In Response to Joel as “Joe Middle Class”

Joel asks in response to my previous blog, “how does this bad debt affect me if the USA doesn't purchase it?”

The argument is being made that if this bad debt is not removed from bank’s balance sheets, then the banking system will be unable to continue lending. If this happens, then everyone will be hurt, because no one can finance the purchase of a house.

Personally, I think Bush has probably stepped aside in these conversations (thank goodness!), Bernake's role is more advisory, and Paulson is basically running the show as far as the Executive Branch. Despite President Paulson's obvious conflicts of interest (e.g., he formerly ran Goldman Sachs and his Assistant Treasury Secretary recently left to run Wachovia), I honestly believe that he wants to do the right thing here. That is not to say Congress or the American taxpayer should trust his judgment implicitly, as this is a very complex and dynamic crisis, and the optimal solution is far from obvious. I would prefer to characterize his past positions, current stock holdings, and friends in high corporate places as leading to bias in his judgment, not blind self-interest. I think what is driving his self-interest now is mostly that he does not want to become the Don Rumsfeld of the Credit Crunch, and I am OK with this as his primary motivation.

I think the current proposal is inherently flawed in four respects:

1) As it has been described in the press, the bailout does not address Moral Hazard, and most suggestions being offered to exact punishment might trigger the theorized death spiral that Paulson is trying to prevent.

2) The premise that lending will seize up is predicated on all banks being in jeopardy of failure, but I have yet to hear is true. If weak banks fail, why can’t strong banks fill the gap? Is this not Free Market Capitalism, which I thought Paulson and the Republican Party has been espousing for decades?

3) There are vulture funds with billions in cash, impatiently waiting for the banks to finally admit they have been grossly overvaluing their loan portfolios (i.e., lying to regulators) so that these funds can purchase these assets at an appropriate discount. In truth, these banks have been insolvent for months, so instead of buying their toxic waste, why doesn’t the government simply seize all their assets, then move RTC style to raise funds to bail out the insured depositors? I do not know whether this strategy could work, but is there even a debate over alternative solutions?

4) This bailout plan is extraordinarily expensive to the US taxpayer, but still only puts a band-aid on the larger problems facing the financial system. Anyone heard of Credit Default Swaps?

If more people like Joel would start asking questions about whether it makes sense to use taxpayer dollars in truly unprecedented ways to bailout financial institutions that have become corrupt and bloated, we might actually encourage Washington to take a fresh look at the core problems and alternative solutions.