Questions and an analogy.

[randomness]

My previous post elicited some answers to questions I wasn't asking, e.g., "should we avoid a financial meltdown" or "what happens if the financial system melts down". One could debate those, but I'm not.

The questions which I think need to be answered are:

Are we in danger of a financial meltdown? (and how quickly will it happen?)

What do we do about it? (and is this proposed plan the right one to fix the problem?)

It's as if we're on a ship, and a crew member discovers there's water in the bilge. Crewmembers point at the water and saying if the ship sinks we'll all drown. They keep talking about all the awful things that will happen if the ship sinks (sharks, drowning, exposure), and tout this great idea of plugging a hole in the hull with a big ball of money which they're going to collect from the passengers.

When we ask if maybe the hole might be patched with something else, or if it's small enough that maybe the pumps will work, or the watertight doors can be closed to keep the rest of the ship from filling up with water, or even if the water didn't splash in in heavy seas...they go back to talking about the sharks. Moreover, it wasn't that long ago that the captain claimed there wasn't any hole in the hull at all.

It's up to the people who want our money to convince us that using that big ball of money to plug this hole in the hull is the right idea.

Comments

[drwex]

I do think we're in the middle of a crisis. Meltdown is probably too strong for it. The problem is that lending in a time of high risk and uncertainty is frelling hard-to-impossible. In theory, if you lessen the uncertainty then you make it more likely that the flow of money will resume. If it does not resume then you have a serious problem.

As to whether this particular proposal is the best way to remove uncertainty I'm less convinced. There are alternative proposals that I like more; for example, this AM I listened to an MIT prof (and former head economist for the World Bank) propose that a better approach would be to have the government loan the banks T bills, with the risky mortgage-backed securities as collateral. The banks can then use their stock of T bills to guarantee the kind of short-term inter-bank loans that have been so hard to get.

The advantage here is primarily that the risky assets remain with the banks. If the assets perform well then great everyone makes out. If they don't, then the banks have to find other assets to collateralize the loans. And since T bill valuations increase with time there are a number of options for limiting potential Treasury losses. For example, the Treasury could withhold interest on defaulted loans. The gov't is out the initial value of the bill, but that's often 50% or less of the eventual end value. Alternatively, on demonstrating continued good performance of the mortgage security the government can issue the coupons for the bond, increasing its value to the bank. In effect the banks are rewarded for cleaning up their act.

The downside of this proposal is that it doesn't get the bad assets out of circulation. Someone, somewhere is going to get socked and the amount of sockage remains unknown. It's possible that this uncertainty would be too much and the problem wouldn't be solved.