This first edition of our Baseline Scenario makes three main points. First, we are facing a serious crisis of confidence in much of the world’s financial system. Second, the Paulson Plan may well bring this crisis under control, at least for a while. But, even so, we should plan ahead for measures to deal directly with the deeper underlying problems of bank capital and restructuring mortages. Third, if as we expect, further serious measures are needed (particularly bank recapitalization and dealing with the underlying mortgage problems), these are entirely feasible and well within the resources available to the US government. Governments in Western Europe and some other countries also need to act, and they also have more than sufficient resources at their disposal; however, we remain worried that some of these governments do not yet understand the gravity of the situation.
Update: to be clear, our plan for pulling the global financial system out of its nose dive is at the end of the document; feel free to skip straight to that and then work your way backwards to see our reasoning.
Update: the next edition will appear by 9am Monday morning, October 6.
Editor’s Note: The original version of this document was a separate page with a link from the short blog post above. I have since consolidated the long document into this blog post. It follows after the jump.
In case you missed it, Simon (my co-author) was interviewed by Scott Simon this morning on Weekend Edition. One point he made, that I don’t believe has gotten a lot of attention in general, was about the global implications of the bailout plan. One way of putting this is that the plan creates a “Noah’s Ark” for financial institutions to escape the storm, but the next question is who will get a ticket onto the ark. The original legislative proposal would only have authorized Treasury to buy assets from “any financial institution having its headquarters in the United States.” While there was talk over last weekend about possibly including foreign banks, or their subsidiaries in the U.S., that was not mentioned in Thursday’s bullet-point agreement between the Executive Department and Congress (the one that was blocked by the House Republican caucus). Indeed, it seems hard to believe that Congress or the American public would be able to stomach a bailout of foreign banks. But if the reason to save financial institutions is the risk of cascading disruption to their counterparties – and that was the reason cited for both Bear Stearns and AIG – we have to be aware of the risk presented by global banks such as UBS that would have similar counterparty effects. While I’m not suggesting that the U.S. bail out every major non-U.S. bank, someone may have to, and right now there is a distinct lack of a coordinated global response.
Update: 9:20pm, Saturday, September 27th, the Financial Times on-line edition is reporting that Bradford and Bingley, a UK mortgage lender, will be nationalized tomorrow. Sounds like Gordon’s Ark just got a bit bigger.
This morning (September 25, 10am) I was on the Diane Rehm show, on WAMU. The guest host, Frank Sesno, did a great job of moving the conversation from today’s White House Summit on the bailout plan to the likely impact on the global economy, with relevant stops along the way. We spent a great deal of time on alternatives.
It turns out, of course, that there are alternatives to the current bailout plan — even if you agree that there is a serious problem and we need to move fast. In fact, perhaps the one thing all three guests could agree on is the availability of workable alternatives.
I was really struck by Ken Rogoff’s points about the need to take over and close down many banks. I think he puts more weight on that part of any sensible approach than I do at present, but I’m definitely taking his points on board.
The more I talk with people, the more I hear agreement that we really need to address the problems of homeowners who are having trouble with their mortgages. It’s actual and expected defaults that got us into this mess, and attacking that issue directly is the best way to make sure we really get out.
Think of it like this. The Treasury wants to use its balance sheet (i.e., it’s ability to borrow at low interest rates) to help the banking system get back on its feet. If a substantial amount of taxpayer money is on the table, which it apparently is, let’s talk more about how to use the Treasury balance sheet to help homeowners get back on their feet.
The debate on what the Treasury should or will pay for mortgage-backed securities has moved fast in the last week. Last week, Mr Paulson said it would be “market prices.” On Tuesday, Mr Bernanke said it would be “close to mark-to-model prices,” which you can presume would be above, and perhaps substantially above market prices. Since then, Mr Bernanke seemed to back track from that statement, towards some version of market prices.
But what are market prices or any other prices in this situation? You need to answer this question to know whether the Treasury is intending to overpay — or whether, after the fact, you can figure out if they did in some meaningful sense overpay.
We attempted to sort this out in The Price of Salvation on the Financial Times website (Economist Forum). It’s hard to say if any of this is getting through, but we are a little bit encouraged by the reaction.
Watch Your Wallet
Ordinarily, you would not hand $100 to your broker to invest on your behalf without some idea of how he or she would invest your money. You would be even less likely to hand over your cash to someone planning to invest it in illiquid assets with no established market prices. However, the original version of the government bailout plan, released on Thursday last week, handed $700 billion of taxpayer money to Treasury to invest in mortgage-backed securities at any price it saw fit.
Our Washington Post op-ed article discusses this governance question and floats a few possible solutions that could align incentives properly and promote transparency. At the same time, opposition from both sides of the aisle on Capitol Hill has greatly increased the chances that some form of improved governance will be included in the final plan. In following the ongoing debate, however, it will be important to make sure that there are adequate mechanisms for setting prices objectively and transparently, or else the opportunity for abuse will remain.