Thursday, November 13, 2008

A recent discussion on TARP

“There are no atheists in foxholes, and no libertarians in financial crises.”
-- Paul Krugman- Economist and New York Times contributor

"In a credit crisis, a central bank should lend freely against good collateral at a high rate of interest"-- Walter Bagehot, Editor of "The Economist" in the 1860's

I've been thinking that I could and should write something about the extraordinary events of the past weeks and months, and the extraordinary request by Hank Paulson for a $700 billion dollar fund to use at the Treasury's discretion. Most of you who read this note will probably be surprised that I support the Paulson/Bernanke/Bush part of this plan. Clearly I and my industry are in "the foxhole" currently. I will not blame anyone who dismisses this note as an abandonment of principle under fire.

It is easy to point out many policy prescriptions that, had they been followed, may have prevented this mess. The mistakes at the government level were myriad 1) Massive government incentivization of home ownership 2) Massive government funding to assist homeownership 3) Legislative extortion of lenders to lend to those who should not have borrowed. 4) Persistent positive inflation causing money illusion and over-borrowing 5) Accounting Rules which were pro-cyclical and did not promote transparency or honesty. The list goes on.

However, none of this is relevant to the world that we live in. Here is the case as I see it, and how this action can be supported. Keep in mind that masochism is not policy and schadenfreude is a particularly pointless emotion. Also keep in mind that I totally disagree with Paul Krugman, and Libertarians can support action in the real world without sacrificing their beliefs. The fact is that in present form our "financial markets" are not free. For better or worse, in the wake of the Great Depression we decided that the act of providing long term credit to those who needed/demanded it was in many ways a social function that needed to be highly regulated. What we have is an intricate web of public and private actors, goals, interests, and incentives that form our financial market.

It is tough to think of a good jumping off point to explain the current financial situation, but here goes nothing. Let’s start with the fact that, our currency, the dollar, is a fiat currency. This means that our currency is NOT freely convertible into any recognized store of value (e.g. gold) AT A RATE SET BY LAW (it is of course freely convertible into almost anything at rates set by the market--a hugely important point). In other words, all that it is backed by is the full faith and credit of the U.S. government and, by extension, your tax dollars and your productivity (assuming we don't have a revolution). The Department of the Treasury is responsible for the management of the supply of this fiat currency in concert with the Federal Reserve. What does this mean?

Here is the normal, semi-Faustian bargain that the people have with the managers of a fiat currency:

1). Rational economic agents recognize that the monetary authority will permit and even desire mildly positive inflation over time because the central government will tend to run deficits and issue debt and, as the nominal value of debt is fixed, inflation will erode the real cost over time.

2). These same rational economic agents quickly learn to treat the currency as a unit of account, but not as a store of value. Immediate consumption occurs in terms of the currency, but stored productivity (savings) occurs in real or financial assets that offer positive or perhaps neutral real returns (stocks, bonds, houses, gold, coins, art, etc.)

3). As time marches on, rational economic agents additionally recognize that their wealth can be increased by borrowing in nominal terms of the unit of account, and investing the borrowed money in real assets (taking a mortgage). Lenders, in a stable positive inflationary environment, can price fixed nominal debt in such a way that they earn a positive spread over time. Everyone is happy.

Occasionally, in periods such as the years leading up to 2007, markets enter manias where flawed assumptions and flawed math lead everyone to believe that the nominal prices of certain real assets will never again go down. When everyone reaches this conclusion, there follows a massive expansion of credit as people attempt to capitalize on this opportunity to build real wealth. For the purposes of this piece, I will just assert that this happens without trying to explain its genesis. It can be seen over and over in the historical record. We have just had one of these in residential and commercial property.

What is the aftermath of such a "mania"? It is important to know the answer, because we are currently there. There comes a time when people start to realize that imprudently high prices have been paid, and perhaps the stored value of their productivity is not safe after all in their recently acquired assets. They try to sell them. If they all try at once, we have a real problem. Why? Remember that the nominal value of the debt that they incurred in the unit of account (the dollar) is fixed. However, the price of the real asset is floating (or sinking in this case). When you have a massive increase in the supply of an asset priced in dollars, the price of that asset in dollars goes down. At the same time that this is happening, lenders start to realize that some horribly imprudent loans have been made, and that they are going to have problems. They begin to call for more collateral to support the loans they have made, and to stop making new loans to protect their own balance sheets. Collateral calls force asset owners to do more selling, further depressing prices. At some point, equity in these assets (value of asset less value of debt supporting asset) disappears. When that happens, the asset owner loses all incentive to continue to pay for and manage the asset. He or she gives it back to the bank in order to satisfy the debt. This is a disaster for banks. They operate on preciously thin capital cushions. For most, an 8-10% loss of asset value would make them totally bankrupt. They do not want to own and manage real assets. They want to own paper claims on future cash flows. Banks tend to sell assets acquired this way almost immediately, perpetuating a downward price spiral. Eventually the reduced value of all the assets on the books of these banks falls below the value of their liabilities in terms of customer deposits and other borrowings. This is called insolvency, and leads to bank failures.

If the only result of these events would be that bad borrowers and bad lenders lost wealth and capital, the proper response would be to simply allow it to play out. However, the particularly vicious reality of a debt-driven asset deflation cycle such as the one I’ve laid out is that the severity of the cycle will harm otherwise prudent borrowers and lenders that potentially need not have been harmed. The Great Depression is the ultimate example of this situation. During the Great Depression, real GDP decreased by a third, and nominal GDP decreased by half. Suffice it to say, owners of assets do not retain much wealth in situations such as these, no matter how prudent they are. Outcomes such as these are truly disastrous for everyone, no matter what “street” they live on. The American people have far more debt today (and far more wealth) than they did going into the Great Depression.

Ben Bernanke is a student of the Great Depression. He knows (or believes) that the transmission mechanism which turned a business downturn and then recession 1929-1930 into the Great Depression was a debt-driven asset deflation cycle which caused a collapse in the banking system, a collapse in lending, and ultimately a collapse in the money supply. This is a view supported and promulgated by Milton Friedman and Anna Schwartz in their seminal work on money and inflation. No matter how likely you think this scenario is (for the record I think it is highly unlikely), it is to be avoided at all costs. I promise you that he has no vested interest in saving “Wall Street” other than his certainty that the potential (however slight) exists for enormous pain to be felt on Main Street.

