Paul Krugman, in yet another attempt to assess the rescue plan, raises some interesting issues but demonstrates a serious misunderstanding of a basic and critical point:
Thinking the bailout through
3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.
4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.
So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.
But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:
(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.
(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.
Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.
His point (a) is well taken. However, point (b) is simply not theoretically accurate.
Firms have capital to support their business activities. If they are undercapitalized they need to either (a) raise more capital or (b) scale back their business activities. By selling $700 billion of troubled assets to the Treasury financial services firms are scaling back (or exiting) a line of business.
Imagine, *hypothetically*, that across the financial services sector these $700 billion of troubled assets were supported by $70 billion of capital, i.e., a 10-1 assets to capital ratio (that is lower than the average leverage across all lines of business but most business lines are less risky and can support higher leverage).
Selling $700 billion of assets to the Treasury reduces the sector's collective balance sheets by $700 billion and frees up $70 billion in capital which then becomes available to support other activities. Will the financial services sector still be undercapitalized after this happens? Maybe, maybe not. But Krugman ought to at least acknowledge the theoretical possibility that the Treasury plan can solve the capital problem by allowing firms to shed assets rather than raise capital. There is no *theoretical* requirement that the Treasury pay premium prices in order to boost the capitalization of the financial services sector to an appropriate level.
As to why Krugman is stuck on this point of premium prices, I can only guess.
Let me be clear - as a matter of fact, it is possible that the financial services sector will still be undercapitalized after selling $700 billion of assets. But as a matter of theory, it is also possible that they will have adequate capital after this sale. For Krugman to state as a theoretical certainty that "the plan does nothing to address the lack of capital unless the Treasury overpays for assets" (his emphasis) is simply not accurate. In fact, the plan does something to address the capital problem - it allows firms to de-leverage by shedding assets.
Whether it does enough, I don't know. Given the resources and reporting available to the Treasury, the Fed and the SEC, I suspect they have a reasonably well-informed opinion on this point, and I certainly hope that by the end of the week our also Congressman also have a well-informed opinion. I also hope the reality-based community can formulate their objections to this rescue package on the basis of, well, reality. Heaven knows there is plenty to which one might object.
MORE: Matt Yglesias is bamboozled I see.
KIDDING? Newt Gingrich sees this as an opportunity to restructure out tax code and our national energy policy. All by the end of the week? Geez, maybe Congress could work through the weekend and solve Social Security and health care, too.