[DEBATE] : Paulson's plan was not a true solution to the crisis, By Martin Wolf

[Riaz K Tayob]

Paulson's plan was not a true solution to the crisis
By Martin Wolf

Desperate times call for desperate measures. But remember, no less, that 
decisions taken in haste may shape the financial system for a 
generation. Speed is essential. But it is no less essential to get any 
new regime right.

No doubt, the crisis has long passed the stage when governments could 
leave the private sector to save itself, with just a little help from 
central banks. For the US, the rescue of Bear Stearns was the moment 
when that option evaporated. But the events of the past two and a half 
weeks – the rescues of Fannie Mae and Freddie Mac, the failure of Lehman 
Brothers, the sale of Merrill Lynch, the rescue of AIG, the flight to 
safety in the markets and the decisions by Morgan Stanley and Goldman 
Sachs to become regulated bank holding companies – have made a 
comprehensive solution inevitable.

The US public expects action. The question is whether it will get the 
right action. To answer it, we must agree on the challenge the US 
financial system faces and the criteria for judging how it should be met.

What then is the challenge? The answer given by Hank Paulson, the 
all-action US Treasury secretary, last Friday, in announcing his 
"troubled asset relief programme", is that "the underlying weakness in 
our financial system today is the illiquid mortgage assets that have 
lost value as the housing correction has proceeded. These illiquid 
assets are choking off the flow of credit that is so vitally important 
to our economy." The core challenge, then, is viewed as illiquidity, not 
insolvency. By creating a market for the toxic assets, Mr Paulson hopes 
to halt the spiral of falling prices and bankruptcies.

I suggest we should take a broader view of events. The aggregate stock 
of US debt rose from a mere 163 per cent of gross domestic product in 
1980 to 346 per cent in 2007. Just two sectors of the economy were 
responsible for this massive rise in leverage: households, whose 
indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 
2000 and 100 per cent in 2007; and the financial sector, whose 
indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent 
in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the 
financial sector exploded, as did the sector's notional profitability. 
But leverage, alas, works both ways.

Since US net international debt was 39 per cent of GDP at the end of 
2007, virtually all of this debt is an asset of another domestic entity 
and would net out to zero. But when the gross debt stock is huge and 
economic conditions difficult, the chances that many entities are 
bankrupt is high. When people fear mass insolvency, lenders stop lending 
and the indebted stop spending. The result can be the "debt deflation", 
described by the American economist, Irving Fisher, in 1933 and 
experienced by Japan in the 1990s.

Sector debt

Given the recent explosion in leverage, the challenge is unlikely to be 
one of mispricing of the toxic mortgage-backed securities alone. Many 
people and institutions made leveraged bets that have since gone sour. 
Their debt cannot be repaid. Creditors are responding accordingly.

Now turn to the criteria to be used in judging the intervention. First, 
it would deal with the systemic threat. Second, it would minimise damage 
to incentives. Third, it would come at minimum cost and risk to the 
taxpayer. Not least, it would be consistent with ideas of social justice.

The fundamental problem with the Paulson scheme, as proposed, is then 
that it is neither a necessary nor an efficient solution. It is not 
necessary, because the Federal Reserve is able to manage illiquidity 
through its many lender-of-last resort operations. It is not efficient, 
because it can only deal with insolvency by buying bad assets at far 
above their true value, thereby guaranteeing big losses for taxpayers 
and providing an open-ended bail-out to the most irresponsible investors.

Furthermore, these assets are illiquid precisely because they are so 
hard to value. The government risks finding its coffers stuffed with 
huge amounts of overpriced junk even if it tries not to do so. Also 
objectionable, though more in design than in the fundamentals, were the 
unchecked powers for the Treasury. Such a fund should be operated 
professionally, under independent oversight. Finally, if the US 
government is to bail out incompetent investors it should surely also 
provide more help to the poor and often ill-informed borrowers.

Yet, above all, a scheme for dealing with the crisis must be able to 
remedy the looming decapitalisation of the financial system in as 
targeted a manner as possible. A fascinating debate on how to do this is 
under way in the economists' forum on FT.com. To the contributions, 
including Tuesday's Comment page article by Dominique Strauss-Kahn, 
managing director of the International Monetary Fund, I would add one by 
Luigi Zingales of Chicago University's graduate school of business.*

The simplest way to recapitalise institutions is by forcing them to 
raise equity and halt dividends. If that did not work, there could be 
forced conversions of debt into equity. The attraction of debt-equity 
swaps is that they would create losses for creditors, which are 
essential for the long-run health of any financial system.

The advantage of these schemes is that they would require not a penny of 
public money. Their drawback is that they would be disruptive and highly 
unpopular: banking institutions would have to be valued, whereupon 
undercapitalised entities would have to adopt one of the ways to improve 
their capital positions.

If, as seems plausible, a scheme that imposes such pain on the financial 
sector would be rejected out of hand, the next best alternative would be 
injection of preference shares by the government into decapitalised 
institutions, on the lines proposed by Charles Calomiris of Columbia 
University. This would be a bail-out, but one that constrained the 
behaviour of beneficiaries, not least on payment of dividends. That 
would make it far better than dropping benefits on the unworthy, via 
mass purchases of overpriced toxic paper.

What then do I conclude? Yes, there may well be a place for intervention 
in the market for toxic securities. But this is a costly and ineffective 
way of meeting today's deepest challenge. What is needed, still more, is 
a clear and effective way of deleveraging and recapitalising the 
financial sector, ideally without using taxpayer funds. If such funds 
are to be used, they must also be injected in as carefully targeted and 
controlled a way as possible. Comprehensive action is essential, as Mr 
Paulson has decided. But let the US take the time to make that 
comprehensive action right.

*Why Paulson is wrong, www.chicagogsb.edu/igm
martin.wolf at ft.com
Copyright The Financial Times Limited 2008