Explaining the Bank Plan

Here is a blog entry by economist Mark Thoma that explains the Paulson, the Geithner, and the nationalization bank "plans" in terms that ordinary people can explain. He starts with a situation that you can understand:

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer's "balance sheet" - the cars on its lot - are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.

Explains the problems and shows how each plan tries to resolve the mess. The key point he makes at the end, and it is a very important point, is:

But, and I want to stress this, the point of these plans is not to make money, the point is to keep the economy of the town going, to keep people employed. If people place a large value on security, then even if the government takes a loss on paper, it may not be an economic loss. That is, we must put a value on the jobs that are saved and the security it brings (simply imagine that the utility function has risk as one of its arguments - by lowering the risk of job loss and the associated household disruption, you have made the agent better off, and this must be counted against any loss from any of the programs above). There is value in economic stability and security over and above whatever the government makes (or loses) on the actual financial transactions, and this must be factored into the evaluation of the policy.

Read the full blog to understand how these three approaches work.

In a separate blog entry, Mark Thoma tries to evaluate these three plans:

Which plan is best, the original Paulson plan where the government buys bad paper directly, the Geithner plan where the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, or straight up nationalization? ...

So which plan is best? Any plan that does these two things, removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has these two features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. The plan for nationalization most certainly has these features, but it has political problems as well.

So I do not take a binary (or, I suppose, trinary), either/or approach to the proposals where I think one plan will work and the others will fail miserably. All three plans have their pluses and minuses. The politics of the Paulson plan make it a non-starter, I have no quarrel with the view that it constitutes a giveaway that is not justified, so the only way the Paulson plan will work is if we can convince people that equity stakes or some other mechanism makes the plan sufficiently equitable. I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear. So all three plans do the requisite things - get assets off the books and provide recapitalization - and each comes with its own set of political worries.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none - to me - is so off the mark that I am filled with despair because we are following a particular course of action.

The Calculated Risk website has sided with Mark Thoma but put out a warning:

I tend to agree with Mark on this. The Geithner plan is suboptimal, but it is probably the best we can get in the current environment. I'd add a caveat: this plan is easy for the banks to game or arb - and if a bank is caught gaming this plan, the AIG bonus flap will seem like a light Summer breeze.

The bold is in the original. I suggest the everybody take this concern very, very seriously. Obama has allowed Geithner to create a flawed "solution".