Voluntary Debt for Government Equity: the Mankiw-Paulson Bank Bailout Plan

Greg Mankiw wrote yesterday:

Some economists have proposed forcing these firms to go raise more capital from private sources. But how exactly can the government do that? It is not entirely clear how, as a legal matter, that can be accomplished. Perhaps regulators can twist the arms of the financial institutions. Call it the Tony Soprano approach. “Nice bank you have here. I wouldn’t want anything bad to happen to it.” Other economists have suggested that the government inject capital itself. That raises several questions. First, which firms? The government does not want to put taxpayer money into “zombie” firms that are in fact deeply insolvent but have not yet recognized it. Second, at what price should the government buy in? Third, isn’t this, kind of, like socialism? That is, do we really want the government to start playing a large, continuing role running Wall Street and allocating capital resources? I certainly don't. Here is an idea that might deal with these problems: The government can stand ready to be a silent partner to future Warren Buffetts. It could work as follows. Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date. This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control. Why would an undercapitalized financial firm take advantage of this offer? Because it would need to raise only half as much capital from private sources, that financing should be easier to come by. With Warren Buffetts in scarce supply, the government can in effect replicate them, by pigging backing on what they do.

Today, we learn:

The Bush administration is considering taking ownership stakes in certain U.S. banks as an option for dealing with a severe global credit crisis ... A decision to inject capital directly into financial institutions in return for ownership stakes would be similar to a plan announced Wednesday by Britain ... Treasury Secretary Henry Paulson told reporters that Treasury was moving quickly to implement the $700 billion rescue effort and he specifically mentioned reviewing ways to bolster the capital of banks.

My concern with Mankiw’s idea starts with the Akerlof demand for lemons problem where insiders may have information about the health of their company that the public or the government does not have (the asymmetric information problem). When this information is positive, they would be less likely to accept new equity infusion. Those willing to accept equity infusion may possess negative inside information about the health of their companies. The case against forced debt for equity swaps is not quite as air tight as Greg Mankiw suggests.