David Ignatius on the Disaster

What Keynes Could Tell Paulson
By David Ignatius
Washington Post Thursday, September 25, 2008

In times like these, when even the most sober analysts are wondering if we're heading for another Great Depression, it's wise to take a deep breath, head to the basement and dust off a copy of John Maynard Keynes's modestly titled 1936 treatise, "The General Theory of Employment, Interest and Money."

Most of us remember Keynes from our college economics courses as the guy who advocated deficit spending to "prime the pump" during downturns. And that was certainly part of his argument. But revisiting "The General Theory," what's striking is that it's a book about economic panics and the market psychology that produces them -- and the consequent need for government intervention. Parts of it could have been written this week to describe the cascading defaults of Bear Stearns, Lehman Brothers and AIG.

The problem with financial markets, Keynes argued, was that investors were periodically seized by an extreme form of what he called "liquidity preference," which made them wary of putting their money into anything but the safest investments. "It is of the nature of organized investment markets . . . that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force," he wrote. "Once doubt begins it spreads rapidly."

That's a pretty good description of what has been happening on Wall Street over the past few months. We've gone from a bubble of overenthusiasm, in which interest-rate spreads took little account of risk, to a state of panic in which financial institutions are so risk-averse that they don't want to lend to anyone. As Keynes observed, "the actual, private object of the most skilled investment today is . . . to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow."

Keynes's revolutionary idea was that financial markets were not inherently self-correcting, as classical economics had argued. Left to itself, Wall Street might remain in a liquidity trap in which the markets would stay frozen and productive investment would cease. So it fell to the government to take actions that would restore confidence and stimulate investment. "I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands," he wrote.

Which brings us to Treasury Secretary Henry Paulson and the present financial crisis. Since he intervened to rescue Bear Stearns in March, Paulson has been trying to pump cash into markets that are locking up because of the extreme liquidity preference of investors. But each rescue measure only sets up the next disaster -- so that Paulson lurches from Bear Stearns to Fannie and Freddie to AIG, and now to a government pledge to buy up $700 billion or more of mortgage-backed securities.

What advice would Keynes offer Paulson and Fed Chairman Ben Bernanke? His first instinct, I think, would be to reiterate that markets, left to themselves, will not solve this sort of crisis. They need government help -- in this case, on a scale that would have daunted even Keynes -- including underwriting mortgage loans, backstopping the market for credit swaps and other steps. But if these measures are taken piecemeal, without broad political support, they may only add to the public's anxiety. Indeed, that's a real worry now: A Wall Street panic may become a Main Street panic.

Keynes's biographer, Robert Skidelsky, makes clear that at every stage of Keynes's career, he tried to think broadly about the social and political consequences of economic policy. That was true in his famous denunciation of onerous German reparations payments after World War I, which he correctly warned would lead to a future war; it was true in the magnanimity of the post-World War II international financial system he helped create at Bretton Woods.

A truly Keynesian rescue plan should do more than bail out foolish investors. How might the pieces fit into a larger design? Well, if the taxpayers are going to acquire a stake in the nation's largest insurance company, perhaps that company can be the cornerstone of a new system of universal private health coverage. If the taxpayers are going to acquire $700 billion in real estate assets, perhaps the eventual profits can fund new investments in infrastructure or energy technology.

Keynes spoke in the finicky English of a Cambridge don, but listen to what he said: "When the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill-done." Keynes wouldn't have wanted to nationalize that casino; he was an active investor himself. But he reminds us that public purposes are best served by public institutions.

James K. Galbraith on the Disaster

A Bailout We Don't Need

By James K. Galbraith
Washington Post Thursday, September 25, 2008

Now that all five big investment banks -- Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley -- have disappeared or morphed into regular banks, a question arises.

The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold assets like that all the time. They're called "loans."

With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn't, the FDIC has the bridge bank facility to take care of that.

Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund -- a cosmetic gesture -- and as much money into that agency and the FBI as is needed for examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary -- as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can't save everyone, and those investors aren't poor.

With this solution, the systemic financial threat should go away. Does that mean the economy would quickly recover? No. Sadly, it does not. Two vast economic problems will confront the next president immediately. First, the underlying housing crisis: There are too many houses out there, too many vacant or unsold, too many homeowners underwater. Credit will not start to flow, as some suggest, simply because the crisis is contained. There have to be borrowers, and there has to be collateral. There won't be enough.

