The Geithner Plan

by Brien Jackson

I’ve taken some time in getting around to writing about this because, at the risk of losing my blogger cred, I’m just not an expert on matters of finance. Shocking, I know. But having had some time to look over the plan and read various reactions to it, I think I’ve got a good enough sense of my thinking on the topic to blog about it.

First of all, I should reiterate that, all else being equal, I think some version of the Swedish plan would probably be the most effective method for dealing with our bad banks. That said, I’m not sure all else is, in fact, equal. For one, this plan would require a massive committment of resources up front and, ultimately, would leave the government holding onto an awful lot of debt and toxic assets for the foreseeable future. One issue I have with this plan, at the moment, is that I feel like a lot of its most ardent backers are really glossing over how much money it really will cost in the long run, and, in some cases, trying to give the impression that it will either be cost neutral in the long run, or even be profitable for the government over time. Secondly, as easily mockable as it may be, the United States really isn’t Sweden. Aside from having a populace that is generally more skeptical of any form of government spending, and particularly massive government intervention in the market, we’re also a much bigger country with a markedly larger economy and more, and bigger, banks, meaning that one would imagine it would be more costly to implement the Swedish plan here than in Sweden.

Secondly, on the underlying assumption of the Geithner plan, I think I come down more in the DeLong camp, namely, it seems to make a lot of intuitive sense that, if we realize that assets can be substantially overvalued in bubble period, it certainly makes sense that they can be undervalued in periods of extreme risk aversion. Of course, firms are highly averse for a reason, namely that not all of the assets are undervalued and some of them are, in fact, toxic. And while I think I tend to come down on what seems to be the consensus opinion that the largest flaw with the Geithner plan is that the government’s underwriting of potential losses on toxic assets will lead firms to overbid on assets, I’m not sure it’s as big of a problem as many make it out to be. To wit, I think that the firms in question would like to make some money, and as such will probably not throw out a lot of money over what they reason the asset’s value likely is. The idea that they will seems to be based upon the notion that, knowing the government is subsidizing any loss, banks will buy up the assets at any price just because. I take a rather more dim view, and imagine that banks won’t want to put that much effort into such a longshot prospect of making money. And, via Yglesias, Mark Thoma has a much more relateable analogy for the question:

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars – the engines blow up and the cars are then worthless – and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer’s “balance sheet” – the cars on its lot – are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.

If all the cars were in perfect shape, they would sell for $20,000 each. Thus, there are (50)*($20,000) = $1,000,000 in assets on the books according to one way of doing the accounting, but that doesn’t necessarily represent the true value of the cars on the lot.

The town where this dealership is located relies upon this business for jobs, it is essential, but, unfortunately, business has fallen off to nothing. Nobody is willing to risk losing $20,000 by purchasing a car that might die just after purchase, so the price has fallen. The expected value of a car is $10,000, but it’s an all or nothing proposition, the car runs or it dies, and since people are risk averse nobody is wiling to pay the $10,000 expected value. In fact, the highest price they are willing to pay, $6,000, is lower than the minimum price the dealer is willing to accept.

This seems like a pretty good description of the problem as I understand it, and given this situation I think a lot of the same economists advocating for the Swedish Plan would find the best course of action to be government guarantees against loss on the “toxic cars.” On the other hand, Krugman’s contention isn’t that this is a bad plan so much as the underlying assumption is wrong. In other words, he thinks that a lot more than half of the cars on the lot are toxic. But, while I generally hate to disagree too much with Paul Krugman, I don’t see how there’s enough information to make that contention on anything other than a guess. I might be being too optimistic here, but it seems as though I’m not necessarily alone in that optimism, such as it is, either. That’s not to say I think Geithner has worked out the best plan ever, but I think it’s a reasonably sound course of actions based on its assumptions about the nature of the problem, that disagreements on the matter basically boil down not so much to critiques of the mechanics of the plan so much as differing assumptions, and that, as such, Geithner’s plan has a much higher chance of being successful than a lot of people are allowing.

 

 

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