Knowledge, Uncertainty, and the Paulson Plan

Like the crisis itself, the conversation surrounding the Paulson Plan has devolved into clichéd talking points, ideological posturing, and an utter inability to discuss the situation in an intelligent and coherent fashion. Financial and political pundits are either heralding the defeat of the plan or lamenting its demise as the trigger towards another depression. Thus there is a great degree of uncertainty in the air as many are left wondering if the defeat of the Paulson Plan (or at least the 110-page House version of the plan) spells disaster. The short answer is “no.”

As I have previously mentioned, the problem in the financial markets is not a lack of liquidity, but rather the result of counter-party risk. The essential problem with the financial industry is the fact that firms need to raise capital, but are unable to do so because of the inability of other parties to accurately and adequately price the assets that the firms would like to sell. Accordingly, confidence must be restored in the market in order to get things moving again. The Paulson Plan, in its original form, would have allowed the government to purchase these assets at depressed prices thereby allowing for re-capitalization of the financials and allowing credit to flow. In addition, the stabilization of the housing and credit markets would allow firms and investors to more accurately price the assets in question. Thus, in theory, the government could buy low and sell high. However, the question remains as to whether or not the government can successfully execute this strategy. As our friend Thomas Palley explains:

The Paulson plan is subject to three fundamental criticisms. First, the Treasury may over-pay for assets, saddling taxpayers with large losses. If the Treasury sets its acceptable price too low, there is a risk it will buy insufficient assets and banks will not be cleansed. If it sets prices too high, the risk is Treasury overpays. Second, Treasury is taking a big risk as prices could fall further, yet it is not being properly rewarded for this risk-taking. That is tantamount to subsidizing banks which have created the mess. Third, markets may not provide finance even after Treasury’s purchases, in which case banks will remain undercapitalized.

The Paulson Plan therefore succumbs the knowledge problem. If those within the market are unable to accurately price these assets, it is unlikely that a government agency could succeed in doing so. In an ergodic world in which risk is easily calculable, the Paulson Plan would likely be successful. However, if the events of the last year have been any indication, the world is non-ergodic and the risks of default associated with mortgage-backed securities and collateralized debt obligations do not necessarily follow identifiable (or even existing) probability distributions (roughly, what Nassim Taleb refers to as the Fourth Quadrant). In the absence of easily quantifiable risk, the Treasury leaves itself prone to setting prices too low or too high and therefore resulting in either a failure to re-capitalize the financials or creating an exorbitant cost to taxpayers.

So while some are decrying the defeat of this bill as the beginning of something terrible, it seems prudent to at least take a step back and evaluate whether the plan could truly have been successful. I am not convinced.

Originally published on September 29, 2008 at The Everyday Economist and reproduced here with the author’s permission.

2 Responses to "Knowledge, Uncertainty, and the Paulson Plan"

  1. ChuckD   September 30, 2008 at 8:49 pm

    How can anyone working in a financial market dare to act according to a long-term plan, when the US Congress threatens to change the rules of the game? Government intervention is the most powerful force destroying the ergodicity of the market. (Loosely speaking, “ergodicity” means that events which were likely then and there remain likely here and now, even if the most recent event looked unlikely. A run of ten heads of a fair coin can happen, but you can’t plan around the risk that your fellow gamblers will swap in a double-header coin.)