they have just been doing infomercials to convince taxpayers to buy the securities at outrageous “hold-to-maturity prices”.

gabe September 25, 2008 at 4:52 pm

Do you think the evaporation of Lehman Brothers’ and Bear Stearns’ stock prices was simply a rational, if rapid reevaluation of those firms’ assets and liabilities over the weekend?

yes it was rational…people realized the companies were going under and they didn’t have enough high ranking former CEO’s running the treasury to save them.

JP Morgan(rockefeller) Chase happily cut a deal to unload all of Bear’s toxic debt on the taxpayer and then fed off the carcass of it’s former competitor.

People who knew this was coming rationally dumped and shorted the stock.

Matt September 25, 2008 at 4:56 pm

The argument rests on the first point, by reducing value uncertainty the feds will increase asset values. The Feds can buy now and reduce uncertainty later, making money.

I think I got it, I think it is wrong.

Nick September 25, 2008 at 5:04 pm

The outstanding open question is why markets don’t now, pre-plan, successfully trade the toxic assets in sufficient quantities.

Markets haven’t been pricing U.S. mortgage paper for over a year now, the Fed has: Bernanke & co. have been buying bad mortgages at artificially high prices. This has delayed a desperately needed creative destruction (of grossly inflated real estate prices, of the corrupt and wasteful GSEs, and of companies stupid enough to buy mortgage paper full of moral hazard). The Fed’s propping up of mortgage paper has habituated financial institutions to having an artificially high floor on mortgage paper prices. When the Fed stopped buying — something about putting the so much of the Fed’s assets in bad mortgages (playing John Law) led to a weak dollar, extremely high commodity prices, etc. and the Fed “ran out of ammo” — the bottom suddenly dropped out of mortgage paper. Because the Fed bought most but not all of the paper in many fungible classes, in many cases there is now too little of this paper in any one class left in private institutions to make a liquid market, and there is always a background threat that the Fed itself will dump this paper if there is a run on the dollar. Furthermore, the habituated holders of this paper now expect subsidized purchases to continue, this time from the U.S. taxpayer. Instead of selling at real market (“fire sale”) prices bankers and other investors currently stuck with this paper naturally prefer to wait and let the taxpayer pay highly inflated Bernanke-says-so prices for their paper.

Bernanke’s theory that one can avoid the tight credit and recessions he so obsessively fears by indefinitely prolong bubbles, the idea that the Fed can indefinetely put off creative destruction, has been proven wrong. Instead the Fed’s artificial subsidy of mortgage paper prices has focused that destruction into a much shorter period, greatly increasing systemic risks.

The Paulson plan is to now have the taxpayer instead of the Fed artificially subsidize the paper, but it’s not at all clear to me that Paulson or Bernanke have learned that if mistakes of timing are made, which they usually are, these mistakes can focus the creative destruction into shorter periods and thus increase systemic risk.

Jeff September 25, 2008 at 5:29 pm

Epicurean: If you really believe that, you should be buying calls on WAMU and other sterling operators. If you think the market is undervaluing these assets, you should be long the owners of them.

The usual retort to people who think the market is irrational is that they should put their money where their mouth is. (Note to Paulson & Co., that’s their money, not mine.) Whatever the supposedly smart people are saying, the smart money is not buying this stuff.

ed September 25, 2008 at 5:43 pm

The unnamed Wall Street economist is relying of M-M for some portion of his argument? If M-M held in the real world a good portion of Wall Street wouldn’t exist. Ridiculous.

y81 September 25, 2008 at 6:06 pm

Nick, you continue to sound like Andrew Mellon. I repeat, in a democracy, no Treasury Secretary will ever play Andrew Mellon again. You will note that the Democrats are proposing to prop up housing prices by subsidizing homeowners, which will have a similar bubble-prolonging effect. No government official will ever say, “Liquidate, liquidate, liquidate.”

srp, I think Bernanke and Paulson are scared because they don’t know where trouble will strike next. I don’t think anyone anticipated that the Lehman bankruptcy would disrupt the CP market, of all things. It was a chain reaction that spiraled out of control. So Bernanke and Paulson think that they must address the root cause, which they perceive as the unmarketability of RMBS paper (and similar assets), before another market crumbles.

srp September 25, 2008 at 6:26 pm

y81: I get that Bernanke and Paulson are scared, but what are they scared of? Presumably, a shutdown of short-term commercial lending that would destroy non-financial firms’ working capital and lead to a huge downward spiraling contraction as everybody hoards cash at the same time. It seems to me that dealing with the “root causes” is more indirect and less likely to solve the CP problem than propping up the CP market to lower spreads. In addition, the B&P plan has all the obvious drawbacks that everyone else has already identified, e.g. prolonging the recognition of insolvency, delaying the correction of real-estate prices, creating moral hazard, and so on.

There’s an old story about operations research, perhaps apocryphal, that occurs during WWII. It seems a flight of our B17 Flying Fortresses had a very tough mission over Germany and many were shot down. An operations research team and a group of generals convened to come up with ways to reduce casualties on future missions. The generals displayed pictures of the shot-up survivors, many with gaping holes, and suggested increasing the armor at those points. The OR guys said “Wait a minute, these are the survivors–we should armor up the places where there AREN’T ANY HOLES.”

