Krugman on the Bailout: But Why Not Intervene at “Step 1”?

My colleague Bryan Wildenthal circulated this thoughtful analysis to faculty colleagues yesterday. With his permission, I’m reprinting it here for Concurring Opinions readers.

Paul Krugman is a progressive commentator I admire greatly, and a seriously credentialed academic economist. His Sept. 22 New York Times column (“Cash for Trash”) on the proposed Bush-Paulson Wall Street bailout is one of the better comments on this issue I have seen.

But I tripped over part of his argument.

First, Krugman, in a helpful summary, takes “a four-step view of the financial crisis.”

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt….

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse….

Krugman then perceptively notes that the Bush-Paulson plan is (at

best) designed to intervene at “step 4” of the problem, by buying up most of the bad mortgage-based securities. Krugman argues:

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

But I’m thinking: Why not intervene at Step 1?

Mind you, I’m not necessarily AGAINST an intervention at Step 2, as Krugman suggests, though many people will understandably oppose it as a massive “socialization” of our banking and investment system, as government obtains (in Krugman’s words) “a share in ownership” in such companies.

But intervening at Step 1 would arguably cut more directly to the GRASSROOTS of the problem, while AVOIDING that whole bugaboo of “socialism” raised by direct, top-end, government buy-outs and bail-outs.

I don’t think I’m the only one thinking along these lines. And hey, I’m no economist! But here’s how I would argue it:

If (1) the federal government really has about a trillion dollars to throw at this problem, and (2) taxpayers are being asked to foot the bill, then (3) why not structure the solution so that, as much and as directly as possible, “we the people (the taxpayers)” BAIL OUT OURSELVES? Why not aim at what Krugman calls “Step 1” by helping millions of ordinary American homeowners (largely the same ordinary American taxpayers who will finance any solution) avoid that “surge in defaults and foreclosures” by firming up the grassroots basis for all those dicey “mortgage-related securities”?

After all, there’s nothing new about government and taxpayers subsidizing home ownership by most Americans of middle incomes and modest means (through tax deductions, creating Fannie Mae and Freddie Mac in the first place, the recent govt takeover of FM/FM, etc, etc).

So, instead of the massive moral hazard — and general unseemliness — of putting taxpayer money on the line to bail out Wall Street banks and brokers at the top end of the pyramid, why not aim at the broad BASE of the pyramid?

The money is there. I mean really, isn’t it funny how when political leaders and powerful interests like Wall Street REALLY need cash, they somehow find a way to pull it out of the federal government’s [ahem]?

To put it more politely: They just stick taxpayers with the bill.

Year after year, there’s somehow never enough money to fund universal guaranteed health insurance (and whatever bailout is passed to deal with this crisis will provide yet one more excuse). But need to invade a foreign country on false pretenses, even in a time of huge deficits? No problem! Need to spend about a TRILLION to bail out Wall Street? Deficits be damned!

America’s population is about 300 million. Divide by 4 (typical household size) and you get maybe 75 million households. Even that doubtless overstates the number of owner-occupied homes covered by bank mortgages, with a value less than, say, $1 million or so (we should exclude the very wealthy — if the $5 million La Jolla mansion is about to be foreclosed, I say tough luck — John McCain, of course, would make $5 million the cutoff, having suggested that anyone under that is middle class — whatever). And remember, you have to exclude the homeless, renters, nursing home residents, all the dependents who live in each mortgaged home, etc.

So, maybe 50 million owner-occupied homes, of middle-class or lower value, with mortgages? Close enough for government work.

Divide $1 trillion by 50 million and you get $20,000 — not to be sneezed at! Over two years, that could cut almost $1,000 off every single monthly mortgage check in America! That amount of mortgage relief targeted directly at the millions of American taxpayers and homeowners of middle incomes and modest means would be an ENORMOUS shot in the arm to the economy (dwarfing the piddly recent “economic stimulus” checks). And it SHOULD mostly solve a crisis supposedly rooted in overextended mortgage lending, and securities built shakily on same.

If Secretary Paulson is about to start cutting similarly huge taxpayer-backed government checks to various banks and Wall Street brokers, to take all their bad mortgage debt off their hands, why not

— INSTEAD — impose on them a legal mandate (backed up by serious criminal penalties to prevent misuse or misdirection of the money) to:

(1) Direct half the money to subsidizing, for the next two years, in some flat amount X per household per month, the mortgage payments on all owner-occupied homes in America worth less than some amount Y. The mortgagor could simply pay X less per month (down to zero, in some

cases) and the bank has to use the subsidy to make up the difference; if the mortgagor happens to pay more, perhaps their full original amount owing, the bank would be legally obligated to refund the homeowner up to amount X (out of the subsidy provided).

(2) Direct the other half of the money to pay off directly, up to some flat amount Z, some or all of any mortgage debt owed on every home worth less than Y.

Voila! Homeowners don’t default or get foreclosed. Banks and investment firms will still get full value on their mortgages. All that “bad mortgage debt” will suddenly BE (and be viewed AS, market psychology being all-important) very GOOD and SOLID debt.

This GRASSROOTS BAILOUT would be PROgressive because it would, as noted, exclude homes above value Y (maybe $1 million?). And X and Z would be flat amounts, thus effectively PROgressive in providing a greater relative subsidy for lower home values and mortgage amounts (just like a flat tax is effectively REgressive because it has a greater proportional impact on lower incomes).