In Texas, recovery from the 1980s oil bust took seven years and the pull of strong national economic growth. The present slump is national, and it can't be cured that way. But it could be resolved in three years, rather than 10, by a new Home Owners Loan Corp., which would rewrite mortgages, manage rental conversions and decide when vacant, degraded properties should be demolished. Set it up like a draft board in each community, under federal guidelines, and get to work.

The second great crisis is in state and local government. Just Tuesday, New York Mayor Michael Bloomberg announced $1.5 billion in public spending cuts. The scenario is playing out everywhere: Schools, fire departments, police stations, parks, libraries and water projects are getting the ax, while essential maintenance gets deferred and important capital projects don't get built. This is pernicious when unemployment is rising and when we have all the real resources we need to preserve services and expand public investment. It's also unnecessary.

What to do? Reenact Richard Nixon's great idea: federal revenue sharing. States and localities should get the funds to plug their revenue gaps and maintain real public spending, per capita, for the next three to five years. Also, enact the National Infrastructure Bank, making bond revenue available in a revolving fund for capital improvements. There is work to do. There are people to do it. Bring them together. What could be easier or more sensible?

Here's another problem: the wealth loss to near-retirees and the elderly from a declining stock market as things shake out. How about taking care of this, with rough justice, through a supplement to Social Security? If you need a revenue source, impose a turnover tax on stocks.

Next, let's think about what the next upswing should try to achieve and how it should be powered. If the 1960s were about raising baby boomers and the '90s about technology, what should the '10s and '20s be about? It's obvious: energy and climate change. That's where the present great unmet needs are.

So, let's use the next few years to plan, mapping out a program of energy conservation, reconstruction and renewable power. Let's get the public sector and the universities working on it. And let's prepare the private sector so that when the credit crunch finally ends, we'll have the firms, the labs, the standards and the talent in place, ready to go.

Some will ask if we can afford it. To see the answer, don't look at budget projections. Just look at interest rates. Last week, in the panic, the federal government could fund itself, short term, for free. It could have raised money for 30 years and paid less than 4 percent. That's far less than it cost back in 2000.

No country in this situation is broke, or insolvent, or even in much trouble. For once, Wall Street's own markets speak the truth. The financially challenged customer isn't Uncle Sam. He's up on Wall Street, where deregulation, greed and fraud ran wild.

James K. Galbraith is the author of "The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too."

Paul Krugman on The Disaster

Cash for Trash

By PAUL KRUGMAN
New York Times September 21, 2008

Some skeptics are calling Henry Paulson’s $700 billion rescue plan for the U.S. financial system “cash for trash.” Others are calling the proposed legislation the Authorization for Use of Financial Force, after the Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq.

There’s justice in the gibes. Everyone agrees that something major must be done. But Mr. Paulson is demanding extraordinary power for himself — and for his successor — to deploy taxpayers’ money on behalf of a plan that, as far as I can see, doesn’t make sense.

Some are saying that we should simply trust Mr. Paulson, because he’s a smart guy who knows what he’s doing. But that’s only half true: he is a smart guy, but what, exactly, in the experience of the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis “contained,” and then offered a series of unsuccessful fixes — justifies the belief that he knows what he’s doing? He’s making it up as he goes along, just like the rest of us.

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)

But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review “by any court of law or any administrative agency,” and this adds up to an unacceptable proposal.

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.

My political joke

Q: Why did John McCain choose Sarah Palin for his running mate?

A: Jesse Ventura wouldn't return his calls.

The Tribe

Dream of August 11
As I approach the door of the house with Art (the Gude Ave. house), I see that the lock has been removed. We enter the house and the TV and stereo are missing. In the bedroom there’s also a TV missing. I am anxious because I think the burglar may still be here or come back, and I say that I don’t want to stay in the house tonight. Suddenly a short young guy appears right in front of me, trying to run for the door. He’s small and slight; it’s easy to catch him. He begs me not to call the police, but his reasons are ridiculous, and I’m going to. But then anther guy dashes across the room and I’m distracted and the first guy gets away. The second guy runs downstairs. At the head of the stairs I can see that the basement is dark and I’m nervous, but as I descend I see that there are young people who are like squatters down there; they seem like anarchist hippie types that I actually would think are pretty cool. Some are gathered around a fire and I see that they are “tribal”—that is, they think of themselves as a tribe—and they’re not at all concerned that I’m there, as if they were my hosts and not squatters. I look at the back door, at the laundry room and bathroom, and at a grid in the ceiling that leads outdoors, and each time I look back there are more of these people, and it occurs to me that it’s like the gathering of the crows in The Birds. Then I find that they are discussing Hitchcock and how great his movies are.

Tina Fey as Sarah Palin on SNL