Secretary Tim Geithner announced today the long-awaited details on the financial repair plan that he promised on February 10.   Some reactions have been negative, both from the left and the right.  Paul Krugman, for example, argues that the plan does not go far enough in forcing banks to recognize the fallen value of their assets.  

But the stock market was “dazzled“ by Geithner’s explanation of the PPIP proposal, with prices up strongly.    The  plan has no shortage of defenders.  Brad DeLong makes some good points, and responds to Krugman.   The Geithner Plan is an improvement over the Paulson plan in that when ”toxic assets,” now called “legacy assets,” are bought from the banks, their prices are set by private bidding (from hedge funds and private equity companies), rather than by an overworked Treasury official pulling a number out of the air and risking that the taxpayer grossly overpays for the assets.   On similar grounds, Nouriel Roubini has surprised the cynics by giving (qualified) support for the plan, and points out that its design appears to follow a recent proposal by my Harvard colleage Lucien Bebchuk.  

Joe Stiglitz, who attacks the Administration’s proposal, offhandedly mentions “It has allowed the administration to avoid going back to Congress” to ask for more money “and it provided a way to avoid nationalization,” as if these were not key advantages for those who have to work in the real political world.  It is true that we might end up with some form of temporary bank nationalization before we are done.  And it is also true that the lesson from Roosevelt’s strategy in 1933, from the slower response to the Saving and Loan problems in the late 1980s, and from Japan’s much more delayed response to its banking disaster of the 1990s, is that biting the bullet early saves even greater expense later.  But as Alan Blinder says, it matters which bullet you bite.  He points out some neglected counter-arguments to the nationalization strategy that is newly beloved of academic critics.  It would be hard to enforce a clear drawing of the line as to which banks would be taken over.   Furthermore — even with the necessary wiping out of bank shareholders — (i) the word “nationalization” would likely violate a political constraint, while (ii) making good on the banks’ outstanding obligations would likely violate the government’s budget constraint.

My feeling is: the Geithner plan deserves to be given a chance.  I discussed it on NPR’s On Point this morning.   Some of the callers evinced the anger that the American public understandably feels against the financial sector and the understandable pain of the recession.   I made an analogy with 9/11/01, when understandable anger and pain led the American public to support presidential policies that made things worse rather then better — the invasion of an irrelevant country, plus big tax cuts for the rich — consequences that we are still living with today.   In the current crisis,it is important that the anger be channeled in directions that will make things better rather than worse.

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Some observations on the plan announced by Treasury Secretary Tim Geithner yesterday:

Clearly we need to hear more details.   I  sympathize with Geithner, who has only been in office a couple of weeks.    He has had to take over in the middle of the worst financial crisis in 77 years, at the same time that he must personally fill out the reams of forms that it takes to get confirmed by the Senate (like all such new appointees)  and to fill lots of positions throughout the upper levels of the Treasury.    But the American public will demand further elaboration  on his plan soon.

For now, one must guess what is going to be the precise shape of the new Private Public Investment Fund (PPIF).    (more…)

In time of war, there is a tendency for both political parties to rally around the president, as we saw (all too well) in Iraq after September 11. In time of financial panic, there is often a similar inclination. The two presidential candidates, for example, are being careful in their statements. I don’t blame them. The issues are too complex to be taken on inside the context of a political campaign. Both candidates realize that the danger of a verbal misstep that the other side can try to blame for worsening the crisis is far greater than the likelihood that either one will come up with a brilliant solution that will gain widespread support or will solve the problem, let alone both.

Quite a few economists are worried about moral hazard in financial markets.   Vince Reinhart wrote a Wall Street Journal column rebuking his former bosses after the Bear Stearns intervention: “…the Federal Reserve’s action can only be viewed as rewarding bad behavior.”  Ken Rogoff recently wrote in a Financial Times column, “it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail?”   

Of course moral hazard is a serious problem that lies close to the heart of the financial market crises.   But I am not sure that I completely share the priority at this point on drawing a tougher line with the ex post bailouts. It may be futile advice.   Fixing the hole in the roof when it is raining is, after all, rather difficult.

Consider two other areas where moral hazard is an issue: commercial banks and river banks. Some economists would prefer that the government refrain from helping the victims of banking panics and river floods, respectively. The worry is that if those who overlend or overbuild do not bear the full costs of their mistakes, they will have no incentive to be more careful in the future.

But I think we figured out some time ago that in practice no democratic government will ever ex post turn its back on poor shivering families who appear on TV huddled in front of the ruins of their flooded out homes (or banks). It is wiser that we recognize this fact, and design a regulatory system that explicitly incorporates mandatory federal flood insurance and deposit insurance, and charges for them up front. We already do this for commercial banks. To me, the lesson of recent months is that we need to do it for investment banks and a wider range of financial institutions.

As a final tweak, I can’t help noting that central bank governors, Treasury secretaries, and chief executives who make the most noise about the evils of moral hazard and bailouts ex ante, are no more likely to stand firm ex post than others. If anything, the reverse.  I am thinking, for example, of how - ten years ago this month - it was the Clinton Administration that finally pulled the plug on continued IMF loans to Russia, despite well-founded fears of systemic contagion.   The Reagan Administration in the 1982-84 international debt crisis and the Bush Administration in the 2001-03 Argentine crisis, for all their laissez-faire rhetoric, never pulled the plug on any of the debtor countries.    When sitting in the hotseat of a financial crisis, officials suddenly discover a need for bailouts, much like soldiers sitting under fire in foxholes sometimes suddenly discover a need for religion.

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