INSOLVENT OR ILLIQUID?
Contrary to widespread popular belief, the "$700 billion bailout" doesn't involve spending $700 billion, since most subprime mortgages are still OK. They aren't all going to default. The problem is that once they've been sold and chopped up into derivative securities, the good mortgages are hard to identify and untangle from the bad ones. If we knew which were which, we could also separate financial institutions into two categories: those that are truly insolvent and those that are simply in a cash crunch caused by uncertainty and panic.

Good policy should seek to help illiquid firms survive the immediate crunch while forcing the insolvent ones to restructure their debts and essentially (or literally) declare bankruptcy--the sooner, the better. My general inclination is to put policy emphasis on helping healthy firms rather than bailing out losers, including homeowners who can't make their payments.

A CHILLING EFFECT
In a perfect world, illiquid firms would pull in private capital looking to profit from the current turmoil. (See Warren Buffett's investment in Goldman Sachs.) Unfortunately, the bailout talk is deterring potential investors, who at the very least want to know what to expect from the government and, in some cases, appear worried they'll lose any investment. Uncertainty is freezing everything.

Having helped create the problem, the Treasury could alleviate the credit crunch either by lending money directly or by guaranteeing loans--either of which should be done at some potential profit to the taxpayers. The goal is not to protect lemons but to give firms that know they'll be able to service their debts a chance.

In that regard, I am a fan of Professor Postrel's recommendation (below) that the Treasury guarantee commercial paper from borrowers with good credit ratings. The commercial paper crunch, not bad mortgages, is the biggest threat to the overall health of the economy. It should not be that hard to identify good credit risks and charge them a small premium for borrowing from the Treasury.

AN ANGRY PUBLIC
Any policy must take account of the taxpaying public's intense and largely justified resentment of having to pay for the screwups of people who got rich taking big risks and then didn't have to suffer the consequences. From a less emotional standpoint, we also don't want to encourage such behavior in the future. Innovation, financial or otherwise, is a wonderful thing. But it only works if innovators receive negative as well as positive feedback.

But what to do? We can't go in a time machine and take away Wall Street bonuses or send mortgage brokers back to selling car insurance (or whatever else they were doing before). Screaming, "It's not fair" won't make the systemic problems, which threaten everyone, go away. But the screaming does remind policy makers that their duty is to the general public, not to specific institutions. Institutions that have made bad decisions need to bear as much of the cost as they can without seriously endangering the rest of us.

For starters, any lending should follow the wise Allan Meltzer's Chilean example of requiring firms to cancel their dividends as a condition of any assistance--a proposal that also has the positive effect of generating cash. (Meltzer, one of those people a lot smarter than I am, doesn't think the government should do anything.)

Second, all assistance should be structured so that it is potentially profitable to the Treasury and--equally important--those profits should be rebated to taxpayers, not thrown into the general federal pot. If, as Andy Kessler suggests, the Treasury stands to make a fortune by becoming a sort of hedge fund, the fund's "investors" ought to reap the gain directly.

Third, and this will take a while, serious thought needs to be given to creating automatic circuit breakers of various sorts to prevent this sort of contagion in the future.

Last but definitely not least, Fannie and Freddie must go. They not only privatize reward and socialize risk. They do so by design. The whole point of these agencies is to put taxpayers on the hook for mortgage risks that private actors wouldn't take without them.

RECOMMENDED READING
Saving Capitalism from the Capitalists, by Ragu Rajan and Luigi Zingales, both of whom have acquitted themselves well of late (see links on their names). I wrote about their book here.

I do think Obama is handling the crisis much better than McCain--not because he is suggesting better remedies (he continues to say little), but because his instinct to reflect before opening his mouth and his impeccable taste in [economic, I assume--vp] advisers are both working to his advantage.

I don't plan to vote in the presidential race, barring a last-minute lurch to Bob Barr, but if you held a gun to my head and made me pick one of the two major party contenders this week I'd have to go with Obama. He scares me, but not as much as McCain.

On substance rather than style, there's lots of good stuff at MarginalRevolution, including a couple of comments from Professor Postrel (a.k.a. srp here), basic points repeated below:

I have a different idea to throw out. If the urgency of an intervention supposedly stems from contagion to the commercial paper market, and the government is now going to play hedge fund anyway, why don't we dedicate the $700 billion facility to guaranteeing the commercial paper of high-quality borrowers for the next six months or so. We could even charge the borrowers a couple of basis points for the service. I'll bet that the taxpayer is a lot less likely to have to pay out much of that $700 billion with this strategy, and then we can use the appropriate tough tactics to flush out any insolvencies in the MBS and CDO markets at our leisure....

