Economists of all stripes remain puzzled about how Treasury Secretary Henry Paulson’s Troubled Asset Relief Plan is supposed to fix the American financial system.
What is not in dispute is that the crisis has been triggered by a collapse in confidence about how much of their debt subprime borrowers will repay. (This affects financial stability and the real economy because bankrupt banks cannot lend, even to sound borrowers.)
An example might help clarify the root of our confusion. Suppose that as of Tuesday, August 24, 79 AD , the Bank of Rome had lent a total of $110 million to citizens of the Roman Empire, funded by deposits of $100 million. Result: Bank of Rome has a net value of $10 million. On Wednesday, the eruption of Mount Vesuvius engulfs properties mortgaged by the Bank of Rome to the tune of $20 million. Result: The Bank of Rome is bankrupt; its depositors can expect to get back at most 90 percent of their money, and the bank cannot lend any new money even to the profitable and creditworthy Marcus L. Crassus Corporation.
The reason the Bank of Rome is bankrupt is that there has been a collapse of confidence that the (now extinct) citizens of Pompeii will repay their mortgage loans.
It is not clear, fundamentally, how this situation differs from the one confronting American banks now.
(It’s true that the recovery value of the properties backing the subprime securities will be greater than for incinerated Pompeiian villas; but this doesn’t change anything – the key question is simply whether the writedown in value exceeds the pre-eruption value of the Bank of Rome, which markets seem to fear is true). The Secretary appears to believe that “confidence” in the subprime securities will be restored if the government purchases those securities through a cleverly designed auction process. But, no degree of cleverness could render the mortgages made to the citizens of Pompeii valuable. And, it is very hard to understand why auctions in the next few weeks should restore anyone’s confidence that subprime mortgages will turn out to be more valuable than markets currently believe.
Perhaps, we economists are missing something. It would not be the first time. My sense is that some important voices have been keeping mum because of our profession’s well-justified confidence in Federal Reserve chairman Ben Bernanke, who made it clear that he supported passage of Mr Paulson’s plan in Congress.
But, we have become accustomed, since Mr Bernanke became Fed chairman, to hearing from him clear and sound explanations of the economic logic behind the Fed’s actions. Mr Bernanke’s public pronouncements about the Paulson Plan thus far have mostly been of the form “Pass the Paulson Plan because it is better than doing nothing” rather than “Pass the Paulson Plan because it is the soundest way to address our financial crisis”.
Returning to the Vesuvius example, a rough analogue of the Paulson Plan might be if Emperor Nero had proposed to use funds from the Roman Treasury to buy the Vesuvian mortgages from the Bank of Rome for their original value of $20 million, or even for a bargain price of $10 million to reflect the “stressful market circumstances”. In that case, the Bank of Rome would no longer be insolvent and could resume lending to M.L. Crassus Inc.
But, Mr Paulson has repeatedly said that the taxpayer will be paying “fair market value” for the subprime securities that it buys. In the Vesuvian example, the “fair market value” would be zero, and buying the worthless rights to the Vesuvian mortgages for $0 would do nothing to restore the Bank of Rome to health.
It is possible that the Secretary does not believe his own promises that the taxpayer will get something valuable from this process. He may simply believe that by overpaying sufficiently he can inject enough capital to revive the banking sector (as the Emperor Nero hypothetically did when he spent $20 million for mortgage-backed securities he knew to be worth $0). But in our context, it would be much more straightforward (and honest) simply to let the doomed banks go bust, sell them to other (still solvent) banks, and pay off the depositors from the resources of the Federal Deposit Insurance Corporation (perhaps augmented with a loan from the Treasury).
Alternatively, the Secretary may believe that an irrational panic has seized the markets for subprime securities; Vesuvius’s eruption was such smaller than rumored, and so most of the Pompeiian mortgages will end up being repaid. However, it is difficult to see how the process of forcing auctions for those securities will stem the panic; what is needed, in this scenario, is hard proof that the eruption was not so bad. Auctions will generate no such proof.
Furthermore, if the Secretary is right that many more of these mortgages will be repaid than expected, the taxpayer could reap the rewards by investing fresh capital directly in the banking system while leaving ownership of the subprime securities in the hands of the current owners. If the Emperor Nero had been willing to invest $20 million in the Bank of Rome (rather than buying the Vesuvian mortgage-backed securities for $20 million), that would have accomplished the goal of restoring the bank to solvency. Then, if the Vesuvian rumors had turned out to be false, the Emperor would have an ownership stake in the bank which he could sell off to recoup his investment.
Mr Bernanke has shown a remarkable talent for communicating complex economic ideas in straightforward language, and his intellect and integrity are justly held in high regard in the economics profession. We therefore have great confidence that he will soon be explaining to us clearly and simply what exactly is wrong with this analogy.
Originally published at the FT and reproduced here with the author’s permission.