The highly-praiseworthy-but-ever-so-occasionally-totally-wrong Bryan Caplan suggests that Paulson should have simply let the debt securities of the mortgage agencies go. In addition to the fact that he favors The End of the World, Bryan is underestimating at least two points:
1. The current operation of the money market requires ongoing faith in a variety of assets and commitments. Just try tracing through the consequences of a general "run" on money market funds, which "promise" a redemption ratio of $1 a share but on the other hand really don’t make such a promise. How quickly would Merrill Lynch cry Uncle, how quickly would the Fed’s balance sheet be exhausted, and how many commitments would they have made in the meantime and how many people would have to sell stocks to find cash and make margin calls? Or think about what would happen if FASB ruled that Frannie debt securities did not qualify as "ready cash" for accounting purposes. (As a general tendency I find that economists vastly underrate the importance of accounting as an economic force. I might add that many market advocates are unaware of how quickly liquidity can vanish in these markets; just look at auction-rate securities.) And those aren’t even the biggest potential problems arising from a default.
2. In essence we already agreed to the bail out some time ago. Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car "really meant"? Well, the Chinese spent $340 billion on agency debt and probably asked the same question at least once or twice. They live in a world of secret agreements with leaders, not transparent democratic arrangements. So when it comes to the U.S government decision, we’re not just starting from scratch here. How many phone calls do you think Hank Paulson has received from the Chinese central bank since August 2007?
"Are you *sure* that paper is safe enough for us to keep on buying?"
We’ll never know exactly what kind of verbal dance Paulson concocted in response, but just look at the resulting flow of purchases and the relatively slight mark-up over Treasuries over that period of time. The Chinese (among others) thought we were standing behind the securities, at least in any world-state short of federal government quasi-bankruptcy. (In fact Paulson is in a total bind once that phone call comes in. He doesn’t have much incentive to just say "tough luck" and precipitate a crisis when otherwise no crisis is on the horizon.)
So should we try this: "Oh, is that what you thought? Guaranteed? Did we use that word? Sorry, try reading our signals better next time. We love you. Great job with those Olympics. And when it comes to those Treasury Bills, we really do still mean it. And don’t forget to support us on Iran and North Korea."
The libertarian critique of the mortgage agencies is, in my view, very much on the mark. But still the error has been made and we must pay up. As Steve Chapman points out, the bailout is a necessary evil, but with emphasis on the word "evil."