Sunday, September 21, 2008

The Paulson Plan: Summary of My Recent Posts

Providing liquidity is what the government should be doing. Recapitalizing banks (without receiving equity participation) is what the government should not be doing. If the government does the former and not the latter, then, although taxpayers are taking a large risk, they should expect, if things go well, to make a very large profit. Unfortunately, after careful consideration, I have concluded that the Paulson Plan is most likely intended to do the wrong thing. However, no matter which turns out to be the case, the government can afford it.

UPDATE: Upon further consideration, I have come to doubt whether it is even possible to implement the Paulson Plan in a way that doesn't effectively give banks more capital for free. For perfectly rational economic reasons, severely undercapitalized banks would rather hold on to illiquid assets and risk failure than sell those assets at fair value and admit the true extent of their undercapitalization. A better plan would require forcing banks to accept fair value.

That said, given the severity of the crisis we currently face, the Paulson Plan is probably better than doing nothing. But surely doing nothing is not the only alternative.


Blogger the_collective_unconscious said...

Recapitalize the banks by lowering reserve requirements, require mark to market (the market will begin to trade quickly), keep the easy money window open, put in place adequate regulation for new lending, provide income assistance to those who need it (cram-downs and direct transfers--Congress's call), give the banks five years or so to recapitalize at prior levels.

Sun Sep 21, 10:24:00 PM EDT  
Blogger knzn said...

Recapitalize the banks by lowering reserve requirements? It's not immediately clear how that would work. I suppose that lower reserve requirements would allow banks to make more loans and thus make more profits, so their capital would increase. But that could be a slow process. And if banks are already barely meeting capital requirements, then lowering reserve requirements won't allow them to make more loans. You could both lower reserve requirements and temporarily lower capital requirements. Lowering capital requirements is a little scary, but I suppose desperate times call for desperate measures. It would be necessary to cross ones fingers that this doesn't merely lead us deeper into the hole, with thinly capitalized banks failing before they had a chance to take full advantage of the reduced reserve requirement.

Sun Sep 21, 10:44:00 PM EDT  
Anonymous Anonymous said...

I deeply deeply disagree with this nutty idea that cramped private sector thinking will fix this. Krugman and Naked capitalism are pushing this because they want the whole thing to fail - so they can get the democrats elected. Paulsons plan is to flood the whole world with money - and it is the only plan that will actually work. I am real sorry you have joined the Ron Paul loonies. The issue is not bank capital. The issue is banks feeling so very flush that they will actually be willing to lend rather than just sit on cash.

Sun Sep 21, 10:57:00 PM EDT  
Blogger the_collective_unconscious said...

I don't like fascism, or hyperinflation, which is where Paulsen's plan leads.

Lowering reserve/capital requirements will enable lending and marking to market and trading of the bad debt. And I'm obviously not a Paulite, if I'm calling for strict regulation.

I don't have a good feeling about any of this.

Sun Sep 21, 11:08:00 PM EDT  
Anonymous Anonymous said...

Flood the banks with money. Its not hyperinflation - though it sure is inflation. Inflation is better that deflation. Those are the choices we face. As to fascism - I am not for that. But the Romans did have the position of a (term limited) dictator for situations such as this. They were nothing if not bold. Paulson as financial dictator for 6 months. I am all for it. I am also in favor of your cram-down reforms.

Sun Sep 21, 11:27:00 PM EDT  
Blogger knzn said...

I have nothing against inducing moderate inflation, and to the extent that the Paulson Plan is designed to do so merely by liquidating illiquid securities, I would support it.

But unfortunately bank capital is an issue. No matter how flush the banks are, they cannot lend if they don't meet capital requirements. And since the assets are hard to value, even banks that appear to be meeting capital requirements may not be.

If the Treasury bids to purchase assets at fair value, banks that are adequately capitalized on the books but not in reality will not accept the bid, because it will force them to own up to the fact that they are undercapitalized. Quite possibly, the Treasury will have to bid more than fair value in order to purchase enough assets to even achieve the objective of increasing liquidity.

Even now, the more I think about the plan, the more I don't like it. It's not the right plan. The right plan would be one where banks are forced to sell illiquid assets at fair value (which would have to be determined by the government), and if they end up undercapitalized, they have two choices: either they can try to raise capital in the private sector (possibly by means of a buyout), or they can negotiate with the Treasury to receive a capital infusion, which, like capital raised in the private sector, would require them to give up equity.

In the case where a bank's capital turns out to be negative, the bank should be liquidated or taken over (either by the government or by some private entity). In such a case, I would not oppose using public money to reduce the bank's liabilities so that some other private entity would be willing to take it over. (In the case of a commercial bank with insured deposits, the government would have to pay that money anyhow, when the FDIC pays depositors' claims.)

Mon Sep 22, 12:25:00 AM EDT  
Blogger knzn said...

Why is it that everyone seems to think either that it's all about liquidity or that it's all about capital? It's about both, for Christ's sake!

Mon Sep 22, 01:27:00 AM EDT  
Blogger the_collective_unconscious said...

Bank "capital" is almost entirely notional, as I said, in a fractional reserve fiat money system. The Fed can always make more. And I'd rather make the errant banks work to restore "reasonable" "capital" levels than bail them out.

As for fascism: I don't trust Paulsen any more than any of Bush's team. The Patriot Act is an abomination, as is the Imperial Fed, as is this bail-out. I don't know that it would be inflationary, although the temptation is clearly there. They'd just have to get a wage-price spiral going without asking consumers to take on debt, which they probably won't be eager to do.

I am *enraged* when Paulsen says he cannot countenance limits on executive compensation of these jokers who are now being bailed out, and I suspect a lot of people feel the same way.

We have a revolution brewing.....

Mon Sep 22, 10:09:00 PM EDT  
Blogger knzn said...

How can the Fed make more bank capital? It can only change the composition of bank capital, exchange one kind of bank asset (e.g. money) with another (e.g. T-bills). There are only subtle ways the Fed can influence bank capital, mostly by influencing bank profits so that capital builds up over time (e.g. keeping rates low so that banks have a bigger profit margins on their fixed-rate loans). But the only way I can think of for the Fed to raise bank capital quickly is by investing in the bank, which the Fed seldom does, or by just giving the bank money for free, which it never does straight out, but possibly it might do so by overpaying for bank assets (though I can't think of an example where the Fed did that).

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