Now let’s consider Hank Paulson’s view from the Treasury. He knows America as a nation is immensely wealthy. This is because we have the most productive labor force in the world that has flourished in a mostly-free-market regulatory environment that encourages wealth creation and risk-taking. It is also partly because of, and related to, the fact that people all over the world have recognized this and lent us their money to use to create wealth. They have done this lending in exchange for debt denominated in U.S. dollars. Most of this lending (or equity financing) has been to the private sector, but a lot of it (2.5 trillion) has been foreign lending to the U.S. Government. Since the start of this financial crisis last September, the U.S. dollar has actually performed remarkably well versus the rest of the world’s currencies. The dollar is roughly unchanged over this time period. The implication of this is that while foreigners may have been selling riskier dollar-denominated assets, they have then held the cash in U.S. dollars, or used the cash to purchase U.S. Treasury bonds, which are still perceived to be the safest asset in the world in terms of retaining principal value. The nightmare scenario is that you have a debt-driven deflationary cycle which engulfs the entire financial system, causing foreigners to totally lose their faith in its integrity as a whole. The flight of capital out of dollars and out of our country would add immeasurably to the pain of any downturn. It would dramatically increase the cost of capital for every project imaginable and harm our future wealth in a way that would take a very long time to repair. No matter how you feel about “foreign capital”, the reality on the ground is that our current standard of living requires billions of dollars of it to flow into our country every single day.

Let’s fast forward to today and then talk solutions. I have chosen to take at face value the fact that Paulson and Bernanke believe that there is a non-zero and growing chance that we will have a total collapse in our banking system. The ongoing stress in the credit and interbank lending markets corroborate this reality. The price tag of such a collapse is unknowable, but suffice it to say, it would be trillions and trillions of dollars. It will make $700 billion seem like a tag sale. The Treasury hopes that by buying assets from banks that can afford to sell to them, the collapse will be averted and the system will have time to absorb its losses in a rational manner. The optimal outcome is for good banks that are currently caught in the vortex to survive, and for bad banks and managements to go out of business. In some sense the Treasury’s plan can ensure this outcome by paying a price for assets that will bankrupt imprudent banks and recapitalize and buttress prudent ones. I do not know whether or not it will work or whether or not Paulson and Bernanke are even correct about the potential for a melt down. Let’s look at four possible outcomes though:

1) Approve plan, P/B wrong about meltdown. Markets don’t collapse, perhaps the money never even gets invested, tax payers make out like bandits on what they do buy.

2) Approve plan, P/B right about meltdown. Money gets invested. Perhaps the potential meltdown is averted. If so, taxpayers make out again. If not…we have a deep and prolonged recession with awful (but perhaps lessened) consequences.

3) Vote down plan, P/B wrong about meltdown. Markets don’t collapse, we experience some further stress, we have a mild recession, and growth continues

4) Vote down plan, P/B right about meltdown. Financial disaster ensues. Trillions of dollars worth of wealth that was honestly acquired and prudently protected is destroyed. America loses its preeminent position in the world financial system. A 10-20 year depression follows.

I believe alternative four is to be avoided at all costs, and further that delay is likely to cause wealth losses in this country that far exceed the $700 billion dollar price tag of this plan, even in scenario 3, no bill, no disaster. Exhibit A is the loss of 1.6 trillion in stock market wealth on Monday, along with huge losses in bond market wealth as well.

At this point it feels almost like a coda, but I believe a purely Libertarian argument can be made for this action on the grounds that the proper sphere of government is in preventing and redressing the harms that one man may inflict on all others as a direct result of his/her actions. I promise you that many many many extremely innocent players could be deeply harmed by continued forced liquidation of real assets at fire sale prices. If this causes a halt in lending, (as it already has in many cases) folks that have no debt may find themselves out of jobs they would have otherwise retained due to business failures during this downturn. The Paulson Plan could almost be seen as forced vaccination against a communicable and fatal disease (financial panic) like polio.

A pragmato-libertarian argument is that if this scenario could be prevented at a small cost to the tax payer or perhaps even at a tremendous gain, it could stave off the avalanche of increased and restrictive legislation that is certain to rain down on us in the aftermath and that could cause decades of unnecessary below-trend growth.

A purely pragmatic argument is that if Paulson is wrong, the cost is almost certain to be negligible to the tax payer, whereas if he’s right, the costs will ultimately be much much higher than $700 billion. In either case, he should have the ability and freedom to try.

You should be angry with our government and your representative for a pattern of action lasting over 70 years that was a major contributor to this problem. You should be angry that the mechanism for getting this passed seems to be stuffing it full of unnecessary goodies. There is plenty of blame to be leveled at both Wall Street and Main Street for the massive expansion of lending/borrowing which led us to this point. However, you should not let any of this stand in the way of the fact that almost no matter how small the probability of a total collapse in our banking system is, the weighted present value of such a collapse is likely to far exceed whatever losses we may all incur in an attempt to invest $700 billion dollars to unclog our banking system and allow for an expedient resumption of the necessary credit which is the engine of our financial system and economic growth.

Respectfully,

Michael W. Griswold

4 comments:

Mike Griswold said...

Mike:
Your argument for the Paulson plan is the most persuasive I have heard . That such an argument has not been laid out by those who seek to pass this plan is, of course, irresponsible but not in the least surprising. Normally, when someone asks for $700 billion, an amount so incomprehensible that it makes the usual haggling over budgets and programs look pathetically irrelevant in comparison--we normally say the burden of proof is, to say the least, on them. Little proof has been presented by Paulson, Bush, Pelosi, and company; this (though, of course, it's not your job), is a start.

So as a reasonable person with an unreasonable request put to them would respond, I present you some quick, on-the-fly questions in response:

1. You note at the beginning that government mismanagement led in no small degree to the current crisis. You also note that this is not relevant at the moment. This is incorrect. A folsky, Sarah Palin-like response to your point would be to say something along the lines of "fool me once, shame on you; fool me twice, shame on me." A more relevant way of responding would be to ask whether a prudent lender would give a large loan to someone who has already proven incapable of managing money. A third, political-theoretical response would be Hayekian, and would run something like this: the market is an incomprehensibly complex signaling matrix. Its great virtue is its ability to coordinate the actions of individuals with greatly imperfect knowledge. One very powerful argument against socialism/centralization/the Paulson plan is that Paulson and his bureaucracy--particularly because they have proven themselves inept in the past--can only by mistake make the situation better, and are much more likely to make it worse. The information problem, of course, extends far beyond Paulson; as it turns out, only 6.7% of the members of Congress have econ degrees, and only 14% have business degrees more generally. This makes the question not one of giving car keys to a teen who has proven himself irresponsible; rather, it is giving the keys to a teen who cannot see. My question, then: seeing as economists--those who spend their entire lives studying questions exactly like these--have reached no consensus on whether the bailout will work; seeing as even those economists who do agree that the plan is needed cannot say how they think it will solve the problem, and to what extent; seeing as Paulson's reaction to the question of whether the plan will actually work has been and continues to be that "it simply has to work"; seeing as it was power in government hands that brought us here in the first place: given these things, why would we ever seek to solve this problem by further centralizing signaling procedures (the government-only MBS auctions) and centralizing decision-making?

