Experts See a Need for Punitive Action in Bailout

By PETER S. GOODMAN
Published: September 22, 2008

As economists puzzle over the proposed details of what may be the biggest financial bailout in American history, the initial skepticism that greeted its unveiling has only deepened.

Some are horrified at the prospect of putting $700 billion in public money on the line. Others are outraged that Wall Street, home of the eight-figure salary, may get rescued from the consequences of its real estate bender, even as working families give up their houses to foreclosure.

Most economists accept that the nation’s financial crisis — the worst since the Great Depression — has reached such perilous proportions that an expensive intervention is required. But considerable disagreement centers on how to go about it. The Treasury’s proposal for a bailout, now being negotiated with Congress, is being challenged as fundamentally deficient.

“At first it was, ‘thank goodness the cavalry is coming,’ but what exactly is the cavalry going to do?” asked Douglas W. Elmendorf, a former Treasury and Federal Reserve Board economist, and now a fellow at the Brookings Institution in Washington. “What I worry about is that the Treasury has acted very quickly, without having the time to solicit enough opinions.”

The common denominator to many reactions is a visceral discomfort with giving Treasury Secretary Henry Paulson Jr. — himself a product of Wall Street — carte blanche to relieve major financial institutions of bad loans choking their balance sheets, all on the taxpayer’s bill.

There are substantive reasons for this discomfort, not least concerns that Mr. Paulson will pay too much, thus subsidizing giant financial institutions. Many economists argue that taxpayers ought to get more than avoidance of the apocalypse for their dollars: they ought to get an ownership stake in the companies on the receiving end.

But an underlying source of doubt about the bailout stems from who is asking for it. The rescue is being sold as a must-have emergency measure by an administration with a controversial record when it comes to asking Congress for special authority in time of duress.

“This administration is asking for a $700 billion blank check to be put in the hands of Henry Paulson, a guy who totally missed this, and has been wrong about almost everything,” said Dean Baker, co-director of the liberal Center for Economic and Policy Research in Washington. “It’s almost amazing they can do this with a straight face. There is clearly skepticism and anger at the idea that we’d give this money to these guys, no questions asked.”

Mr. Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the door: a potentially swift shredding of the American financial system. That would be catastrophic for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to buy homes and cars, and to pay for college.

Some are suspicious of Mr. Paulson’s characterizations, finding in his warnings and demands for extraordinary powers a parallel with the way the Bush administration gained authority for the war in Iraq. Then, the White House suggested that mushroom clouds could accompany Congress’s failure to act. This time, it is financial Armageddon supposedly on the doorstep.

“This is scare tactics to try to do something that’s in the private but not the public interest,” said Allan Meltzer, a former economic adviser to President Reagan, and an expert on monetary policy at the Carnegie Mellon Tepper School of Business. “It’s terrible.”

In part, Mr. Paulson’s credibility has been dented by his pronouncements in previous weeks that the crisis was already contained. Some suggest this was a well-intentioned effort to stem panic. But the aftermath complicates his quest for the bailout.

“If you view your public statements as an instrument of policy, people don’t believe you anymore,” said Vincent R. Reinhart, a former Federal Reserve economist and now a scholar at the conservative American Enterprise Institute.

The biggest point of contention is over whether and how taxpayers would benefit if the bailout succeeded in righting the financial system, sending banking stocks upward.

In Mr. Paulson’s plan, the Treasury would have the right to buy as much as $700 billion worth of troubled investments, with the taxpayer recouping the proceeds when those investments were sold over coming years. But many economists — Mr. Elmendorf among them — argue that taxpayers should get more out of the deal, securing stock in the banks that make use of the bailout. The government could then sell off that stock at a profit when conditions improve. A similar approach was used successfully in Sweden in the early 1990s when its financial system melted down.

Others argue that any bailout must pinch the people who have run the companies now needing rescue, along with their shareholders, addressing the unseemly reality that executives have amassed beach houses and fat bank accounts while taxpayers are now stuck with the bill for their reckless ways.

“It absolutely has to be punitive,” Mr. Baker said. “If they sell us the junk, then we own the company. This isn’t a way to make these companies and their executives rich. This should be about keeping them in business so the financial system doesn’t collapse.”

Other questions center on how to value what the Treasury aims to purchase — an issue that goes to the heart of the crisis itself.

The financial system got to its dangerous perch by betting extravagantly on real estate. When housing prices began plummeting and borrowers stopped making payments, financial institutions found themselves with huge inventories of bad loans. Not simple loans, but complex investments created by pooling millions of mortgages together and then slicing them into pieces. These were the investments that Wall Street bought, sold and borrowed against in cooking up the money it poured into housing.

The trouble is that these investments are so intertwined and complex that no one seems able to figure out what they are worth. So no one has been willing to buy them. This is why banks have been in lockdown mode: with mystery enshrouding both the value of their assets and their future losses, banks have held tight to their remaining dollars, depriving the economy of capital.

Now, the Treasury aims to clear the fog by buying up these investments. But their value is as mysterious as ever.

“There’s a tendency for people to think these are stocks and bonds and you know what the price is,” said Bruce Bartlett, a former White House economist under President Reagan. “The problem is people are operating in a world in which nobody knows what the hell is going on. There’s some naïve assumptions about how this would function.”

If Mr. Paulson pays the market rate — whatever that is — that presumably would not be enough to persuade banks to sell. Otherwise, they would have sold already. For the plan to work, Treasury has to pay a premium.

“It’s a straight subsidy to financial institutions,” said Martin Baily, a former chairman of the Council of Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings Institution. “You’re essentially giving them money.”

Mr. Baily favors the basics of the Paulson plan, albeit with some mechanism that would give the government a slice of any resulting profits. And yet he remains troubled by the dearth of information combined with the abundance of zeroes in the bailout request.

“I’d like a clearer statement of what we were afraid was going to happen that requires $700 billion,” Mr. Baily said. “Maybe they don’t want to talk about it because it would scare everybody, but it’s a bit much to ask.”