I get that Bernanke and Paulson are scared, but what are they scared of? Presumably, a shutdown of short-term commercial lending that would destroy non-financial firms' working capital and lead to a huge downward spiraling contraction as everybody hoards cash at the same time. It seems to me that dealing with the "root causes" is more indirect and less likely to solve the CP problem than propping up the CP market to lower spreads. In addition, the B&P plan has all the obvious drawbacks that everyone else has already identified, e.g. prolonging the recognition of insolvency, delaying the correction of real-estate prices, creating moral hazard, and so on.

There's an old story about operations research, perhaps apocryphal, that occurs during WWII. It seems a flight of our B17 Flying Fortresses had a very tough mission over Germany and many were shot down. An operations research team and a group of generals convened to come up with ways to reduce casualties on future missions. The generals displayed pictures of the shot-up survivors, many with gaping holes, and suggested increasing the armor at those points. The OR guys said "Wait a minute, these are the survivors--we should armor up the places where there AREN'T ANY HOLES."

My suggestion is in this spirit.

Posted by Virginia at 02:01 PM | TrackBack

UPDATE: Stephen Bainbridge saves me the trouble of explaining [via Megan McArdle, who has more.] I will also note that private equity funds and hedge funds, which aren't subject to all this wonderful regulation, appear to be doing better than the rest of the financial world.

UPDATE 2: McCain is even crazier and more clueless than I thought, as Robert George explains.

On a lighter note, don't miss the Diaries of a Groomzilla, beginning this week on DeepGlamour.net.

By Sunday, K.K.R. and the Texas Pacific Group made it clear they would not come to the rescue, worried that A.I.G. might be taken over by the government, wiping out their investments. Goldman Sachs also balked.

Blessed with the advantages of a government agency and a private company at the same time, Fannie Mae and Freddie Mac used their windfall profits to co-opt the politicians who were supposed to control them. The companies fought successfully against increased regulation by cultivating their friends and hounding their enemies.

Of course, anyone who's been reading the WSJ editorial page for the past decade knew this.

Ross Douthat is on fire on the subject.

And I connect her to cowgirl glamour. (But I largely agree with Megan about what I don't like.)

In an astute comment on my post on horror versus humor in McCain's "The One" ad, Jens Fiederer writes, "I don't think horror diminishes glamor, horror is a glamor of its own. Watch some vampire films if you doubt that. If this ad is supposed to evoke horror..., it works WITH the glamor to paint a glamorous arch-villain and encourage those convinced to choose sides."

Jens is absolutely right to that glamour and horror often go together. The original meaning of glamour was, after all, a literal magic spell cast to deceive the viewer into seeing things that weren't there. "When devils, wizards or jugglers deceive the sight, they are said to cast glamour o’er the eyes of the spectator," explained a 1721 glossary of poetry. The word's definition has obviously evolved, but glamour is still an illusion.

He's right, too, to single out vampires as a glamorous archetype. While horror comes in different forms, some decidedly unglamorous (e.g., Alien, Saw), a lot of horror, including vampire tales, depends on glamour: What starts out as beautiful and alluring is revealed to be terrible and life-destroying--and by then it's too late. Witness not only the vampire but the femme fatale, especially in her 19th-century form. Glamour promises escape and transformation; horror replaces escape with entrapment.

Read the rest here.

Well, I don't know if Palin is the reformer some claim her to be or the faux reformer others (notably a rather snarky Andrew) say she is. How can anyone know? What we read about her is like reams and reams of unclean data that won't be sorted out until long after November.

But her candidacy has clarified something for me: when I think about Obama becoming president, I feel good about it, but for one reason and one reason only: he's a black man (sort of) and surface identity being the primary motivator apparently for most people, his election will have very good effects on the populace. (Like Shelby Steele, though, I think it says much more about the utopian hopes of white liberals than the desires of regular black folks.) He may well turn into an exemplary chief executive--I'm certainly willing to give him a go far beyond the honeymoon stage--but there's nothing to base this on except for his speeches, inasmuch as he has absolutely no track record, in Illinois or Washington, of taking unpopular stands or reaching across the aisle. But, hey, hope floats, at least in politics.

Maybe I'm just falling prey to my own identity politics, but I honestly don't think that's it. I like what I see so far because in Palin's candidacy I see a glimmer of hope for citizenship, for regular folks (that is, nonparty stalwarts) handling things again. She may well crash and burn: it is, after all, an American Idol type of candidacy. But maybe, just maybe, her narrative will excite those "ordinary" Americans like me who are tired of the political parties and the coronation atmosphere of presidential elections and maybe, just maybe, be the opening that allows new faces and new ideas to emerge on our philosophically tired political scene.

I'm agnostic on Palin's policy knowledge or executive qualifications--Leslie is right about the "reams and reams of unclean data"--but I do think the rush to condemn her because she's not an Ivy Leaguer or hasn't spent her life in politics demonstrates a shallow definition of merit and a consequent lack of imagination in understanding just why many people find her appealing.

Besides, there's this precedent. [Thanks to Cosmo Wenman for the tip.]