Revolting Economists

Economists are not famous for agreeing with each other. (“The First Law of Economists: For every economist, there exists an equal and opposite economist. Second Law: They’re both wrong.”)

So it is striking that publicly expressed opinions among non-Wall-Street economists on the Paulson/Frank plan range basically from former-Wall-Streeter Henry Blodget’s “it stinks” to Luigi Zingales’s “it will destroy the capitalist system for the next 50 years.” (Zingales is worried about the moral hazard problem). The only other common and prominent public point of view is Greg Mankiw’s “Ben Bernanke is a very smart guy who knows more than I do, and if he says we have to do it then maybe we have to do it.” But even Mankiw seems to have grave doubts, and a lot of economists suspect that Bernanke actually thinks it’s a bad deal too; he has looked awfully pale and has taken a conspicuously deferential and back-seat role to Paulson in his public comments (see Robert Shimer’s reply to Mankiw). My own best guess is that Bernanke’s deep regard for the constitutional structure of the government has led him to conclude that it is not his role as Fed chief to undercut the Treasury secretary even if he thinks the Paulson plan is a bad one.

(In addition to this long and ideologically diverse list of economists opposed to the initial plan, prominent recent critics include Ronald Reagan’s Council of Economic Advisers chair and emeritus President of the National Bureau of Economic Research Martin Feldstein as well as Democratic economists from former Fed Vice Chair Alan Blinder to Bill Clinton’s Council of Economic Advisers chair (and subsequent Nobel laureate) Joseph Stiglitz writing in The Nation to the middle-of-the-road Brookings economist Douglas Elmendorf to leftish gadfly James K. Galbraith to former CBO chief economist Debby Lucas to Paul Krugman to former Clinton Administration official and economist-blog-king Brad deLong.).

The fact that this near unanimity seems to have had little effect in slowing down the bailout train wreck brings to mind Alan Blinder’s famous observation that “Economists have the least influence on policy where they know the most and are most agreed; they have the most influence on policy where they know the least and disagree most vehemently.” (It’s those vehement disagreements that gives us the reputation that is being mocked in my opening paragraph).

In talking to people involved in the inside-baseball political side of the discussion on Capitol Hill, I get the impression that they are very unhappy about being asked to sign on to this bill, but are planning to do it because they have been told that if they don’t, the apocalypse is around the corner.

The key point that I think is not penetrating from the economists to the Congress is that what sticks in our craw is ONE SPECIFIC ASPECT of the Paulson/Frank plan: Its focus on having the government buy up the toxic subprime securities. This may well prove to be almost a pure bailout for Wall Street, and there is no reason that any of us sees that this has to be the core of the rescue plan. I think you could get near-unanimity from economists, from across the political spectrum, in favor of a simple, easy-to-do alternative that would be both more economically sound and more politically palatable: The Federal government should do, with respect to the banking sector as a whole, what Warren Buffett did last week in his investment in Goldman Sachs.

Buffett did not become the richest man in the world by making bad investments. The money he provided to Goldman was emphatically NOT a bailout. It was a prudent investment – he thinks he will make his money back, and much more. The taxpayer should follow his lead and take a similar stake in the financial industry.

This is the essence of the concrete plans that conservative, moderate, and liberal economists have been proposing (cf. Zingales and deLong). I think the reason these ideas have not made more headway on Capitol Hill is simply that the proposals are written in terms that are too technical for members to realize that they are all basically saying the same thing: The right way to recapitalize the financial system is by investing money in the system as a whole, so that the taxpayer benefits when the economy recovers. This is not a new idea; it is basically what Sweden did in 1992 when it faced a financial meltdown, and it worked out OK in the end for the Swedish taxpayer (at least compared with the alternatives). Just like Warren Buffett, the taxpayer might even ultimately make money on the deal.

At the risk of making eyes glaze over, let me sketch one way of doing this (which is basically similar to the more concrete and detailed proposals of others): The taxpayer could approach each financial institution that is in trouble and offer them a take-it-or-leave it deal: You need capital and we have capital. We’ll either lend you the money you need (in exchange for being first in line for repayment out of any future profits, and in exchange for your cutting your dividends to zero until your capital is restored), or we’ll buy preferred shares in you in an amount directly proportional to shareholder equity from your last audited financial statement (again, you must cut dividends to zero until you are healthy again). This solution is not perfect, but I am assured by people who should know that it is something that could be organized very quickly and would provide the needed capital. The plan would need to specify, in an ironclad way, that the taxpayer’s stake would be sold off (at a profit) when the system regains its footing.