Some lower-income people with small mortgages would be paid off entirely (at least over the next two years). Upper middle income people would get substantial marginal relief. It would benefit ALL homeowners (other than the very wealthy who do not need help), including those who planned carefully and are not in danger of default

— thus not creating the moral hazard and inequity of targeting only those facing imminent default (the problem with a “foreclosure holiday” or similar measures).

Some type of relief should be thrown in for renters (who also pay taxes!), for equity purposes — perhaps the long-overdue reform many have proposed of allowing renters to fully deduct rent payments from federal taxes — maybe even an immediate cash credit to renters to further boost the economy and match the immediate cash relief to mortgaged homeowners.

Finally, this proposal would NOT tend to “socialize” the economy (in the way that direct, top-end, government buyouts of banks and investment firms and insurance giants DO amount to “corporate socialism”). It would leave the private economy and free market in place. Taxpayers would just be using our collective financial muscle to give the entire system a HUGE shot in the arm.

Am I missing something? Doubtless, but this seems like a much better starting point for debate than the Bush-Paulson top-end bailout.

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57 Responses

  1. gijoe says:

    Now that you mention it, imho… If your house burns and it was non code abiding, you should have to pick up the expenses to put the fire out.

  2. jaed says:


    If you want to stabilize the mortgages – at the bottom end of the pyramid – it’s pretty straightforward: get these improvident people out of whatever horrific terms they have on their current mortgages and refinance them into 50-year fixed-rate terms. (With one exception to the fixed rate: they get a lower rate at such time as they achieve 20% equity in their homes, but it doesn’t change the monthly payment, only shortens the term.) No discounts – they eat the difference between the original mortgage and the current value.

    This gets them on a stable basis, with a predictable monthly payment and no unpleasant little reset surprises. It also gives them an incentive to hang in there and get their equity up to a nice respectable level as soon as practical. They pay a price for having bought more house than they can afford with the much longer term, but they get terms that let them keep the house, and their credit rating isn’t screwed. If they’re underwater, they’re paying for nothing for a while – but they’d be paying rent anyway, so that’s a wash.

    The homeowners get to keep their houses and have a predictable budget item, the asset stabilizes so the mortgage holders are in better shape, people who were responsible and therefore did not buy too much house don’t get screwed by taxes… I’m not sure why no one has done this already, actually. Is it legal?

  3. Joe Leahy says:

    Great idea. I have been batting around a similar idea in private email conversations for days now. Unfortunately, I still do not have a rejoinder for the best two responses I received:

    1) Bail out lower on the pyramid and the transaction costs become enormous. More money is spent valuing assets/investments to purchase (rather than bundles of assets), purchasing assets, and selling assets — and less money is injected straight into the financial system.

    2) The Paulson plan is not to invest up to $700B, not spend that much outright. So, hopefully the Fed will make some — or perhaps all — of its investment back by re-selling the troubled investments later. By contrast, money simply given to homeowners would never be recouped.

    I don’t think these problems ultimately are fatal to your idea, because it’s just SO the right thing to do. (Talk about promoting “the onwership society”) But it raises the price.

  4. Kaimi, I understand why I have to pay for something. The “Anonymous Coward” who quoted me missed the point. I know that what I lose on a bailout to any party is only to try to prevent the collapse of the system that will take everything I have with it.

    The point is not that I shouldn’t have to pay for anything. The point is that I’m not happy about having to pay for this breakdown, and your suggestion doesn’t make me any happier. Either way I’m paying for someone else’s foul-up, and I want to see more punitive measures in here. Someone needs to go sit in the corner over this, and it doesn’t look like anyone will.

  5. says:

    Or perhaps a ‘trickle-up’ approach might work ??

    As you know the Feds already subsidize homeowners via the Mortgage interest deduction.

    Would it not be easier, quicker, safer and a more ‘populist’ political act to simple adjust our tax laws so that, for example, for the remainder of 08 & 2009 a married-filing-joint couple with an adjusted gross income of under a quarter million could replace their current mortgage interest *deduction* with a sliding-scale 50 to 90% mortgage interest ‘refundable credit’.

    While insufficient to assist some unemployed folks who couldn’t make payments regardless, for most struggling middle-class citizens the promise of a fat IRS refund in April would provide a huge incentive to *make their mortgage payments* as well as provide incentives for new home buyers.

    End result = fewer mortgage defaults, bank stock values soar, home sales skyrocket and the Federal subsidy to eliminate this problem goes to millions of individual taxpaying families rather than to a relatively small group of already wealthy gamblers…

    Your thoughts ??

  6. greg says:

    My wife & I have planned and saved for our retirement since we were 35 years old. We lived within our means, saved money & made responsible choices. Now that I am within 1 year of retirement I see NO need to pay for the GREED of others. Let those who caused the crash, pay……… Let there be a criminal investigation to seek out the guilty.


  7. Robert says:

    Instead of looking at house values that would exclude renters, put a requirement of $250,000 combined household income or less. Make it available to all those who file a 2008 tax return and also turn in a credit report. Have the items that are most effecting debt to income ratio paid off directly through the account number of the bill. Put a cap of say $50K on total amount that can be paid. This will free credit, whether revolving or fixed. Allow the American people to shift their own money towards the larger remainder of their own debt (mortgages, medical bills, etc) to prevent repossessions of vehicles and foreclosures of mortgages.