2. You've depicted the Paulson plan as a move to recapitalize banks. In fact, many economists who oppose the bailout say the most appropriate move would be to recapitalize banks. But how can this be? Where in the Paulson plan, and where in Paulson's descriptions of the plan, does he say that recapitalization of banks is the way to go? To which institutions are we, in fact, throwing a lifeline in this case?

3. You mention several times that the "taxpayers" may make money here. When will we see that money? In what form will we see that money? Are you seriously suggesting that Washington will reimburse us? Will treat us, as we've been hearing, as investors? Are they not more likely to, say, spend it? To up the budget to account for a sudden influx of funds? Where can I log on to view my government portfolio? The bailout-as-carry-trade argument is, unfortunately, more dishonest than it is laughable, but it is plenty of both.

4. If, as you note, the likelihood of economic collapse is small, then why are we in such a rush? Nowhere do you state that economic collapse will occur tomorrow, or the next day, or two weeks from now. Bush's all-too-frequent references to the credit markets "freezing up," is, of course, absurd, because there is a great difference between a frozen credit market, in which loans have ceased to exist, and a tightening credit market, which, in this case, means that people who were getting loans yesterday--many of whom, as we've learned, shouldn't have been getting loans--aren't getting them today. If this is the credit market snapping back to reality, then who are we to step in?

5. Which belies a more important point, and the point at which I will speak as a principled libertarian who studies philosophy for a living. Allow me to make some principled statements. The word tyranny, in the American context, typically pertains to the powers one exercises. We have checks and balances, for example, to guard against the "tyranny" that would result from their being consolidated in the hands of one person. This, as I say, is a distinctly American idea because it is the definition we get from the Federalists, from Hume, and Locke, and all these great guys. It is, at the same time, a slightly impoverished notion of tyranny because it assumes a kind of radical (Puritan) moral equality. For the ancients, tyranny had much more to do with the kind of conduct one was willing to engage in; the appetites for which one was willing to pursue satisfaction. You could act "like a tyrant," for example, without ever acquiring political power. It had as much to do with intentions and conduct as it did with official capacity (the flipside of this, of course, is that the Greeks were more willing to put stock in the idea of a beneficent despot than we are today). Under this second idea, Henry Paulson is a tyrant. Paulson, an unelected official in a democratic government with a long history of constitutional rule, with checks and balances, with judicial review, with congressional oversight, with a strong faith in the value of deliberation and reason; Henry Paulson, in this government and age, asks for unchecked, unseen access to an amount of capital and, thus, influence, so vast as to be inconceivable. Who would be more powerful than Henry Paulson, were it to go through? Henry Paulson wants to assume world-historical power, and we're willing to give it to him with some minor scolding and a few congressional committees. Why should we think that such an amount of money, with so few strings attached, an amount with little oversight, an amount whose oversight is conducted by morons with no economic training--why should we think that such an amount won't't breed corruption in ways we've never imagined? Surely, the response to widespread corruption in both Washington and New York--surely the response is more money, more influence, more power.

6. Finally, you note that a libertarian could vote for this, and I suppose that's true. Libertarians can do a lot of things. Yet your definition of libertarianism says more than you let on. You write: "I believe a purely Libertarian argument can be made for this action on the grounds that the proper sphere of government is in preventing and redressing the harms that one man may inflict on all others as a direct result of his/her actions." This may be true, but it is not relevant. Who is the "one man"? What is the nature of the harm? Only if we assume that the market is not what libertarians must assume it to be--namely, an impartial allocator of goods--only then can this argument make sense. No one forced me to invest in WaMu. Likewise, no one at WaMu stole my money. That would be coercion or fraud. This is neither. Your idea of libertarianism is clearly a utilitarian one. There's nothing wrong with this; most economists are libertarians on utilitarian grounds. But the bailout brings out, more than any other issue I can think of, the difference between being libertarian on utilitarian grounds--in believing that markets are merely the best way of allocating goods, and that government intervention is therefore a matter of suboptimal outcomes--and being libertarian on moral grounds--believing that coercion is wrong, that power can only be transferred through consent, that it is always wrong, come hell or high water, to seize the property of one person and give to another who did not earn it. The utilitarian libertarian is still a libertarian, I'll allow, but must be subject to increased levels of questioning. What if the bailout was $2 trillion? What if it was $5 trillion? What if it merely required the imprisonment of a few unlucky individuals (and before you say there's a difference between jailing someone and taxing them, think about it a moment)? What if the bailout was only $25 billion, and it was given to the auto industry instead? At this point, says, the man to the indignant woman, we're just haggling over the price.

7. Let me put this point a little more clearly: say the bailout works. Say Paulson, against all odds, figures this out and we escape a major recession. What are we left with?

Land of the free, home of the brave? My ass.

Yours in liberty,
Brandon Turner
Visiting Assistant Professor
Department of Political Science
Wake Forest University

Mike Griswold said...

Brandon,

These are challenging and thoughtful questions and, as usual, they go to the heart of every bit of queasiness that I have about my support for this plan. I will try to answer them
sequentially and as clearly as I can.

1) I did not mean to imply that government mismanagement was irrelevant. I was more trying to convey a sense of crying over spilt milk, or sunk cost effect or whatever you want to call it. In addition, let me reluctantly invoke the ghost of Rummy--you go to war with the army you have, not the army you wish you had. To the point: How can we possibly trust or ask those who have partially or wholly caused this problem to provide a solution? Keep this in mind: U.S. Government debt and U.S. dollars are government obligations and the responsibility of the U.S. Treasury. They are feeling enormous pressure from owners of dollar denominated assets and obligations the world over to limit systematic event risk and fall out from this situation. Make no mistake about it, they will act and have. In October of 2007, the assets of the Federal Reserve were worth approximately 900 Billion dollars, of which approximately $800 billion were U.S. Treasury notes and bonds. Since that time, and in a very ad hoc manner, the Federal Reserve has, through its various new facilities and programs, grown the asset side of its balance sheet to 1.2 trillion dollars, while over that same time period its value of Treasury notes held has declined to roughly 500 billion dollars. In other words, the Federal Reserve has accepted 700 Billion dollars worth of non-U.S. Government collateral or guarantees in exchange for loaning the private market badly needed dollars and 300 billion dollars worth of treasury bonds. They are rapidly approaching a point where they would have to go to the U.S. Treasury for a credit line to continue this expansion. The Treasury, in turn, would have to go to Congress to get an increase in the National Debt ceiling to make this happen. Consider the Paulson plan a preemptive attempt to do something that they see as inevitable in a way, believe or not, the provides more oversight to the legislative branch than merely continuing what they are doing. Assuming we are committed to working within the system, this may be the American public's best chance to have a greater voice in the outcome.

