Concerning the present financial crisis, the only financial minds I have any confidence in are those who had the wherewithal to anticipate it. Both financier George Soros and the economist Paul Krugman fit my criteria.
Soros was one of the first big investors to stress the gravity of the global financial situation in early 2008. Of course, Soros had been warning about the dangers of securitized mortgages for five years.* Similarly, economist Paul Krugman has been warning about the dangers presented by a bubble in the housing market since the dot-com bubble burst.
At this time, both advocate the nationalization of insolvent banking institutions. That's the essence of a bailout plan proposed by the British government on Wednesday. It was Sweden's strategy when that country faced a similar crisis in the early 1990s.
On October 1, George Soros, writing in the Finanacial Times, outlined a means by which the US treasury could save the country from disaster:
Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve - effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.Soros outlines the details as to how it would work, and concludes:
Private investors, including me, are likely to jump at the opportunity. The recapitalised banks would be allowed to increase their leverage, so they would resume lending. Limits on bank leverage could be imposed later, after the economy has recovered. If the funds were used in this way, the recapitalisation of the banking system could be achieved with less than $500bn of public funds.
A revised emergency legislation could also provide more help to homeowners. It could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated, based on the Treasury’s cost of borrowing. Mortgage service companies could be prohibited from charging fees on foreclosures, but they could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.
Banks deemed to be insolvent would not be eligible for recapitalization by the capital infusion programme, but would be taken over by the Federal Deposit Insurance Corporation. The FDIC would be recapitalised by $200bn as a temporary measure. FDIC, in turn could remove the $100,000 limit on insured deposits. A revision of the emergency legislation along these lines would be more equitable, have a better chance of success, and cost taxpayers less in the long run.
Paul Krugman wrote on his blog today:
During the debate Tuesday night, John McCain announced his own proposal for bailing out homeowners. Krugman commented, ". . . John McCain’s bailout plan manages to take everything that’s wrong with the Paulson plan and make it worse. I’ll outsource the explanation to Brad."
Readers ask what I think should be done about the financial crisis. The answer is, what Gordon Brown in doing in Britain: a bailout, yes, but one that gives the government an ownership stake in the bailed-out institutions. That plus a serious fiscal stimulus plan that includes emergency aid to state and local government.The Brown plan, by the way, is 50 billion pounds; scaled by GDP, that would be the equivalent of a $500 billion plan here. The headline number would be smaller than the Paulson plan, but the probable effectiveness much, much greater. Not so incidentally, my reading of the TARP as passed is that thanks to the equity participation provisions, it could be converted into a version of the Brown plan at the Treasury secretary’s discretion; let’s hope that he does so discrete, or something like that, as soon as possible.
It is encouraging to note Krugman's observation that the $700 billion TARP bailout program could be "converted into a version of the Brown plan."**
* At least since the publication of The Bubble Of American Supremacy.
** Bloomberg surveys some reactions to the Gordon Brown bailout plan.