An Emerging Consensus on the Paulson Plan: Government Should Force Bank Capital Up, Not Socialize the Loans

In time of war, there is a tendency for both parties to rally around the president, as we saw (all too well) in Iraq after September 11. In time of financial panic, there is often a similar inclination. The two presidential candidates, for example, are being very careful in their statements. I don't blame them. The issues are too complex to be taken on inside the context of a political campaign. Both candidates realize that the danger of a verbal misstep that the other side can try to blame for worsening the crisis is far greater than the likelihood that either one will come up with a brilliant solution that will gain widespread support or will solve the problem, let alone both.

Having said that, opposition to the $700 billion plan proposed by Treasury Secretary Henry Paulson September 19 has coalesced quickly, from both ends of the political spectrum.

Sebastian Mallaby also pursues the Iraq analogy in "A Bad Bank Rescue" in the Washington Post, September 21: "...in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice. It would spend billions of dollars on the theory that preemption will avert the mass destruction of banks."

We can all join in, tweaking the supposed free-market conservatives of the Bush Administration for proposing the biggest bailouts of history. But it is not the hypocrisy of the bailout that bothers me, or the size. I have used yet another military analogy: "They say there are no atheists in foxholes. Then there are also no libertarians in financial crises."

The explicit lack of oversight or checks and balances in the Treasury proposal is worrisome -- and it worries Congressional Democrats -- with its overtones of suspending constitutional rights and checks in what was supposed to be a war on terrorism.

But the nature of the bailout, how the money is to be used, is what bothers me. As Mallaby says, "Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans.” Examples are not tied to a particular political viewpoint or party. He mentions the proposal of Ragu Rajan and Luigi Zingales that the government could tell banks to cancel all dividend payments; and one by Charlie Calomiris and Doug Elmendorf that the government could buy equity stakes in banks themselves, rather than just buying their bad loans.

Similarly, in today's New York Times op-ed page, Paul Krugman on the left side and Bill Kristol on the right side both attack the plan. Krugman's logic ("Cash for Trash") is a good example of what Mallaby calls the core insight: "…the financial system needs more capital. And if the governments is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don't go to the people who made the mess in the first place." Sounds right to me. You can’t socialize the losses if you don’t also socialize some of the gains.

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