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Sunday, March 30, 2008

Resolving the Financial Market Crisis

In thinking about how to resolve the financial market crisis, I've said that we should do two things, pursue some version of a mortgage repurchase plan, and pursue some means of removing risky assets from financial markets:

[T]he Fed [can] remove risk from the market by purchasing risky mortgage backed securities... I think purchasing mortgages would [also] help to stabilize the mortgage market, so I ... favor ... the mortgage purchase plan, particularly since it helps homeowners directly. I am just not sure that it will be enough by itself to get credit flowing again. ... Because of the uncertainty about whether purchasing mortgages will be enough to stabilize markets, I would advocate doing a combination of both policies, purchase troubled mortgages and purchase troubled financial assets at the same time... (and other measures, e.g. regulatory change, could also be put into place so his is not all that can be done).

In a follow-up, I added that:

I believe a combination of both plans - the Treasury intervening to purchase mortgages and reissue them on more attractive terms, and the Fed intervening to purchase mortgage backed securities (MBS) - is the safest bet. Even if one of the measures isn't enough on its own, hopefully the combination will prove sufficient.

The analytics of proposals such as this are starting to come together. Brad DeLong has done us a favor and provided the latest step in the analytical process. Here's a fragment of a much longer post he has provided. Notice that he has also added recapitalization to the list of policies, an important innovation since this is one of the keys helping financial markets to move forward:

What do we do now? That is the subject of Larry Summers's column. We do two things. First, we have the Federal government reduce the supply of risky financial assets by having the government buy or guarantee (thus making the assets no longer risky, you see) or support the purchase of mortgages (and other things) and so push the private financial-sector supply of financial assets to the left. Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the supply up and to the right, like so:


And so pushing up the prices and reducing the interest rates charged on financial assets, making the good equilibrium reappear, and keeping us out of depression, like so:


That, in a nutshell with simple graphs, is what Larry is saying, with the addition that he thinks that we now have in motion enough policy moves to resolve the crisis and save the world economy from depression. But there are four additional points that don't fit easily on the graphs. We need to make sure that we also:

  • do smart things to try to keep this from happening again
  • assign blame and try as hard as we can--without causing a depression--to make sure that those who bear responsibility don't make out like bandits by looting the Treasury as this is accomplished.
  • make sure that others--even if they are still largely innocent bystanders at the moment--do not earn unjustified windfall fortunes in the process.
  • make sure that the upward-and-to-the-right orange-arrow movement of the supply curve does in fact take place: make sure that financial intermediaries that survive and profit because of government intervention become not just part of the problem but part of the solution: that because "much is being given to financial institution shareholders and management, [it is only fair that much] action to help the economy and protect the taxpayer... be expected in return."

Now there are three objections to this analysis and this plan of action, roughly: (1) it's immoral, (2) it's unfair, and (3) it can't work in the long run. To expand a bit ... [...Brad's post...]

    Posted by on Sunday, March 30, 2008 at 08:18 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (21)


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