There is no question that the market is extremely complex, and centralization of signaling procedures is highly undesirable. Furthermore, the signals coming from our financial markets have long been complicated and adulterated by government interference and flawed accounting rules. In looking for resolution to this problem, keep in mind that no major bank/broker except Merrill Lynch came to a private market solution recapitalization or merger. This was mostly because they had tangible assets in their Bloomberg stake, Black Rock stake, and the largest retail brokerage force in America. Indy Mac, Bear, Fannie Mae, Freddie Mac, Lehman, AIG, Wamu, and Wachovia all either were forced by their regulators into a deal, nationalized, or filed for bankruptcy. The major problem in all of these cases is the seeming judgment of private capital providers that the short naked put options (an upside-down homeowner can "put" his house to the bank in most states in America and the bank has no recourse to pursue his other assets to make up for principal shortfalls) imbedded in the mortgage loans and other structured products on their balance sheet were very difficult to value and rendered these entities potentially worthless. While surfing the wave of a debt-driven asset deflation spiral, none have been willing to speculate on "how low is low". It was only after the "Paulson Plan" was announced that Goldman raised money from Buffett, Morgan Stanley raised money from Mitsubishi, and Citigroup and Wells Fargo got into a bidding war over Wachovia. I believe that these events are related.

On to the how: The Treasury has stated that it intends to hire 10 sub-advisors from the private sector to invest this money on its behalf in eligible securities. This should serve to mitigate both the keys-to-the-blind-teen problem and the centralized signaling procedures problem. I further hope that they allow private capital to compete alongside these auctions and provide it with the full range of available information. The most pertinent issue is: How do we achieve the goal of floating only the responsible and punishing the incapable and culpable? What I hope is that none of these managers are forced or coerced to pay a price that is obviously unsupported by the likely future cash flows of the asset. What I believe that Paulson and Bernanke are hoping is that this price will prove to be higher than current "fire sale" or liquidation prices such that many banks are able to sell these assets without rendering themselves insolvent, and then go to the private market with cleaner balance sheets and recapitalize themselves. The likely future path for banks that are ultimately dead will be as follows: They will recognize that the gap between newly established market prices and their current carrying values are such that to sell in these auctions would render them insolvent. The private market will take their refusal to sell to mean either one of two things: They are so strong that they don't need to, or so weak that they can't. This distinction will not be hard to draw given publicly available balance sheet information. The bad banks will quickly be forced into the arms of better ones and cease to exist.

If the prices that these advisors are willing to pay are so low that no bank can afford to sell, then the Paulson plan will have been rendered essentially moot. This will signal that the problems are much worse than we thought. If these advisors are some how coerced or decide to pay prices higher than they should, undeserving entities could end up surviving. Given the justifiable furor surrounding the Treasury having this money at all, I find this scenario unlikely.

2) I believe that Paulson and Bernanke see the plan as a way to provide a floor under asset prices which gives the private sector the confidence it needs in order to recapitalize these banks on its own. I view the transfer of asset ownership as much cleaner than attempting to negotiate terms on which the government will provide outright equity to these firms. This is the scenario that will be on the table next should the Paulson plan fail. I view it as much scarier, much messier, and much more fraught with the danger for abuse, graft, and a general sense that the government is picking winners and losers.

3) I suppose that when I say that the tax payers may make money, what I really mean is that the price tag of this plan is likely to be far less than the face value of $700 billion, and potentially even negative (I.e. the assets could be liquidated for more than $700 billion). Perhaps it is too much to hope that any excess money would be simply used to pay down government debt, but to the extent that it did that would be a net positive for us all. In the Wall Street Journal a few days ago, Andy Kessler wrote an article where he asserted that the ultimate recovery/profit from AIG/Fannie/Freddie plus the "TARP" could be in excess of 2 trillion dollars. Maybe he's astronomically off, but this isn't small potatoes. My intention was not to specify how proceeds would be used, but merely that they might exist. This is in direct contrast to the "stimulus package" of a few months ago which was pure expenditure.

4) The lesson of the last several weeks is that in the electronic age, the loss of confidence in a financial institution can take it from rock solid to illiquid to dead within a matter of days. Presumably flight of capital out of our system and even the country could take a similarly short time period. I have no idea whether or not they have any specific information about a likely future event. Perhaps they were trying to terrorize Congress into action. Harry Reid let slip some statement about a major insurance company on the brink of failure Wednesday, and on Thursday they were all murdered. Sometimes the consequences of an outcome are more important that its likelihood. Perhaps I could cross a set of train tracks every day without looking with a very low likelihood of getting splattered. This would not change the finality of the adverse event. How much dumber would it be if a wise observer saw the train coming and said nothing to me? As you point out, we should rejoice if this merely represents a lack of credit availability to the unworthy. However, in a world where AAA-rated GE has to sell a 3 billion 10% perpetual preferred to Warren Buffett and $12 billion worth of common stock to the public at multi-year lows, I think it is safe to assume that the cost and availability of capital has gone up dramatically for everyone.

5) Wow. Well, I have tried to specify how I think the Treasury would decentralize this authority. Further, I firmly believe that the original bill was sent up the way it was not because they thought that they would get that unfettered authority, but because they knew that this process would be so fraught with sausage-making that they decided to send up the cleanest bill possible. Witness its expansion from 1 to 407 pages. Further, I don't think you have to worry that giving Paulson $700 billion to invest would give him world-historical power. It is rather scarier to imagine that this amount of money might not even be close to what is needed to get the job done. That may have been the message from the market today--who knows. Does the level of power make Paulson a tyrant, or is it his use of it? To badly abuse Plato, I think that Paulson is uniquely equipped for this role and is a much more likely candidate for some kind of economic version of Plato's Philosopher-King than a tyrant (that's a bit tongue in cheek).

6) So we're clear, I believe that the genesis of most of these harms comes from improper government action, incentivization, accounting standards, and regulations, not from market failures. Perhaps under my argument this makes it doubly theirs to redress. Properly functioning markets need information dissemination and transparency, neither of which is readily attainable when it comes to the financial realities of the bad assets on these balance sheets. What I have been trying to convey is that this intervention is an attempt to address a current situation of near panic. Panics lead to collapses, and collapses cause very significant collateral damage to innocent bystander firms and people. This is one of the lessons of the Great Depression. This is not "the government can fix the market". This is "the government helped create this quasi-market monster panic and therefore has an obligation to help destroy it". I hoped to couch it in terms that were a morally acceptable government intervention in economic life, perhaps similar to incurring national debt to fight necessary wars, in order to allow Libertarians to support trying this. As I've said repeatedly, its utility is still a matter of some doubt.

