BETTER BAILOUT IDEAS

BETTER BAILOUT IDEAS… One of the classic mistakes we all make–and this is true of political leaders and average citizens alike–is to accept unquestioningly that the choices we’re being presented with are in fact the only choices we have. And so it was on Friday that Democratic leaders in Congress seemed to line up behind the Bush administration’s plan to have the federal government spend half a trillion dollars or more to buy up toxic mortgage securities held by banks and other institutions. It was a radical idea, suspiciously lacking in detail, and rife with taxpayer risk with moral hazard. But if it’s either that or the whole financial world melts down, the thinking went, what choice do we have?

Actually, several better ones, Sebastian Mallaby reports:

Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into a bad-loan bazaar and being ripped off by every merchant.

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don’t do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don’t want to signal weakness and they don’t want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks’ bad loans but by buying equity stakes in the banks themselves. Whereas it’s horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

I feel better already.

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Paul Glastris

Paul Glastris is the editor in chief of the Washington Monthly. He was an editor at the magazine from 1986 to 1988.