Away from Wall Street, Economists Question Basis of Paulson's Plan

Treasury Secretary Henry M. Paulson Jr.'s rescue plan rests on the government buying troubled mortgage securities.
Treasury Secretary Henry M. Paulson Jr.'s rescue plan rests on the government buying troubled mortgage securities. (By Nikki Kahn -- The Washington Post)
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By Neil Irwin and Cecilia Kang
Washington Post Staff Writers
Friday, September 26, 2008

The Bush administration's pitch for a sweeping bailout of the financial system has centered on two simple premises: that the economy could suffer a crippling downturn if action is not taken very quickly and that this action should consist of the government buying troubled mortgage securities from banks and other institutions.

But many of the nation's top economists disagree with one or both of those ideas, even as many top political leaders have swung behind them.

Wall Street economists have mostly endorsed Treasury Secretary Henry M. Paulson Jr.'s plan, or a variation thereof.

But almost 200 academic economists -- who aren't paid by the institutions that could directly benefit from the plan but who also may not have recent practical experience in the markets -- have signed a petition organized by a University of Chicago professor objecting to the plan on the grounds that it could create perverse incentives, that it is too vague and that its long-run effects are unclear. Sen. Richard C. Shelby (Ala.), ranking Republican on the Budget Committee, brandished that letter yesterday afternoon as he explained his opposition to the bailout outside a bipartisan summit at the White House. The petition did not advocate any specific plan, including that offered yesterday by House Republicans.

Economists tend to agree that the nation's economy is at serious risk as the flow of credit threatens to freeze. Just yesterday, the interest rate at which banks lend to each other rose steeply, as it has every day this week, suggesting that lenders are hoarding cash. History shows that when this happens, a broad economic crisis can follow, for instance, the Great Depression and Japan's decade-long recession in the 1990s.

"If nothing is done, the potential for these markets to seize up in a big way is definitely there," said Frederic S. Mishkin, an economist at Columbia University who was a Federal Reserve governor until last month. "When you look at the history of these crises, when things spin out of control, the cost to fix it later goes up exponentially."

But many others with a deep theoretical knowledge of finance and experience in government are skeptical of the structure of Paulson's plan -- and the speed with which it has been crafted.

The critics can be roughly divided into two camps. One group thinks money should be directly infused into banks, which should allow it to trickle down through the financial system to borrowers. A second group thinks the government should buy individual mortgages, thus helping ordinary Americans more directly, with the benefits trickling up to the banks.

The plan promoted by Paulson and Fed Chairman Ben S. Bernanke is somewhere in between: buying up packages of mortgages and hoping that the benefits spread both up to banks and down to households.

"The plan is a trickle-down approach from banks to Main Street," said Alan S. Blinder, a professor at Princeton University. "But if you reduce the flood of foreclosures and defaults" -- which he would have the government do by buying loans directly and then renegotiating the terms -- "it will make mortgage-backed securities worth more."

That might help ordinary Americans but would be extremely difficult to administer. The government would have to make decisions on the foreclosure and resale of individual houses all over the country. Still, many economists with left-of-center political views favor some variation of this approach to the plan endorsed by Bush.

"There is a kind of suggestion in the Paulson proposal that if only we provide enough money to financial markets, this problem will disappear," said Joseph Stiglitz, a Nobel Prize-winning economist. "But that does nothing to address the fundamental problem of bleeding foreclosures and the holes in the balance sheets of banks."

Coming from the other direction, more conservative economists worry that by having the government buy mortgage securities, the Paulson plan would manipulate prices in that market without getting at the nub of the problem: that banks do not have enough capital and are having difficulty raising any on private markets.

In a sign of how the debate over the economy has shifted in recent weeks, some conservatives, even as they argue for a relatively limited government role, are calling on the government to invest public money in private banks.

"The root of the issue is recapitalizing banks," said Glenn Hubbard, dean of Columbia Business School and a former chairman of President Bush's Council of Economic Advisers. "That could be done more efficiently through the government injection of preferred equity. Then the market could figure out the prices of the assets."

Many of these critics don't care for the assumption behind the administration's plan that the market is now pricing these mortgage securities incorrectly, a problem that the government intervention aims to fix.

"The premise appears to be that the market is irrationally pessimistic," wrote Greg Mankiw, a Harvard University economist and another former Bush economic adviser, on his blog this week. "That might be so. Nonetheless, one has to be at least a bit skeptical about the idea that government policymakers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own."

Some conservatives are now arguing, notably, that the government should be investing in banks.

Many economists fault the Bush administration and Congress for moving so quickly on the bailout package without allowing more time for debate. That sentiment was reflected in the petition organized by John Cochrane of the University of Chicago. (None of the economists quoted here were signatories.)

"I totally disagree that this needs to be done this week. It's more important to get it right," Blinder said.

Moreover, some economists said the proposed $700 billion may not be enough to address all the problems stretching across the financial landscape. "You only show up if you can win, and this is not that package," said Simon Johnson, a professor at Massachusetts Institute of Technology and former chief economist at the International Monetary Fund. "This cannot be the ultimate, decisive solution if you are not addressing the underlying cause."

The plan is short on details, instead giving the Treasury secretary wide latitude to determine how to execute the purchases of mortgage securities.

"I'd like to see how they see the evolution of an end game. There are still many questions," said Myron Scholes, a retired professor at Stanford University and Nobel Prize winner. He said how long the government holds the assets and how they are later resold would be the keys to determining whether the plan works.

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