7) What I hope we are left with is a functioning system that has been recapitalized by the private sector, a Treasury with a surplus from judiciously timed and chosen investments, and some breathing room to properly and deliberately evolve the system towards something more stable and freer. I hope that other like-minded people are not wishing for the apocalypse of the financial system, out of which will rise the a brand new and morally pure system that will never have problems again. I am struck by the the downside risk and widespread pain that such an event would cause. It reminds me of Mill's pointed rebuke to the Socialist revolutionaries in his "On Socialism" essay. It is abject craziness to hope for a collapse of the old and a sublime transition to a new and glorious utopia.

Best,

Mike

Mike Griswold said...

Now we're talking. I hate it when people do this to me, but I'm about to do it to you. I've parsed and responded to your points below.

Mike Griswold wrote:
Brandon,

These are challenging and thoughtful questions and, as usual, they go to the heart of every bit of queasiness that I have about my support for this plan. I will try to answer them
sequentially and as clearly as I can.


More sequence and less clarity, please.


1) I did not mean to imply that government mismanagement was irrelevant. I was more trying to convey a sense of crying over spilt milk, or sunk cost effect or whatever you want to call it.
Fitting that you put it in economic terms. Part of where we talk past each other, I think, is that you're talking economics and I'm talking politics, or normative political theory. Figuring out whodunnit, so to speak, is certainly not the equivalent of crying over spilled milk. It is called accountability, and it is one of the only mechanisms available to citizens in a representative government for rewarding and punishing their leaders. This is a small point, but I've made it.

In addition, let me reluctantly invoke the ghost of Rummy--you go to war with the army you have, not the army you wish you had.
Wrong. You might decide to sit at home--something Rummy should've thought about in 2003. Small gripe, again, but I'm full of them.

To the point: How can we possibly trust or ask those who have partially or wholly caused this problem to provide a solution? Keep this in mind: U.S. Government debt and U.S. dollars are government obligations and the responsibility of the U.S. Treasury. They are feeling enormous pressure from owners of dollar denominated assets and obligations the world over to limit systematic event risk and fall out from this situation. Make no mistake about it, they will act and have. In October of 2007, the assets of the Federal Reserve were worth approximately 900 Billion dollars, of which approximately $800 billion were U.S. Treasury notes and bonds. Since that time, and in a very ad hoc manner, the Federal Reserve has, through its various new facilities and programs, grown the asset side of its balance sheet to 1.2 trillion dollars, while over that same time period its value of Treasury notes held has declined to roughly 500 billion dollars. In other words, the Federal Reserve has accepted 700 Billion dollars worth of non-U.S. Government collateral or guarantees in exchange for loaning the private market badly needed dollars and 300 billion dollars worth of treasury bonds. They are rapidly approaching a point where they would have to go to the U.S. Treasury for a credit line to continue this expansion. The Treasury, in turn, would have to go to Congress to get an increase in the National Debt ceiling to make this happen. Consider the Paulson plan a preemptive attempt to do something that they see as inevitable in a way, believe or not, the provides more oversight to the legislative branch than merely continuing what they are doing. Assuming we are committed to working within the system, this may be the American public's best chance to have a greater voice in the outcome.

I don't follow your reasoning here. The Paulson plan explicitly demanded no congressional oversight. I seriously doubt it was drafted in an effort to provide for as much popular sovereignty as possible in an otherwise "inevitable" public-spending spree.


There is no question that the market is extremely complex, and centralization of signaling procedures is highly undesirable. Furthermore, the signals coming from our financial markets have long been complicated and adulterated by government interference and flawed accounting rules. In looking for resolution to this problem, keep in mind that no major bank/broker except Merrill Lynch came to a private market solution recapitalization or merger. This was mostly because they had tangible assets in their Bloomberg stake, Black Rock stake, and the largest retail brokerage force in America. Indy Mac, Bear, Fannie Mae, Freddie Mac, Lehman, AIG, Wamu, and Wachovia all either were forced by their regulators into a deal, nationalized, or filed for bankruptcy.
Those are three pretty different outcomes, first off. Second off, unless they're giving you guys more information on Wall Street than what the rest of us out here have (which is entirely possible), how can we assume that in a government-free vacuum, these institutions would've suffered the same fate? If you've seen what happened to Stearns, Fannie, and Freddie, why would you ever wait to sell to the lowest bidder? If you know the government has promised to ride in at some lower-level-but-not-basement-price--something Barney Frank and Co. promised Fannie and Freddie since at least 2003--then all you're really trying to do is make things look as bad as possible and bide your time.

The major problem in all of these cases is the seeming judgment of private capital providers that the short naked put options (an upside-down homeowner can "put" his house to the bank in most states in America and the bank has no recourse to pursue his other assets to make up for principal shortfalls) imbedded in the mortgage loans and other structured products on their balance sheet were very difficult to value and rendered these entities potentially worthless. While surfing the wave of a debt-driven asset deflation spiral, none have been willing to speculate on "how low is low". It was only after the "Paulson Plan" was announced that Goldman raised money from Buffett, Morgan Stanley raised money from Mitsubishi, and Citigroup and Wells Fargo got into a bidding war over Wachovia. I believe that these events are related.

Again, the Paulson Plan is only the latest (if, I'll allow, the most absurdly gargantuan) bailout.


On to the how: The Treasury has stated that it intends to hire 10 sub-advisors from the private sector to invest this money on its behalf in eligible securities. This should serve to mitigate both the keys-to-the-blind-teen problem and the centralized signaling procedures problem. I further hope that they allow private capital to compete alongside these auctions and provide it with the full range of available information.
You see no flaws at all with this plan? You see no problems in letting government agencies compete alongside private companies? If playing the stock market with taxpayer money is so apparently free from hazard, why haven't we been doing this all along? Seriously? As long as the government can just blend in, play the poker game with everyone else at the table, just one of the guys--as long as the usual issues of corruption, conflict of interest, complete lack of accountability and an apparently infinite line of credit--as long as these factors are negligible, than I'm left wondering why we didn't do this ages ago.

The most pertinent issue is: How do we achieve the goal of floating only the responsible and punishing the incapable and culpable?

One way would be to let them go bankrupt.

What I hope is that none of these managers are forced or coerced to pay a price that is obviously unsupported by the likely future cash flows of the asset. What I believe that Paulson and Bernanke are hoping is that this price will prove to be higher than current "fire sale" or liquidation prices such that many banks are able to sell these assets without rendering themselves insolvent, and then go to the private market with cleaner balance sheets and recapitalize themselves.
My understanding is that Paulson has been explicit about this, at least behind closed doors. By overpaying now, these guys recapitalize in a hurry and get back in the game. Lending resumes and everybody's good. But how desirable is this? Why is the moral hazard not blindingly apparent at exactly this juncture? How can this possibly be a practice we want to start, regardless of its overall effects on the economy?

The likely future path for banks that are ultimately dead will be as follows: They will recognize that the gap between newly established market prices and their current carrying values are such that to sell in these auctions would render them insolvent. The private market will take their refusal to sell to mean either one of two things: They are so strong that they don't need to, or so weak that they can't. This distinction will not be hard to draw given publicly available balance sheet information. The bad banks will quickly be forced into the arms of better ones and cease to exist.

If the prices that these advisors are willing to pay are so low that no bank can afford to sell, then the Paulson plan will have been rendered essentially moot.
Is this an available outcome when the line of credit is endless? The advisors are pulling from the same fund.

This will signal that the problems are much worse than we thought. If these advisors are some how coerced or decide to pay prices higher than they should, undeserving entities could end up surviving. Given the justifiable furor surrounding the Treasury having this money at all, I find this scenario unlikely.
Why is this unlikely? Why isn't this exactly what we'd expect to happen? Who the hell could understand this stuff enough to create such a furor? The American people and their leaders haggle over whether Sarah Palin was for or against the Bridge to Nowhere--and that's the part of the public that pays any attention at all. You're suggesting that a class of fifth-graders is going to provide adequate check on the visiting rocket scientist as he writes his formulas on the board. I can barely string sentences together, but your fourth equation has several factors that look fudged, sir.


2) I believe that Paulson and Bernanke see the plan as a way to provide a floor under asset prices which gives the private sector the confidence it needs in order to recapitalize these banks on its own. I view the transfer of asset ownership as much cleaner than attempting to negotiate terms on which the government will provide outright equity to these firms. This is the scenario that will be on the table next should the Paulson plan fail. I view it as much scarier, much messier, and much more fraught with the danger for abuse, graft, and a general sense that the government is picking winners and losers.
These assets have no clear value. That's pretty scary, and pretty messy.


3) I suppose that when I say that the tax payers may make money, what I really mean is that the price tag of this plan is likely to be far less than the face value of $700 billion, and potentially even negative (I.e. the assets could be liquidated for more than $700 billion). Perhaps it is too much to hope that any excess money would be simply used to pay down government debt, but to the extent that it did that would be a net positive for us all. In the Wall Street Journal a few days ago, Andy Kessler wrote an article where he asserted that the ultimate recovery/profit from AIG/Fannie/Freddie plus the "TARP" could be in excess of 2 trillion dollars. Maybe he's astronomically off, but this isn't small potatoes. My intention was not to specify how proceeds would be used, but merely that they might exist. This is in direct contrast to the "stimulus package" of a few months ago which was pure expenditure.
Again, this is an economic response to a political question. The Fed and Treasury have no say on where this money goes, nor should they. These assets should be held by Congress, but Congress is the last place you'd want this money. Kessler's argument is "neat" in an economics kind of way (pretty outlandish, too, since you'd think that such a high return would make at least a few other big players bite), but it is, like most of what's going on here, not particularly relevant. Constitutional government is a catch-22 in the sense that these sorts of matters should go through the representative institutions, and yet heaven forbid something this large go through our representative institutions. This is an argument for limited government. If proceeds "exist," I see no reason why this would even be an unqualifiedly good thing. Such proceeds, after all, could be the difference in funding another war, whether it be against Muslims or against poverty.


4) The lesson of the last several weeks is that in the electronic age, the loss of confidence in a financial institution can take it from rock solid to illiquid to dead within a matter of days. Presumably flight of capital out of our system and even the country could take a similarly short time period. I have no idea whether or not they have any specific information about a likely future event. Perhaps they were trying to terrorize Congress into action.
Yes, terrorizing constituents and representative bodies has become a real staple these days, especially in the executive branch. I'd think we could get a bit more worked up about this, but maybe not. This, again, speaks to the fact that, while this may look good at the systemic level in economic terms, it looks awful at the systemic level in broader terms of political culture. Paulson and Bush have unabashedly terrorized citizens and their representatives into following them into action. This isn't illegal, obviously, and it's not unconstitutional. It is, however, wrong. We've faced crises before in this country, and we've had instances in which swift action was necessary and sometimes even absent--but the prevalence of fear-mongering since 9/11 has reached a fever pitch. We've gone from having our leaders remind us that the only thing to fear is fear itself to a situation in which our leaders reassure us constantly that there is much to fear, that they are able to identify these sources of fear, and that the time to fear is right now. I take your point that fear affects markets in ways unimaginable even ten years ago, but I insist that, while that may be the lamentable case, we should nonetheless discourage fear-mongering in our representative institutions, at all turns.

Harry Reid let slip some statement about a major insurance company on the brink of failure Wednesday, and on Thursday they were all murdered. Sometimes the consequences of an outcome are more important that its likelihood. Perhaps I could cross a set of train tracks every day without looking with a very low likelihood of getting splattered. This would not change the finality of the adverse event. How much dumber would it be if a wise observer saw the train coming and said nothing to me? As you point out, we should rejoice if this merely represents a lack of credit availability to the unworthy. However, in a world where AAA-rated GE has to sell a 3 billion 10% perpetual preferred to Warren Buffett and $12 billion worth of common stock to the public at multi-year lows, I think it is safe to assume that the cost and availability of capital has gone up dramatically for everyone.

5) Wow.
I assume this is an acknowledgment of genius, not of overstatement.

Well, I have tried to specify how I think the Treasury would decentralize this authority.
I remind you, again, that the original Paulson plan said nothing about such decentralization.

Further, I firmly believe that the original bill was sent up the way it was not because they thought that they would get that unfettered authority, but because they knew that this process would be so fraught with sausage-making that they decided to send up the cleanest bill possible.
What? The original plan was unconstitutional. You don't flirt with eradicating checks and balances and back it up with less-than-vague threats about the end of the known world as a matter of political savvy. The House defeat was, by all accounts, "stunning." There's very little evidence, and certainly not enough to "firmly believe," that Paulson and Co. thought they'd receive more than showmanship in opposition.

Witness its expansion from 1 to 407 pages.
This should be yet another reason against. Funding the bill with tax cuts? Recipe for success.

Further, I don't think you have to worry that giving Paulson $700 billion to invest would give him world-historical power.
Name someone more powerful, had the plan gone through as planned.

