Financial Crisis: Stepping Back from the Precipice

Tarpeian Rock, Rome

Economists, bloggers and amateur historians will read with interest the rich exchange of ideas on the Paulson bailout plan instigated by Christopher Carroll, the economist from Johns Hopkins University, on the Economists' Forum blog of the Financial Times, TARP and the Ruin of Pompeii: An Analogy.

Professor Carroll poses a simple model of a financial system in crisis that results when an under-capitalized bank holding mortgages of the citizens of Pompeii learns that its balance sheet has been compromised by an unforeseen event, the eruption of Mount Vesuvius. Writing during the critical days immediately following passage of the Emergency Economic Stabilization Act of 2008, Carroll and a cast of contributors try out a number of policy alternatives as they enrich the model, in the process making it ever more analogous to the present situation.

Mr. Carroll takes the question directly to Secretary Paulson, wondering rhetorically why the classical, free-market solution--let the banks fail--would not be more sensible than the approach initially suggested by Paulson, by which agents of the U.S. Treasury would inject capital into financial institutions by purchasing troubled assets at prices to be set by auction on exchanges to be named later. Carroll doubts that any auction can establish the real value of these securities and thus suggests that policy-makers consider direct investments in bank equity.

The contributors poke at Carroll's model and his history, variously:

• Defending TARP (Troubled Asset Relief Program) as a mechanism for creating liquidity in the short term
  
• Introducing complexity (e.g., suppose Pompeii's mortgage had been insured by entrepreneurs at Vandelsbank)
• Considering the fallout of market failure ("it will trigger a run on all the other banks in the Empire, putting millions of potential tourists to the new Pompeian ruins out of work and unable to afford the trip") and
  
• Noting that Titus and not the despised Nero was Emperor at the time of the Eruption

One commentator remarked:

How strange to call this plan “TARP” when the old Romans used to say “The Tarpeian Rock is not far from the Capitol.” (Editor: Following his link, one finds that the Tarpeian Rock is the precipice from which ancient Romans flung traitors, murderers, and those "cursed by the gods.")

Within days of Carroll's article the finance ministers of the G7, led by the UK, announced plans to battle the world liquidity crisis by directly injecting capital into their respective banks. Secretary Paulson, in what seemed a remarkable turnabout, shifted his policy focus from purchase of troubled assets to direct investment in financial institutions. Calling a meeting of the leaders of the nine largest U.S. banks, Paulson called on each of them to contract immediately with the US government for a direct infusion of federal cash in the form of escalating loans, along with warrants for preferred stock and limits on executive pay. In dramatic reporting for the The New York Times, Mark Landler and Eric Dash wrote:

In addition to the capital infusions, which will be made this week, the government said it would temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in noninterest-bearing accounts, mainly used by businesses.

All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks.

Carroll and his contributors have provided a masters class in political economy, open to the public. In it we read the thinking behind policy as it is crafted and revised in real time. More than that, we are witness to the development of economic theory. Hypotheses are set out. Models are postulated, tested and examined for implications. (One commentator, Professor Perry Mehrling of Columbia University, interprets the technical balance sheet entries of the U.S. Federal Reserve Bank on October 1, 2008 to conclude that the Fed had run out of ammunition to battle the crisis.) Consequences of policy provisions, with their inevitable compromises and disappointments, are weighed against the risks of doing nothing.

For the moment, the consensus view that banks should be forced to recapitalize despite concerns about damage to free market principles, seems to be carrying the day. And it should.

• Direct investment in bank reserves is considerably more efficient than purchase of troubled assets in producing liquidity because such action dramatically improves banks' reserve ratios.
  
• Under the latest plan banks remain responsible for their balance sheets.
  
• The government has agreed to charge a fair price for the required capital investment and has provided banks incentives for banks to buy back the the government's stake through privately financed equity. (The Treasury will purchase preferred stock paying 5% dividends initially, but rising to 9% on shares held beyond five years. Treasury will also get warrants to purchase common shares equivalent to 15% of its initial investment.)
• Compulsory action against the largest banks provides cover for others to volunteer for the program without suffering the financial taint of appearing weak. Without compulsion, which bank would have been first to appear at the government's lending window? Which executives would have volunteered to cap their own pay?

The crisis is not over and the full implications are not well known. Governments around the world will need to act responsibly and in coordination to bring the world economy to a soft landing.

Our thanks go out to bloggers like economists Christopher Carroll, Paul Krugman, Greg Mankiw and Peter Orszag for raising the level of discussion above that achieved by the mainstream media.

See also previous reports on the financial crisis, including A Review of the Economic Stabilization Act of 2008, The Bailout Explained by the CBO, The Case Against the Paulson Plan and Can the Banking System Hold Water?

A collection of posts about the US Economy is maintained here.

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