Economists Talk About Crises

It's what we do. Now, I in no way consider myself an expert on financial markets, nor do I consider myself peculiarly well informed about the current situation or the Treasury's plan to fix it. But I know the jargon of economics well enough to get a picture of what's actually debatable here and what's political posturing.

To get a pretty good (and I think remarkably clear from a non-economist perspective) understanding of what is currently being debated in congress, I'd like to direct you to Harvard economist Greg Mankiw's blog:

The Case Against the Paulson Plan

There are only two things I'd prefer to add to Dr. Shimer's characterization there. In reference to paragraph 7 of the letter, I think it's inaccurate to say the plan won't deal with banks and other institutions fears that they will end up buying bad assets (Akerlof's 'lemons' mentioned in the letter is taken from the term for a used car that is no good, but the buyer can't know in advance). The contention of the administration is that if the government voluntarily buys the assets containing the bad debt, then what firms later offer to sell other banks will be mostly good assets, and the buyers will know that. The government can afford, as the argument goes, to take the hit from the bad debt and then sell what's left of the assets, good debt, later on. These companies can't afford to wait it out, but the government can. That's the argument in favor of this plan.

On the other hand, the number one problem with the plan, in my view, is that in order to prevent panic (which this plan will likely do, I think), we are failing to allow mismanaged firms to suffer their losses. An alternative plan that allows insolvent institutions to take losses while still preventing panic and alleviating the lemons problem would be better. However, in order to prevent panics / bank runs / etc. there may not be time to design a better plan.

Ideally, what we want to see is firms taking risks, and if things go well they get all of the reward (the benefits don't get syphoned off to someone who wasn't at risk), and if things go poorly they suffer all the loss. Clearly this is not the way these markets are currently operating, regardless of the plan chosen now. The public is going to suffer a loss because of these financial companies decisions one way or another. Henry Paulson and Ben Bernanke seem to think their plan is the best way to cut the public's losses. Robert Shimer and many others disagree. But that's what this debate is really about. It's not about helping the rich at the expense of the poor or which party takes money from whom. It's about finding the best way to balance panic prevention, sound incentives, and public pursestrings, all recognizing that the first puts serious constraints on how long congress gets to make a decision.


...or maybe it's like this: