Free Markets, Free People

Zombie Ideas And Moral Hazard

Paul Krugman has seen the new Treasury plan (the “Geithner plan” as he calls it) that addresses the problem with the banks and he finds it wanting:

The Geithner plan has now been leaked in detail. It’s exactly the plan that was widely analyzed — and found wanting — a couple of weeks ago. The zombie ideas have won.

The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

The plan itself is a three part plan as described here:

The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell.

In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money.

In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Securities Loan Facility, a joint venture with the Federal Reserve.

The Geithner Plan

The Geithner Plan

The goal of the plan is to leverage the dwindling resources of the Treasury Department’s bailout program with money from private investors to buy up as many of those toxic assets as possible and free the banks to resume more normal lending.

 As noted, Krugman is not impressed. In fact, he suddenly discovers the problem of “skewed incentives” and “massive” moral hazard:

To this end the plan proposes to create funds in which private investors put in a small amount of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad — I mean misunderstood — assets. This is supposed to lead to fair prices because the funds will engage in competitive bidding.

But it’s immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.

Or to put it another way, Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard.

How in the world could the level of intrusion contemplated by the government create anything but “skewed incentive” and “massive moral hazard”? But that aside, will it work?

Per Krugman, probably not:

This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized. And I fear that when the plan fails, as it almost surely will, the administration will have shot its bolt: it won’t be able to come back to Congress for a plan that might actually work.

What an awful mess.

Indeed. And an amazing admission by Krugman who was as sure as anyone in the tank for Obama that he’d be “the answer” to all of our problems. Instead he’s discovering what a lot of Obama supporters are discovering – Obama’s an empty suit who is more interested in the perks and rewards of the office than the work it entails.

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5 Responses to Zombie Ideas And Moral Hazard

  • Off topic, though perhaps slightly relevant: I owe Warren Buffett something of an apology (not that he would give a flying anything about it, but I’ll do it anyway) for comments I made at this blog about his level of experience. I said I didn’t think he really understood economics, and that’s probably largely true. (And my own understanding of economics is of the bootstrap variety.) I said that Buffett was primarily a great investor, and that is certainly true. He knows how, when, and where to put his money to work. But I also said, and here’s where I owe the apology, that he had never created anything, implying that he was not really an entrepreneurial capitalist. That’s wildly wrong. Buffett was an entrepreneurial prodigy, literally, from childhood. I did not know that. My opinion was formed on the basis of his apparent liberalism and belief in big government solutions, which would seem to contradict his entreprenuerial genius.

    I thank Bruce for his indulgence on this OT comment.

  • So, Obama has already lost Mo Dowd, and now Krugman. Things are not going well in Unicorn Land when a really liberal politician loses those two.

  • I suspect, Bruce, that at least part of the problem is an inability to change direction.  This inability is caused by not being able to admit that the economy was in trouble, because of democrat party policies.  The only way out of that box is to continue the policies without change, and to justify this inaction, they make the absurd claim that there is in fact nothing wrong with the economy. 

    Krugman of course isn’t going to make that connection, at least publicly.

  • They are trying to reinflate the bubble. Of course it won’t work.

    As for approach number 1, it is already being tried by the private sector;