My suggestion is in this spirit.

aaron September 25, 2008 at 6:35 pm

Bailout Plan.

Looks OK to me, except for the part about directing a portion of profits to Affordable Housing Fund and the Capital Magnet Fund to meet America’s housing needs.

Nick September 25, 2008 at 6:49 pm

y81: No government official will ever say, “Liquidate, liquidate, liquidate.”

BTW, I don’t support government officials encouraging liquidation like the benighted Mr. Mellon and his friends at the Federal Reserve did in the latter half of 1929. I just tend to be skeptical that they can improve matters by using law or government or central bank finance to discourage liquidation. The current year’s events with the mass Fed purchases of commercial paper, and the parallel or subsequent phenomena of extreme commodity prices and the recent week of panic are bearing me out. Really, Bernanke & co. need to study the 1970s more than the 1930s or 1990s Japan to see what happens when central banks or governments try to inflate our way out of much-needed creative destruction.

In other words,there is little if any good evidence to indicate that government officials either promoting or opposing liquidation can do any better than government officials acting as neutral referees, and quite a bit of evidence that they can cause further damage and create substantially greater risks by taking sides.

simpsonian September 25, 2008 at 8:04 pm

Could it have something to do with the uncertainty of future government action?

meter September 25, 2008 at 8:37 pm

I am personally elated that McCain has managed to stick his unwelcome nose into this. He’s apparently engendering ill will from both sides of the aisle and he just may scuttle the whole deal now that the Dems have a bad taste in their mouths.

David September 25, 2008 at 9:01 pm

Credit is available. The greedy executives of failing banks just don’t like the terms. Look at the terms AIG had to accept. Or the terms Buffet got with Goldman. That’s what it takes. Time to take your lumps.

When I was shopping for my house, competing bids were placed by morons with 3% teaser ARMs, 5% down, you name it. I probably overpaid by $50,000 because of these poor misguided victims of predatory lending. Now I have to pony up to help buy their mortgages. I’m just disgusted and I’m afraid I catch a case of terminal cynicism after this bailout becomes law.

David September 25, 2008 at 11:15 pm

Hey, I wouldn’t be complaining if I didn’t have to pay for their mistakes too!

SheetWise September 26, 2008 at 5:02 am

“I probably overpaid by $50,000 because of these poor misguided victims of predatory lending.”

Predatory? How does a lender losing everything make them predatory? If they were, they sure weren’t very good at it.

After reading about all of these issues for several days now, I have to say that I feel strongly about it either way.

Whatever distortions they choose to make — the market will correct it all in either a short or a long time. Another chapter for the textbook, and either way — we’ll be smarter (at least the market side will be).

David Heigham September 26, 2008 at 8:36 am

Hurrah!!

Lucian Bebchuk has “A Plan for Addressing the Financial Crisis.† which is a critique and amendment of the Paulson plan which looks as though it would make that plan workable and adequate. He even suggests a new market mechanism which could produce sensible market prices for the toxic mortgages packages. Freakonomics has it.

Maybe it is untried and therefore less robust than the loans on tough terms to claer up the mess which Metzler recommends from Chilean experience; or the type of package of tough loan plus equity warrants which Goldman Sachs have accepted from Warren Buffet; maybe it is marginally less efficient in concept than some of the innovative ideas for insurance plus equity stake that are in circulation, but Bebchuk’s scheme is Paulson compatible and therefore politically much more possible.

Even so, the Paulson Plan as proclaimed should be and will be something for Paulson and Bernabeke to be ashamed of.

David September 26, 2008 at 12:11 pm

SheetWise, didn’t you get the memo? Everyone getting foreclosed on didn’t know what they were signing. It’s all the mortgage broker’s fault. He’s a predator.

John T. Kennedy September 28, 2008 at 8:31 pm

Mankiw’s friend argues that government will buy these securities at “market prices”. This seems highly implausible on it’s face for many reasons. Has the law of supply and demand been repealed? I think when $700,000,000,000 of demand for these securities materializes out of nowhere that their price has already changed. Nothing short of a gun could then get owners to part with those securities for for the market price of the securities before the $700,000,000,000 showed up. The market will of course compete for the securities in light of the increased demand, driving up prices at the expense of the taxpayers. And of course any later attempt to recover the taxpayers money means removing at least $700,000,000,000 of demand from the market which must drive prices down.

But today comes a clincher: The plan about to be passed will require participants to curb the pay/benefits of CEOs and top officers.

Doesn’t that make it a metaphysical certainty that participants will *not* sell to the government for market prices? If the market price of a security bundle is X that means there are multiple parties willing to pay X – so why on earth would you sell at X to a party that requires such burdensome additional concessions?

This makes it certain that the government will pay more for these securities than they are worth. The government will clearly have to pay at least X + Y where Y is the cost CEOs charge to curb their own pay. And all they can turn around and sell is a security worth X – the curbed salaries are not bundled with it.

Of course I don’t think there was ever the slightest intention to attempt to buy the securities at market prices – this is fully intended to be one of the greatest transfers of wealth in history, from the taxpayers to the lenders.

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