Dynamist Blog

Debate Commentary

McCain is rambling and incoherent, and Obama keeps repeating the untruth that there's hardly any regulation on Wall Street. I want to puke.

Thoughts on the Panic of 2008

While I've been doing important and time-sensitive things like writing about cancer drugs (for a future Atlantic column) and unimportant but time-sensitive things like interviewing a middle-aged supermodel (for DeepGlamour), people who are smarter than I am and know far more about the institutional detail of financial markets have been filling the Internet with commentary. But, for what it's worth, here are some thoughts about the central issues.

Contrary to widespread popular belief, the "$700 billion bailout" doesn't involve spending $700 billion, since most subprime mortgages are still OK. They aren't all going to default. The problem is that once they've been sold and chopped up into derivative securities, the good mortgages are hard to identify and untangle from the bad ones. If we knew which were which, we could also separate financial institutions into two categories: those that are truly insolvent and those that are simply in a cash crunch caused by uncertainty and panic.

Good policy should seek to help illiquid firms survive the immediate crunch while forcing the insolvent ones to restructure their debts and essentially (or literally) declare bankruptcy--the sooner, the better. My general inclination is to put policy emphasis on helping healthy firms rather than bailing out losers, including homeowners who can't make their payments.

In a perfect world, illiquid firms would pull in private capital looking to profit from the current turmoil. (See Warren Buffett's investment in Goldman Sachs.) Unfortunately, the bailout talk is deterring potential investors, who at the very least want to know what to expect from the government and, in some cases, appear worried they'll lose any investment. Uncertainty is freezing everything.

Having helped create the problem, the Treasury could alleviate the credit crunch either by lending money directly or by guaranteeing loans--either of which should be done at some potential profit to the taxpayers. The goal is not to protect lemons but to give firms that know they'll be able to service their debts a chance.

In that regard, I am a fan of Professor Postrel's recommendation (below) that the Treasury guarantee commercial paper from borrowers with good credit ratings. The commercial paper crunch, not bad mortgages, is the biggest threat to the overall health of the economy. It should not be that hard to identify good credit risks and charge them a small premium for borrowing from the Treasury.

Any policy must take account of the taxpaying public's intense and largely justified resentment of having to pay for the screwups of people who got rich taking big risks and then didn't have to suffer the consequences. From a less emotional standpoint, we also don't want to encourage such behavior in the future. Innovation, financial or otherwise, is a wonderful thing. But it only works if innovators receive negative as well as positive feedback.

But what to do? We can't go in a time machine and take away Wall Street bonuses or send mortgage brokers back to selling car insurance (or whatever else they were doing before). Screaming, "It's not fair" won't make the systemic problems, which threaten everyone, go away. But the screaming does remind policy makers that their duty is to the general public, not to specific institutions. Institutions that have made bad decisions need to bear as much of the cost as they can without seriously endangering the rest of us.

For starters, any lending should follow the wise Allan Meltzer's Chilean example of requiring firms to cancel their dividends as a condition of any assistance--a proposal that also has the positive effect of generating cash. (Meltzer, one of those people a lot smarter than I am, doesn't think the government should do anything.)

Second, all assistance should be structured so that it is potentially profitable to the Treasury and--equally important--those profits should be rebated to taxpayers, not thrown into the general federal pot. If, as Andy Kessler suggests, the Treasury stands to make a fortune by becoming a sort of hedge fund, the fund's "investors" ought to reap the gain directly.

Third, and this will take a while, serious thought needs to be given to creating automatic circuit breakers of various sorts to prevent this sort of contagion in the future.

Last but definitely not least, Fannie and Freddie must go. They not only privatize reward and socialize risk. They do so by design. The whole point of these agencies is to put taxpayers on the hook for mortgage risks that private actors wouldn't take without them.

Saving Capitalism from the Capitalists, by Ragu Rajan and Luigi Zingales, both of whom have acquitted themselves well of late (see links on their names). I wrote about their book here.

Keeping Your Head

I will blog more about the economic crisis later, but for the moment I want to agree wholeheartedly with Clive Crook on why Obama's style has been more appropriate to the situation than McCain's:

I do think Obama is handling the crisis much better than McCain--not because he is suggesting better remedies (he continues to say little), but because his instinct to reflect before opening his mouth and his impeccable taste in [economic, I assume--vp] advisers are both working to his advantage.

I don't plan to vote in the presidential race, barring a last-minute lurch to Bob Barr, but if you held a gun to my head and made me pick one of the two major party contenders this week I'd have to go with Obama. He scares me, but not as much as McCain.

On substance rather than style, there's lots of good stuff at MarginalRevolution, including a couple of comments from Professor Postrel (a.k.a. srp here), basic points repeated below:

I have a different idea to throw out. If the urgency of an intervention supposedly stems from contagion to the commercial paper market, and the government is now going to play hedge fund anyway, why don't we dedicate the $700 billion facility to guaranteeing the commercial paper of high-quality borrowers for the next six months or so. We could even charge the borrowers a couple of basis points for the service. I'll bet that the taxpayer is a lot less likely to have to pay out much of that $700 billion with this strategy, and then we can use the appropriate tough tactics to flush out any insolvencies in the MBS and CDO markets at our leisure....

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.

I'm So Glad I Never Planned to Vote For this Guy

John McCain is a demagogic lunatic. Imagining him as president in a crisis is terrifying.

UPDATE: Stephen Bainbridge saves me the trouble of explaining [via Megan McArdle, who has more.] I will also note that private equity funds and hedge funds, which aren't subject to all this wonderful regulation, appear to be doing better than the rest of the financial world.

UPDATE 2: McCain is even crazier and more clueless than I thought, as Robert George explains.

Wedding News

A new Field Poll shows growing opposition to Proposition 8, the ban on same-sex marriage. The poll of likely California voters finds 55 percent against, 38 percent in favor, and 7 percent undecided. Although the poll shows that the ballot language has a small effect, I suspect that experience is the major factor. As more and more gay weddings take place, Californians have a chance to see that, far from a parodying traditional marriage, single-sex unions honor its value. Or maybe it just doesn't seem to be a big deal.

On a lighter note, don't miss the Diaries of a Groomzilla, beginning this week on DeepGlamour.net.

Do Bailouts Beget More Bailouts?

Is fear of expropriation deterring the private capital infusions that might rescue failing financial firms without involving the taxpayers? This passage, buried in Eric Dash and Andrew Ross Sorkin's detailed NYT account of the scramble to save AIG, suggests that might just be the case.

By Sunday, K.K.R. and the Texas Pacific Group made it clear they would not come to the rescue, worried that A.I.G. might be taken over by the government, wiping out their investments. Goldman Sachs also balked.

Fannie and Freddie: What Went Wrong?

The WaPost's Binyamin Appelbaum, Carol D. Leonnig and David S. Hilzenrath have a very good article on how Fannie and Freddie avoided oversight, despite ample warning that they were headed for trouble. Money graf:

Blessed with the advantages of a government agency and a private company at the same time, Fannie Mae and Freddie Mac used their windfall profits to co-opt the politicians who were supposed to control them. The companies fought successfully against increased regulation by cultivating their friends and hounding their enemies.

Of course, anyone who's been reading the WSJ editorial page for the past decade knew this.

"Terror Is Glamour"

In 2006, Salman Rushdie gave an interview to Der Spiegel in which he was asked about the causes of terrorism. After first demurring, he suggested a few: "a misconceived sense of mission," a "herd mentality," the desire to become "a historic figure," an attraction to violence, and--shocking the interview--glamour.

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