Krugman on what's wrong with the Paulson proposal

Paul Krugman explains what has happened to cause the current 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.

Krugman's analysis says that Paulson's proposal isn't going to work. All it does is tax taxpayers to provide a new stake to the same banker gamblers who caused the current problems in the first place.

Why should the taxpayers be expected to pay taxes to let the same bankers go back to the game with no more controls than they had in the first place? In addition, if the gamblers win, the taxpayers get none of the profits. That sounds to me like a good reason to stop paying taxes.

Instead, the government needs to take over the failed banks, replace the executives, regulate all the banks in the industry, and then carefully sell off the loans the banks hold with the profits going to the taxpayers.

In my next post I will show why Nouriel Roubini's analysis suggests that is going to be the inevitable result of the financial crisis anyway.