The question is, "Will the Geithner plan work?" There are responses from Paul Krugman, Brad DeLong, Simon Johnson, and me:
How to Tell It’s Working, by Mark Thoma, Room for Debate, NY Times Blogs: A bailout plan must do two things to be effective. It must remove toxic assets from bank balance sheets, and it must recapitalize banks in a politically acceptable manner. I believe the Geithner plan has a chance of doing both of these things, but it’s by no means a sure bet that it will.
How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem. If the free insurance against downside risk that comes with the non-recourse loans the government is offering doesn’t induce sufficient private sector participation, then it will be time to end the Geithner bank bailout. Even if increasing the insurance giveaway would help, legislative approval would be unlikely and the political fight that would ensue would hurt the chances for nationalization.
The second factor to watch is the percentage of bad loans the government makes as part of the program. These non-recourse loans are the source of the free insurance against downside risk. Borrowers can walk away if there are large losses, and if the number of bad loans is unacceptably high (a potential political nightmare), then policymakers will need to act quickly and pull the plug on the program.
Unfortunately, however, the loan terms make it unlikely that we’ll have timely information on the percentage of bad loans. But there is something else we can watch to assess the health of the loans: the price of the toxic assets purchased with the loans. If the price of these assets is increasing sufficiently fast, then the loans will be safe. But if the prices do not respond to the program, then the loans will be in trouble.
In that case, we will need to end the program as quickly as possible and minimize losses. The next step will have to be bank nationalization, though the political climate will be difficult. Sticking with the plan until it completely crashes and burns on the hope that a little more time is all that is needed will make nationalization much more difficult.
[The discussion is supposed to continue through today.]
There were three plans to choose from: the original Paulson plan in which the government buys bad paper directly, the Geithner plan in which the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, and outright nationalization.
So which plan is best? Any plan that does two things -- removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner -- has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has the two necessary features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. This option also comes with its own set of political problems -- problems that will worsen if the loans to private sector "partners" turn out to be as bad as some fear. Finally, the plan for nationalization also includes these two features, but it suffers from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives (though not everyone agrees with this assertion).
I am not wedded to a particular plan. Each has its good and bad points. Sure, some seem better than others, but none is so off the mark that I am filled with despair because we are following a particular course of action.
Thus, I am willing to get behind this plan and to try to make it work. It wasn't my first choice; I still think nationalization is better overall. But trying to change the plan now would delay the rescue for too long, and more delay is not something we dare risk at this point.
Update: A second entry at the NY Times blog:
Random Actions on Failing Banks, by Mark Thoma: Mark Thoma responds to Simon Johnson:
One of Simon Johnson’s points is very much worth emphasizing. When this crisis hit, we did not have the procedures in place for an orderly resolution for banks that were failing. Thus, because there were no well known procedures to follow, the actions that the government took when faced with a failing bank appeared ad hoc, almost random, because they were constructed on the fly to deal with problems at individual banks.
The first thing we need to do is to change the regulatory structure so that banks cannot get too big and too interconnected to fail. When they are too big, their failure puts policymakers and the public in a position where there is no resolution that can confine the costs to those who were responsible for the problem. The dynamic is bad both ways: If the bank is allowed to fail, people who did nothing to cause the crisis are hurt. But if the bank is saved the people responsible are let off the hook at taxpayer expense, at least to some degree, and that brings up issues of both moral hazard and equity.
But despite our best efforts, banks may become too large or too interconnected anyway, particularly if the interconnections are not transparent until trouble hits, and that’s where we need to do much, much better than we did in the present crisis. We need to have procedures available to resolve problems that are backed with a credible enforcement threat so that everyone understands in advance exactly what will happen to institutions that are deemed insolvent. We simply cannot repeat the uncertainty generating ad hoc, case by case approach that was used in the present case.
[And Brad DeLong has a second entry responding to Paul Krugman.]