September 21, 2008

I'm not an economist, but I play one on the internets

Paul Krugman (whom, let me be clear, is not the `I' of the title of this post) has been working on a nice series of blog posts commenting on the impending bailout. He gives a nice, rigorous version of the basic liberal problem with the plan in its current form: it's a huge transfer of wealth to the already extraordinarily wealthy people in the finance industry who got themselves (and us) into this mess, with absolutely no guarantee of success.

In the linked post, Krugman breaks the situation down into a cascade of four stages:

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

The current Bush administration plan targets stage 4 by attempting to set a sufficiently high floor in the prices of `toxic' assets (that is, mortgages with such egregious terms that the homeowners may not be able to afford to pay them, and derivatives based on those mortgages; isn't it great how the financial difficulties of working class people are being reframed as `toxic' for the wealthy and powerful?). Krugman's points out that, if this floor is too low, it might not do much to help out struggling firms.

As an alternative, he suggests intervention at stage 2. Rather than becoming the buyer of last resort for these `toxic' assets, he wants `public injections of capital, in return for a stake in the upside'. I assume it would work something like this: to deleverage (move the balance sheets from red to black), firms with `toxic' assets would issue more stock (rather than selling those assets), and the US government would be a (or the) major buyer of that new stock. That way the struggling firms get black balance sheets now, and when their stock prices go back up, the government can gradually sell those stocks and get a nice little return on the investment. According to Krugman, compared to the Bush administration plan, this plan is not as risky, is more likely to be successful, and doesn't involve just handing nearly a trillion dollars of taxpayer money over to the `geniuses' in the financial industry with no strings attached.

Another possibility -- that I'm surprised to see no-one making at all on the lefty blogs -- is an intervention at stage 1. Rather than bailing out the wealthy idiots who caused this problem, why don't we help out the people who are likely to default on their mortgages? If these mortgages aren't in danger of failing, or failing as dramatically, the assets based on them are no longer toxic, or as toxic.

There are two obvious ways of doing this, corresponding to two radically different ways the government could intervene in the borrower-lender relationship. First, the government could give a direct cash infusion, covering the gap between what the homeowner can pay and what the terms of the mortgage require. Second, the government could change the terms of the mortgage, eg, negotiating a lower rate.

I actually don't like this plan, whichever of the two strategies it adopts. This is because it not only fails to deal with the ultimate underlying problem, but it can actually exacerbate the underlying problem.

Go back and look at stage 1 in Krugman's list. This all started with the housing bubble -- the inflation of housing costs, especially the cost to buy a house, over the past 20-25 years, especially in places like California and large cities (SF, LA, Chicago, the Acela cities, etc.). A wide variety of serious development and environment issues -- the spread of suburbs, the proliferation of single-driver cars, car-based rather than pedestrian-based communities, etc. -- are connected with the housing bubble in various ways, and a contraction in housing prices is, frankly, necessary for addressing most of them in any effective way.

But addressing stage 1 of the current crisis by preventing mortgage failures in pretty much any way is maintaining housing prices at the current inflated level. It's preventing the deflation in home prices that is necessary to get people to move out of the suburbs and back to the cities.

I genuinely feel for the people who have already and will lose their homes due to predatory lending practices. Owning a home is an important part of the ideal of American middleclassness to a lot of people, and, more pragmatically, declaring bankruptcy also completely ruins your ability to get credit. (Although pretty much no-one can get credit at this point -- which is the part of this whole mess that has the wealthy and powerful worried.) But owning a home is, ultimately, not that important, especially when it's owning in a home in a bedroom `community' built on top of a paved-over wetland.

Let me make one final point. Perhaps everyone in the leftist blogosphere has already realised everything I've said in this post. Still, it's something we -- including the leftist blogosphere, but also the citizenry of this country as a whole -- need to be talking about, if for no other reason than it gets us thinking about the nature of the problem. Right now, the mainstream discourse seems to be all about `fixing' the economy. But fixing something requires first having an explicit idea of what the thing is supposed to do, and how it does it. The mainstream discourse doesn't talk about what the economy is supposed to do, much less what we want the economy to do. Do we want it to produce and distribute lots of cheap consumables -- cheap food, cheap clothes, cheap houses, cheap electronics? Or do we want it to go for quality rather than quantity? Simply getting the finance industry `working' the same way it has been for 25 years isn't fixing the industry if it's been radically dysfunctional for that period of time.

No comments: