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An Emerging Consensus Against the Paulson Plan: Government Should Force Bank Capital Up, Not Just Socialize the Bad Loans

In time of war, there is a tendency for both political parties to rally around the president, as we saw (all too well) in Iraq after September 11.    In time of financial panic, there is often a similar inclination.  The two presidential candidates, for example, are being very careful in their statements.   I don’t blame them.  The issues are too complex to be taken on inside the context of a political campaign.   Both candidates realize that the danger of a verbal misstep that the other side can try to blame for worsening the crisis is far greater than the likelihood that either one will come up with a brilliant solution that will gain widespread support or will solve the problem, let alone both.

Having said that, opposition to the $700 billion plan proposed by Treasury Secretary Henry Paulson September 19  has coalesced quickly, from both ends of the political spectrum.    Sebastian Mallaby pursues the Iraq analogy in “A Bad Bank Rescue” in the Washington Post, September 21:   “…in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice.  It would spend billions of dollars on the theory that preemption will avert the mass destruction of banks.

The explicit lack of oversight or checks and balances in the Treasury proposal is very worrisome – and it worries Congressional Democrats.

But the nature of the bailout, how the money is to be used, is what bothers me most of all.   As Mallaby says, “Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives.  Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans.”  Examples are not tied to economists from a particular political viewpoint or party.   He mentions the proposals of Ragu Rajan (FT.com) and Luigi Zingales (Vox) that the government could tell banks to cancel all dividend payments;   and proposals by Charlie Calomiris  (Ft.com) and Doug Elmendorf (Brookings) that the government could buy equity stakes in banks themselves, rather than just buying their bad loans.

Similarly,  in today’s New York Times opinion page, Paul Krugman on the left side of the page and Bill Kristol on the right side of the page.  What Mallaby calls the core insight is also the crux of Krugman’s logic (“Cash for Trash”):  “…the financial system needs more capital.  And if the governments is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.”  Sounds right to me.   Don’t socialize the losses without socializing the gains.


Originally published at Jeffrey Frankel’s Weblog and reproduced here with the author’s permission.

4 Responses to “An Emerging Consensus Against the Paulson Plan: Government Should Force Bank Capital Up, Not Just Socialize the Bad Loans”

GuestSeptember 23rd, 2008 at 9:21 am

And put a limit to bonuses, as any capital increase risks being diverted immediately towards increasing paychecks overthere. We’ve seen enough of that stuff.

artichokeSeptember 25th, 2008 at 9:41 am

Absolutely right, no debt reduction for banks. Increase their capital and make them give stock for it. This is the best solution of all.Secondly, inflate (without sterilization). At least then foreign dollar holders share in the pain.The government seems to want to do the worst to us: load all the debt onto the taxpayer. We must stop it.

GuestOctober 1st, 2008 at 2:53 pm

1) Backstop homeowners with negative equity so they don’t walk away to stabilize housing market2) Eliminate dividends, stock options,bonuses and excessive pay in the banks and financial firms involved.3) Buy convertible preferred shares in the banks, diluting existing owners.4) Unwind as much as possible all the derivatives, CDS, etc. and get auditors to value remains based on “value at maturity”.5) Make derivatives, CDSs, shortselling,and any other “synthetic” financial products and trading illegal going forward, except as in 4) above.6) Begin legal processes against executives and traders in mortgage lenders, investment banks, hedge funds, etc. who willfully created, sold, and traded sub-prime mortgages, securitized products, etc. which led to this mess.Combine jail time with expropriation of assets unlawfully gained from this fraud.7) Debrief everyone involved and put in new regulations to ensure a stable and trustworthy financial system.

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