It is rather scarier to imagine that this amount of money might not even be close to what is needed to get the job done. That may have been the message from the market today--who knows. Does the level of power make Paulson a tyrant, or is it his use of it?

Well, by definition, the power makes him a despot, the use of it (assuming it is poor) makes him a tyrant. Wanting it and asking for it in the way he did--two things that you seem to think are completely irrelevant--these are equally tyrannical. I can see from your perspective why this seems so trivial. Who cares how he asked for it? Just. Git. Er. Dun. But, again, I think it is essential to view the Paulson plan as part of a broader political and cultural movement in America. You're arguing that this is the right move for this problem. That's what Paulson's arguing too. I'm arguing that this problem-and-solution derive from and contribute to a broader context that is taking us places we don't want to go. You say several times that the current setup is imperfect, and that a failure to grasp that or to deal with it earnestly is irresponsible. I sympathize greatly with this view, but ultimately I think it is wrong. The bailout, despite its merits, is part and parcel of a decade- and probably century-long trend toward decentralization, towards increasing government intervention, towards the corrupt crossbreeding of New York and Washington, toward an ever-expanding executive bureaucracy with powers the likes of which we've never seen. In the past eight years we've been spied on by our own government, deliberately lied to by our own officials in an effort to shore up war support, dragged into a never-ending "war on terror" against faceless foes who keep us always on "orange" alert--these are things out of Orwell, not the Federalist papers. And I'm not simple enough to make this about Bush. This is a question about political culture, about the relationship between individuals and their representatives and officials. Liberty--which is more important than money, and more important than life--liberty will not benefit from the Paulson plan.

To badly abuse Plato, I think that Paulson is uniquely equipped for this role and is a much more likely candidate for some kind of economic version of Plato's Philosopher-King than a tyrant (that's a bit tongue in cheek).
That is a bad abuse. Some might say that Plato's philosopher-kings are tyrants. Plato would say that the idea of Paulson-as-guardian is patently insane. Guardians were not allowed to handle money or own property, and that's not coincidence. Why? Because money corrupts; money brings us always to the concerns of the body, the appetites--and thus not the mind. Money distracts us from justice and the good. These are not trivial matters. I'm glad you brought up Plato.


6) So we're clear, I believe that the genesis of most of these harms comes from improper government action, incentivization, accounting standards, and regulations, not from market failures.
Markets don't fail.

Perhaps under my argument this makes it doubly theirs to redress. Properly functioning markets need information dissemination and transparency, neither of which is readily attainable when it comes to the financial realities of the bad assets on these balance sheets. What I have been trying to convey is that this intervention is an attempt to address a current situation of near panic. Panics lead to collapses, and collapses cause very significant collateral damage to innocent bystander firms and people.
Paulson, Bush, Bernanke--these guys are trying to control panic? To assuage our fears? The ones telling us that if more power isn't concentrated in their hands, then "God help us"?

This is one of the lessons of the Great Depression. This is not "the government can fix the market". This is "the government helped create this quasi-market monster panic and therefore has an obligation to help destroy it".
This is a very weak argument, and I suspect you know it. If you're going to make the appeal based on utility, than this turn to moral obligation sticks out badly, all the more so because it's not properly couched. The argument works if the government is the only entity with the funds to price the assets, but it falls apart quickly if the government is merely obligated based on prior performance.

I hoped to couch it in terms that were a morally acceptable government intervention in economic life, perhaps similar to incurring national debt to fight necessary wars, in order to allow Libertarians to support trying this. As I've said repeatedly, its utility is still a matter of some doubt.
Hopefully not that much doubt, since its utility is literally its only virtue.


7) What I hope we are left with is a functioning system that has been recapitalized by the private sector, a Treasury with a surplus from judiciously timed and chosen investments, and some breathing room to properly and deliberately evolve the system towards something more stable and freer. I hope that other like-minded people are not wishing for the apocalypse of the financial system, out of which will rise the a brand new and morally pure system that will never have problems again. I am struck by the the downside risk and widespread pain that such an event would cause. It reminds me of Mill's pointed rebuke to the Socialist revolutionaries in his "On Socialism" essay. It is abject craziness to hope for a collapse of the old and a sublime transition to a new and glorious utopia.

This last bit is pretty disingenuous, whether it's coming from you or some libertarian you know. No one's wishing the apocalypse here, and most libertarians I know are willing to bend on some issues of government intervention in this case (i.e. temporarily easing capital requirements; the most interesting idea I've heard is to temporarily allow insider trading in an effort to quickly and efficiently (if somewhat sneakily) weed out insolvent firms). What's ironic about this final remark is that most libertarians would view the Paulson plan as a kind of utopian thinking. What is common to utopias is the notion of order and thus the notion of control. They are perfectly regulated by perfect regulators. If libertarians can be accused of anything, it's merely the willingness to take their lumps. Yes, things are going to get rough, but I'd rather keep my "sacred honor," so to speak, than compromise it--at least partly because there's little reason to believe that Paulson has the ability to sort things out. But hell, I'll even take the bait. The flipside of liberty, and the flipside the Founders understood so well, is responsibility. Being free is about being responsible, about taking care of one's own problems, and about being willing to take one's well-earned lumps. Liberty promises nothing; it does not promise prosperity, it doesn't promise car loans; in this sense it is undoubtedly the hardest political doctrine. We promise life and liberty, but only the pursuit of happiness; we can only hedge when it comes to happiness, because the free life often has little to do with the happy life. This is to say that fundamental to libertarianism is the belief that the free, unhappy life is better than the unfree, happy life--to quote Mill back at you, better to be Socrates unsatisfied than a pig satisfied.

Best,
Brandon T.

Mike Griswold said...

Here is the issue I've always had with this Morality/Utility argument. You're couching it as a dichotomy, or at least that I'm choosing utility at the expense of morality. I see one as a subset of the other. Of course the morality of an idea driven by concrete principles is of overarching and paramount importance. I have been proceeding with this argument on the premise that it is a morally justifiable use of government power to prevent real disaster for everyone (or if you like, for everyone who isn't directly culpable for causing the problems along with some fortunate free-riders). However, once you have convinced yourself of the morality of an action or a plan, is not utility where the battle is actually fought? If it's immoral I can't possibly ask or expect you to support it.

