Willem Buiter nails the latest Treas/Fed PPIP proposal with his usual acuity. His analysis is spot on regarding the relevance of Akerlof’s lemons, the unwholesome mixing of bad and toxic assets, the shabbiness of the measures taken to obscure the true costs to the public, and the colossal waste of the whole enterprise in light of the far superior alternative of establishing a good, new (public) bank. I would differ only with his final sentence, which calls for tax increases and spending cuts in the teeth of an effective demand crisis.
Now three additional observations:
1. The one genuinely beneficial potential of Geithner’s public-private partnership plan is that it can generate price discovery: the market process it jumpstarts will price the toxic assets that are purchased. Buiter and other critics note that this will be a biased subset of the total—this is where Akerlof comes in. I would add one more complication. The subsidy scheme Geithner is putting in place is asymmetric: capping losses on the downside but not earnings on the up. If the subjective probability functions of investors regarding the true value of these assets is normal and reasonably compact, the subsidies will result in minimal pricing distortion. I haven’t looked at Lucian Bebchuk’s analysis (he is the intellectual godfather of this price discovery scheme), so I don’t know if he took a position on subjective probability form, but the proposal makes the most sense this way. My suspicion, however, is that fundamental uncertainty clouds the perception of what complex, toxic derivatives will ultimately be worth. If so, the distribution is neither compact nor normal. With long, fat tails the asymmetry in the payoff structure becomes crucial, and exerts strong upward bias to the resulting bids. If this is true, the prices “discovered” in this arrangement will be a poor guide to what private sector buyers are willing to offer in the absence of subsidies.
2. Much of the evasiveness of the sequential bailout schemes can be traced to a simple political-economic fact: unlike European countries, such as Sweden, whose resolute responses to earlier financial crises are held up as models for the present, the US has a legislative-executive, not a parliamentary, system. Obama’s crew does not possess a guaranteed legislative majority; it has to charm or obfuscate to win support for each new measure. This alone can explain why decisive action, like nationalization, is off the table. (Even worse, of course, is the fragmented authority of the EU, which shows us what the US would be like if we had stuck with the Articles of Confederation.)
3. In the end, even the most comprehensive, expensive program of bailouts will not put the US or global economy back on its feet. We are not building a bridge back to 2006. Financial systems everywhere and households in many countries (including ours) are massively overleveraged and will be consolidating their balance sheets for years to come. There was real misinvestment on a grand scale, encompassing not only housing (and not only in the US), but also a distribution of manufacturing capacity that depended on global imbalances persisting to eternity. The process of writing all this off will be protracted and painful. Finally, a destructive feedback loop has taken hold, in which weak economic prospects dampen investment demand, and weak investment depresses incomes. Even unfrozen banks no longer stuffed with junk will lend gingerly at best.
This is why I think a rapid shift in policy toward public banking is essential. How it can be reconciled with (2) is unclear, however. How can we get from here to there?