Dynamist Blog

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.

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