What is mystifying to me and many other economists is why there seems to be such resistance to the Zingales/deLong/Buffett plan by people who do not seem to be able to offer a coherent rational argument for why it would not work, and an insistence instead that the taxpayer should buy the toxic assets directly. I can think of only one potential explanation: A rigid ideological opposition on the part of Henry Paulson to taxpayer ownership of even one dime of the financial sector. If this is the right explanation, it is scarily reminiscent of the rigid ideologies that led to catastrophic errors of policy judgment during the Great Depression. A lot of conservative economists, who share Paulson’s presumed predilictions in this regard, have seen the light and now feel that the Zingales/deLong/Buffett plan is the best of a bad set of options. Why doesn’t Henry Paulson agree?

(I should note, in fairness, that Paulson has moved somewhat in this direction; the latest versions of his plan involve taxpayers getting some ownership stake in exchange for their purchases of the toxic assets. But if he is willing to compromise in that regard, it is all the more mysterious that there is still an insistence on buying the toxic assets).

9 Responses to "Revolting Economists"

  1. Guest   September 27, 2008 at 2:00 pm

    The moral of this story: ATTEMPTING A FINANCIAL COUP D’ETAT within The United Socialist States of AmericaSupport HR 2755 Abolish this Federal Reserve.Nationalize the Central Bank

  2. DarrylS   September 27, 2008 at 2:36 pm

    To use the Buffet example is not quite valid as he said he would not have done the deal if the bailout was not going to happen in the first place. He must have seen that the bailout was going to provide liquidity to the toxic loan (and above mark to market prices nonetheless) which is what made the GS deal viable to him. Whats more his intent of the deal was not to address the toxic the debt (since his presumption was the bailout addressed that). The revised Paulson plan does address that which is why its better than any of these other econo proposals. Even Sweden created a ‘bad bank’ to address these. These proposals do not and as long as they do not no real long term solutions is presented by them

    • give me a lever   September 27, 2008 at 9:13 pm

      it should also be noted that buffett has his share of bad investments also. His bond purchase from solomon brothers intially cost 700m, took 11 years for him to get 1.9 billion. Clearly one of his most dismal returns and an event that kept him wary of wall street hype.

  3. artichoke   September 27, 2008 at 2:54 pm

    The banks do not know what to do with their CDO^2, so they would like me, a taxpayer, to take them off their hands. But I don’t know what to do with a CDO^2 either so I do not want it. I didn’t create it, I must apologize to that bank but say that it remains the bank’s problem.I never saw a well defined version of the “revised Paulson plan” so I don’t know what it would do. I am sure that “ties go to the bank” so all ambiguity must be removed now, not later.Buffett made his investment in GS expecting the taxpayer to bail him out. He even said so. Now it may seem petty, but I just don’t want to bail out Buffett, most especially because he bought in just so he could be in on the gravy train. It’s the principle of the thing. I would rather eat less for a month than let Buffett win that little encounter.The economists’ plan is the way to go. Paulson does not want it because he thinks he can get this other plan instead and stick it to the taxpayers. He might be right, but I am still fighting and more and more of my countrymen are waking up to this every day.

  4. Mandarin   September 27, 2008 at 3:21 pm

    The main problem with the Paulson plan is that it would magnify the problem of moral hazard. Bankers and their lobbyists will walk away from this wreck, convinced that derivatives, speculation and risky loans of every type are just ducky. They’ll redouble their efforts against any future regulation and we’ll be back in the same mess if we ever leave it to begin with. A Federal equity stake and independent oversight are under consideration, and they are essential.

  5. Guest   September 27, 2008 at 4:07 pm

    What else could have come out of an administration that will go down in history as being straight from hell. Does anyone really believe the Bush Administration give a hoot about the american people?Let’s be serious. This is his going away present to his comrades before he leaves office. The office of The United Socialist States of America. Welcome

  6. Lloyd Gillespie   September 27, 2008 at 4:41 pm

    Why hasn’t anyone mentioned Dr. Paul Davidson’s ideas for fixing the problems? We need also go to a complete reform of the entire international financial architecture.

  7. Guest   September 28, 2008 at 8:00 am

    1929/2008 History repeats itself. FRB trying to bring the U.S. to its knees. manipulation, blackmailing, power, politics.

  8. Anonymous   September 28, 2008 at 2:51 pm

    The only way to make sense of the structure of this bailout is an effort to save Goldman. AIG was Goldman’s largest trading partner. Goldman has a boat load of overstated, illiquid assets that are multiple of its book value. My guess is that Goldman is insolvent. Paulson’s friends stood to lose billions and maybe his personal money was tied up in the firm. This gave him the perfect excuse to act so beneficently for his friends in the face of overwhelmingly better plans that might address the heart of this blowup. Almost seems a little jaded after the Treasury Secretary is about to be given almost dictatorial powers.