• Log in
• Register free
• Subscribe
• Help
• Tour & Trial IC Advantage

• Share Tips
• Trading
• Companies
• Markets Data
• Columnists
  • Bear Bull
  • Chris Dillow
  • No Free Lunch
  • Simon Thompson
  • The Trader
  • Your Opinion
• Funds Data
• Covered Warrants
• Research Tools
• Investment guides
• Q and A
• Blog
• Video

Subscribe today

Celebrate our 150th anniversary with fantastic savings on a joint magazine and IC Advantage subscription.

Subscribe today and save £150

What's wrong with the Paulson plan

Created:

23 September 2008

Updated:

25 September 2008

Written by:

Chris Dillow

There are two widespread objections to Hank Paulson's the plan to buy illiquid assets from banks that strike me as very questionable. These are:

1. Moral hazard. In socialising losses while keeping gains private, banks will have incentives to make risky loans and investments in future, knowing the tax-payer will pick up the bill if such loans and investments don't work out.

2. Asymmetric information. Banks will sell their most worthless assets to the state at an inflated price, thus ripping off the taxpayer.

If these objections were right, the Paulson plan would work, at least by its own lights. A little more moral hazard is just what we need to get banks lending again; as Charles Goodhart says, the time to worry about moral hazard is in booms, not now. And the more the Treasury pays for "toxic assets", the more banks' balance sheets will improve, and the sooner they'll be ready to lend again.

However, I fear both these objections are overdone. I'm not sure that moral hazard has ever been a big problem, at least in the west. The reason people take bad risks isn't that they think the government is ready with a safety net, but rather that they get overconfident, or misjudge the risks, thinking they are onto a sure thing. Come the next bubble - and of course there will be one - it'll be the result of irrational exuberance, not the hope of being bailed out by the taxpayer.

And I'm not sure asymmetric information is a problem, either. The thing about mortgage-backed securities is just that no one knows what they are worth; they are an object lesson in Knightian uncertainty. If banks knew which were "toxic" and which were not, they wouldn't be in the trouble they're in. What's more, it's possible that the Bank of Hank will be able to employ people who are no less ignorant than the banks about such assets - as it could hire the asset-backed traders laid off from the banks, or subcontract the job to fund managers. Paulson is not only the investor of last resort, but the employer of last resort.

So, perhaps the taxpayer won't get ripped off. Which is, of course, bad for the banks.

Instead, I think there are three bigger objections to the Paulson plan:

1. In the long run (not that anyone cares about the long run right now), it's a no-win situation for investors. If the state buys mortgage-backed securities that do subsequently rise in value, thus making money for the taxpayer, it'll be proof that private sector banks are awful judges of risk. In which case, why tolerate their remaining in the private sector? But if the assets do prove of nugatory value, there'll be a taxpayer revolt. Either way, the status of banks as privately-owned entities will be in question.

2. There's a better alternative - suggested by Paul Krugman and Luigi Zingales (pdf), among others. The government should force banks to recapitalise themselves, through rights issues or debt-equity swaps. One reason banks don't do this themselves is that - as we've learned in the UK - rights issues are regarded as signals that banks are in trouble, which cause share prices to plummet. If if the state ordered such recapitalisation, such a signalling problem would be mitigated.

The question is: why did Paulson not do this? Is it because he's worried that it would mean "American" banks falling into Arab or Chinese hands? Or is it because, as Professor Zingales says, "It is much more appealing for the financial industry to be bailed out at taxpayers' expense than to bear their share of pain"?

3. No government anywhere in the west will be able to "reform" conventional welfare states again without raising the objection: "If a massive welfare state is good enough for capitalists, why isn't it good enough for ordinary people?" Saving capitalism - if that's what Paulson has done - has meant killing free markets.