Treasury Secretary Henry Paulson announced yesterday that he won’t be going forward with the Wall Street bailout plan after all. It’s a stunning about-face. President Bush two months ago scared the world half to death about how civilization would come to an end if the program wasn’t authorized immediately, and Paulson went to Capitol Hill to explain patiently how fundamentally necessary it was. And now it won’t be happening at all.
It seems Paulson came to realize that the critics of the plan were right. The Treasury was going to buy sheets of paper from banks for arbitrary sums of money — and when you get right down to it, how does that make any sense? How do you separate the banks that deserve help from the ones that are doing fine and the others that deserve to fail? How do you set prices for assets that no one seems to know very much about?
Most of all, how do you separate the very abstract assets that banks are built on from the phantom assets that really aren’t worth anything? The conventional answer, of course, is that you would have to have underwriters who go over the underlying assets one by one, making sure, for example, that the real estate really does exist, really is worth something, really is owned by the people who claim to own it, and so on. The Treasury would need enough underwriters to fill up the old WaMu headquarters, and it would take forever for them to sort through all the papers. And if the Treasury didn’t do this work, it would essentially be pulling values out of thin air. Folks would take advantage. I think this is what Paulson was getting at when he said yesterday that the process of buying distressed assets was too slow and would take too long to work.
Nearly half of the $700 billion fund authorized by Congress has already been spent building up the capital of banks (and AIG). The rest, apparently, will be reserved to shore up banks at risk of failure. It is an awkward position for the Treasury to be in, owning a share in more than half of the banking system in what is supposed to be a free-market economy, but if it can help prevent otherwise solid banks from failing, that will help to stabilize the economy, which is more than you can say for the now-abandoned Wall Street bailout. It is also not nearly as inflationary as the Wall Street bailout plan. The U.S. dollar won’t collapse, but it will still be hurt. With the deficit spending approved already, it wouldn’t be surprising at all to see inflation running around 20 percent for much of next year. On the other hand, there are deflationary forces at work too, and there is no historical model that tells us where the economy is going from here, so if inflation runs at just 10 percent, that won’t be surprising either.
When Congress approved the Wall Street bailout, it seemed that we had lost the chance to rescue the U.S. economy. It turns out we won after all. The tremendous reluctance with which Congress passed the bailout bill put equally tremendous pressure on Paulson to deliver a program that would succeed. But it couldn’t be done, for all the reasons that everyone said back in September, and Paulson’s only chance for a successful program was to do something different. No one is entirely happy with Paulson’s new plan, but at least it’s a plan, and it’s a tremendous improvement over the original proposal. Look at it this way. Paulson originally suggested that he would spend the entire $700 billion in a matter of a few days, with no controls or oversight at all and not really knowing anything about the assets he was buying. If he had done that, most of that money would have been offshore by the end of the day, and it is fair to say that the U.S. economy would be collapsing around now.