Left Flank

I'm worried about US Treasury Secretary Henry Paulson's draft bill for a coup d'etat to rescue America's financial sector. Since I'm not an economic expert, and I've read every economics blog in my blogroll, I'm going to make an unwieldy list of links I would like to share with you.

1. Visible Hands

The New Capitalism is not only attempting to regulate incomes so that incompetent executives do not benefit from golden goodbyes when the government has to bail out the firms they have damaged. More importantly, it is elevating equity to a role co-equal with, or perhaps superior to, efficiency as a guide to policy. It might maximize efficiency for government to minimize its interference in economic affairs, which is the position of defenders of the Old Capitalism (proponents of deregulation and low taxes on high earners); and efficiency, in the form of rising productivity, is the driving force behind increasing material wellbeing. But man does not live by efficiency alone, at least not New Capitalist man. There is something offensive about the multimillion-dollar birthday parties that some hedge fund operators favor in an era in which middle-income families are struggling.

No matter. For whatever reason--good or bad--we are about to see equity given greater weight relative to efficiency as New Capitalists recast the tax structure erected in the last days of the Old Capitalism. Old Capitalists worry that if the marginal tax rate on the highest earners is raised from 35 to 40 percent, the wealthy will be less inclined to invest and take risks. New Capitalists, who would distribute those funds to the middle class, think it is worth sacrificing a small bit of efficiency to gain a great deal of fairness. This is the one area in which the Old Capitalists have not capitulated, and are mounting a last-ditch effort to preserve the Bush tax cuts. They will lose, whether to a President Obama or to a Democratic Congress that will drive an only apparently reluctant President McCain back to the position that he took when first confronted with the Bush cuts: They just don't seem fair.

None of this is to say that the New Capitalism will produce material results superior to the Old Capitalism, which has, after all, greatly improved living standards and reduced poverty. Or that its new regulations, new trade regime, new tax structure, or new emphasis on fairness will satisfy those who are driving and those who are acquiescing in these changes. I have my doubts on both scores: The New Capitalists have not entirely met the burden of proof that rests on those who would change a system that has done so much to improve the lot of those fortunate enough to live under it. But there can be no doubt that the world has changed. Capitalism as we knew it even until a few years ago is no more, and we who are saddened at some of the changes had better learn how to make the New Capitalism function as well as it can, rather than curse those who have capitulated to its demands.

2. Opposition Growing to Mother of All Bailouts (MOAB)
3. The Mortgage and Banking Mess: Don't Play The Blame Game
4. A Bad Bank Rescue
5. Glass-Steagall : RIP
6. Proposal
7. Obama Steps Up: The Seven Point Plan
8. Attacking The Root Problem
9. Why Should We Negotiate With Bush At All?

Cut Bush out of the equation. Start negotiating with the candidates instead, thus forcing them to make this their first action as President. This will also have the positive result of making the election about the bailout and corporate malfeasance in general. Hell, it would also make every single congressional campaign about the same thing, since every candidate would be forced to work out the deal for two weeks before the next President is in office.

10. From Louis XIV to George W. Bush
11. Bailout
12. Will America pay the world's tab?
13. Matt Yglesias, drunk
14. The Crisis
15. A defence of the Paulson plan
16. In Defense of the Paulson Plan
17. The Opposition Grows
18. Where did we go wrong?
19. For a Bailout, Press 'One' . . .
20. Why You Should Hate the Treasury Bailout Proposal
21. More Capital for the Financial System
22. Paulson's Plan Is Necessary And Costly
23. Grazing On The Paulson Plan
24. Financial Frustration
25. A break in the clouds

Mr Paulson's plan is stunning in its brevity (two-and-a-half pages) and audacity. It would authorise him to purchase any «residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages,» implying the right to take over derivative positions. A fact sheet later distributed by the Treasury broadened it to include «other assets, as deemed necessary to effectively stabilise financial markets.» The government could, in effect, buy anything it wanted: student or car loans, loans, equities, entire companies.

The Treasury secretary's decisions «may not be reviewed by any court of law or any administrative agency.» He would report to Congress three months after the programme begins and every six months thereafter. It is now conventional wisdom that recent events have guaranteed a heavier regulatory hand for government in the economy. Mr Paulson's programme raises the prospect of it becoming a huge player in the allocation of capital as well. The ability to buy assets expires after two years, but its management of those assets would continue.

Mr Paulson said that the lack of oversight gives future administrations «flexibility to run this any way they would like to run it.» And some experts say decisions must not risk being tied up in lawsuits, or confidence could suffer. But the great discretionary power seems to fly in the face of the original rationale for the programme, which was for a systematic rules-based approach to resolving the crisis rather than ad-hoc bail-outs. Future administrations could find a $700 billion fund a potent tool for various policy goals.

To acquire mortgages the Treasury plans to use «reverse auctions». But as Lou Crandall of Wrightson ICAP, a research firm notes, «Auctions work well when you have a group of bidders for a single set of identical assets. They work less well when you have a single bidder for a group of disparate assets.»

Another problem is that it would reward the least deserving institutions the most. «Banks that stayed clear of this debt or sold such debt at cut-rate prices earlier this year in an effort to move beyond the crisis would receive no direct gain from such a programme,» notes Doug Elmendorf of the Brookings Institution, a think-tank, while banks who had the most junk and had dragged their feet on writing it down would benefit most.

Mr Paulson has rightly noted that the cost of the programme should be well below $700 billion since some of the mortgages will be repaid. But it may be optimistic to expect it to turn a profit. Indeed, profit is inconsistent with the point of such a programme which is to socialise losses that would otherwise cripple the financial sector and toss millions of people out of their homes. The lack of an upside for taxpayers is one reason that some scholars, like Mr Elmendorf, favour the taking of direct stakes by the government in financial firms instead.

Profit is possible, of course. The market prices of many mortgage securities today reflect not just the likelihood of default, but a steep liquidity premium, because the paper no longer trades. The Treasury could conceivably buy something above market value but below fair value and hold it to maturity. But it could deepen the financial crisis by forcing institutions to recognise the assets' deeply distressed prices.

Even if the programme is designed perfectly, it is no sure thing it will end the crisis. It does address the root problem, defaulting mortgages, and Mr Bernanke has long worried that bad debt would fuel a vicious circle of crippled lenders, constricting credit, weakening growth and more defaults. But that is not what happened last week. Losses on Lehman debt forced several money-market funds to «break the buck» (lower their net asset value below the sacred $1 per share), triggering a flight out of short-term commercial paper. Banks, forced to contemplate redeeming hundreds of billions of dollars in maturing commercial loans, began hoarding liquidity. Interbank lending froze. This generalised loss of confidence was many steps beyond the root cause of the crisis. Announcement of bail-out plans helped ease things, but the effect was purely psychological.

For this reason, ad hoc responses will still be critical, such as last week's federal guarantees for money-market funds, Fed loans to banks to buy asset-backed commercial paper and, on Sunday, approval of the remaining two big independent investment banks, Morgan Stanley and Goldman Sachs, to become Fed-regulated bank holding-companies whose investment bank units can now borrow from the Fed on the same terms as other banks.

It could be some time before the Treasury is able to buy mortgages en masse, and longer still before that starts to affect the broader financial system and economy. In the meantime, the crisis could claim other victims.

Thinking about my parents' direct exposure to this meltdown, through pensions and IRA's, and my own exposure through mutual funds, as well as the knock-on effects on the employment market, I think I'm fortunate. But, I'm just dumbfounded how this crisis occurred

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