I hate being in the role of Cassandra, and I suspect Henry Paulson does as well. In fact, while I find general State of Fear arguments against the expansion of government power to be very persuasive, I can't close the loop on it in this case. What do Henry Paulson and The Treasury stand to gain for putting themselves on the hook for $700 Billion of taxpayer money? New Power? Henry Paulson could have retired and purchased Aruba and stayed out of this mess. Every fiber of his being is probably wishing he had right about now. Perhaps the only persuasive argument is that they feel this is the only way to defend the entrenched power that they already have. If you believe that though, you have to accept their message that a collapse in this power structure is a distinct possibility, and which, as I've argued, would have extensive side effects. My utilitarian position is predicated on the following beliefs: The Financial Crisis is real and terribly imminent. If I didn't believe that potential large problems were days away (although unlikely), I would not support this form of the Paulson plan. I would support much more waiting and deliberation, and perhaps no action. A utilitarian view of this would weigh the benefit of delay versus the cost of inaction. Furthermore, the potential exists for a financial collapse to precipitate a Depression. The ostensible lesson of the Great Depression was that it COULD have been prevented in many ways, and the collapse of the quantity and velocity of money was a major cause of the extent of the damage. Maybe you don't believe that. But I think this plan can be part of a process to prevent this from happening again. The Great Depression cost this country between 15-25 years of growth depending on how you measure it. The Japanese problem has cost them 20 years and counting. This is not a purely theoretical discussion.

So...sitting the war out is not an option as far as I'm concerned. Accountability is a major concern. They have attempted to address it in the bill. I am quite certain that we will have endless theater of whodunnit operations dragging on for the next 10 years. I was trying to assert that Paulson/Bernanke & Co were moving their approach out of adhockery and into a systematic plan.

You are dead right that there are major differences between gov't brokered deals, gov't takeovers, and bankruptcies. In the case of Fannie and Freddie, there is no private entity in the world that could have taken on their balance sheet. Could they have been divided and sold immediately? Perhaps, but neither the law nor time was on their side. In the case of every firm that has been taken under by the gov't, all the top managers have lost their jobs and the equity holders have been decimated. No publicly traded firm that is a likely SELLER has any incentive to make things look bad. The buyers do, of course. If this is a conspiracy of buyers, where are they? There is a reasonably good consensus on Wall Street that the bankruptcy of Lehman has escalated the situation from crisis to CRISIS. One thing I haven't touched on at all is the Credit Default Swap market. I'm not going to try to explain this in full (since I don't understand it all that well), but essentially traders sell insurance to others against the default of certain major companies. Until 2007 this was viewed sort of like selling insurance against an asteroid hitting the planet in the next five years (i.e. not gonna happen). The notional size of this market is comfortably north of 50 TRILLION dollars. These contracts are concentrated on the credit worthiness of a handful of major companies, many of whom are currently reaping the whirlwind (think FNM, FRE, GE, GM, MS, GS etc) Assuming even 10% losses to credit holders in the event of bankruptcy, you are talking 5 TRILLION of potential losses (2007 total GDP was 13.8 trillion dollars). This is, I believe, where discerning types see the market meltdown scenario comes from. No matter what you believe should happen, it is probably safe to assume that no financial companies of size will be allowed to file bankruptcy any time soon. This is terribly unfortunate. However, what I think you would end up seeing in the event of bankruptcy filings on a massive scale would be the abrogation of contracts and the rule of law. Contract abrogation on a nationwide scale, by the way, is what a number of policy makers are proposing to fix the mortgage foreclosure situation. I think that this would be a disaster, and I fervently hope that mortgage holders and mortgage debtors will renegotiate their contracts where possible, and enter foreclosure where impossible. There is historical precedent for the alternative scenario in the Depression era Home Owners Loan Corporation.

Private entities have been investing government money in the stock and bond markets for a very long time. Every state in the nation has a pension plan with money sub-advised by private firms, and many federal pension plans do as well. I'm not saying that I have no problems with the plan, only that it is workable. I know not whether coercion will play an extensive role here, but I am fairly certain that Bill Gross of PIMCO and Larry Fink of Black Rock and their cohorts are going to be very reluctant to overpay. If the plan is to snow the taxpayers, dramatically overpay, and bail everyone out, I have enormous problems with this. Even so, this would be tremendously cheaper to the taxpayers if it worked then the worst case alternatives. If it doesn't work you and I are going to be talking about the next big idea a few weeks from now. I've no idea how to get around this idea of the Congress spending any profits inappropriately except to very glibly state that it seems like a good problem to have given the range of alternatives.

You assert that there is no such thing as market failure. This is only conditionally true and requires 1) perfect competition 2) perfect informational efficiency 3) perfect substitutes; among other things. For the purpose of our discussion, we are dealing with none of these things. Let's call what we have a "quarket" so that we can escape this morass. Quarkets can and do fail. This quarket has failed to price debt, especially mortgage debt and underlying homes, properly ever since securitized home mortgages were invented and Fannie Mae and Freddie Mac were allowed to embark upon their epic expansion. Hundreds of millions of Americans have planned their financial futures and their life's savings around the value of an asset that is now being shown to have been perverted by mania piled on top of improper incentives. Are we really going to argue that these people should suck it up and take what's coming to them if it's preventable? Must not even Libertarians take the measure of both liberty AND justice? (I'm fully cognizant that you will hammer me on that last stupid sentence.) I agree that this solution is fraught with moral hazard and my only rebuttal is that this moral hazard can be weighed against other more tangible hazards.

Let me name 2 people more powerful than Hank Paulson, and several entities: 1) George W. Bush 2) Hu Jintao, General Secretary of the Communist party of China, whose government holds 1.4 Trillion worth of U.S. dollars and assets, not to mention the U.S. Dollar wealth that his citizens own. 3) Two or three oil exporting Arab nations, including Saudi Arabia. Wars have been fought over far less wealth.

Look, assuming this operation is morally justifiable, my entire argument hinges on Paulson and Bernanke being right about the potential for collapse, right about the potential to prevent it, and right about the consequences of doing nothing. In fact, it even hinges on the value and probability you assign to the alternatives. Reasonable people can (and apparently do) disagree about many of these things. Perhaps stringing them altogether is a bridge too far. I'm all for relaxing some accounting provisions, capital requirements, and allowing insider trading (keep in mind that a great many insiders got a look at the books of Lehman and they all took a pass). I suspect we can and will give these remedies a shot. The lesson of the Japanese experience seems to be that if you don't get in front of these things, there comes a time when no amount of government intervention will break the spiral. If it is naïve utopian thinking to believe that the government might be able to cushion the downside for the innocents here, and we truly lack any means to exert control over the situation, this may soon be another lesson learned. What I've tried to argue about a debt-driven deflation cycle is that while it might be the day of reckoning for some, it's more like catching Ebola for a great many others. If you catch it, you're finished, and there's literally no way to prepare for it. You may be right in your Stoicism, but I think the proper analogy is not satisfied pigs but slaughtered lambs.

Best,

Mike