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.