So, the House has rejected the bailout, 228-205, and the stock market plunged 777 points. We're definitely living dangerously here. I'm scared but, on balance, glad: I think the Paulson plan would have altered the relations between government and economy in a highly undesirable way; or perhaps it would only have continued a trend, but that's even worse. The price of the bailout would have been an upsurge in the incentives for the private sector to bet on government policy instead of maximizing value, with far-reaching, insidious effects. Whereas the bailout rejection does the opposite: it says we the people are willing to suffer a lot of risk and pain in order to keep public and private separate, or, if a tacit contract has taken shape between Washington and Wall Street that hardly anyone understands, we repudiate that contract, never mind the cost.
It reminds me a bit of the signers of the Declaration of Independence: reckless in a way, but foresighted in that a few men were willing to pay a huge short-term price for the sake of principles about the rights of men and the proper role of the state. In the belief that in the long run having a government based on the right principles was more important.
For all that, in 1776, it was far from clear what the principles the Revolution was for were. They knew what they were against: King George III, and the Stamp Act, Star Chambers, etc., and taxation without representation. But Hamilton, Jefferson, John Adams and Patrick Henry were far from ideological clones. Now it's even less clear. It's true in a way to say that the opposition to the bailout (or some of it) stands for "limited government" and "free markets," but it's naive to regard market and government as separate: the government has to enforce contracts by any account, and few really want the government to get out of the business of insuring bank deposits or regulating capital requirements or accounting. I think the heart of the problem here is a lack of either transparency or tradition: we trust the government to do x only if (a) we (the public) understand x quite well-- which means keeping policy fairly simple-- or (b) it's been doing x for years and years, e.g., the courts, the military, which deal with all kinds of arcana but which are governed by their own powerful traditions. The Paulson plan was at once arcane and newfangled; so the public revolted.
Economists have been critical of the Paulson plan. What's our alternative? has been asked. Do nothing? Before I present my suggestions, let me make this point: there's been a lot of anger at Wall Street, not much against deadbeat borrowers. But, if people would just make their mortgage payments, Wall Street wouldn't be in trouble. This line of thinking was inspired by something Jeffrey Ely (never heard of him till now) wrote that was quoted on Tyler Cowen's blog:
True just sending money is not incentive compatible. But there is no reason to bail out homeowners. Just intervene in any mortgage default. Seize the property and continue making the mortgage payments. In the short run rent the property back to the homeowner.
What I'd emphasize, though is that the public could understand this. Blaming Wall Street gets us nowhere: it leads into financial arcana that no one understands, and we feel helplessly at the mercy of incomprehensible forces of disaster. Blame deadbeat borrowers, and the problem starts to make sense.
Some commenters figured this was at odds with the takings clause in the Constitution (I'm no lawyer). Others said that banks should take a haircut-- makes sense. So I suggest: let the government make a blanket offer to homeowner-borrowers and banks, conditional on the consent of both parties. Let me start with numbers:
80 / 95 / 5
What the numbers mean:
- 80% - the share of original purchase price of any home that the government will offer to pay to rebuy it from homeowners in financial distress. (Details: there should be an upper limit, say $400,000, on what the government will pay for a given home. And no cash should go to the homeowner; straight to the bank that holds the mortgage.)
- 95% - the share of the principal that the bank gets back, by the government. But the borrower is not let off the hook; he/she owes the other 20% of the loan to the government, but on favorable terms, e.g., no payments for three years.
- 5% - the share of the value of the home that the borrower will pay on an annual basis to live in the house he/she formerly owned, until such time as the government sees fit to sell it or rent it to someone else, in which case the former owner is entitled to, say, six months' notice.
An example: suppose Joe bought a home for $200,000 with an interest-only loan, and now he's having trouble making his mortgage payments. His loan is at 7%, so he pays $14,000 per year in mortgage payments. The value of Joe's house has fallen to $150,000. If Joe (and his bank) take this deal, the government pays $190,000 to Joe's bank, and Joe's obligation to the bank is dissolved. The government owns Joe's house. And Joe owes $30,000 to the government, but with a three-year holiday on payments and interest. Meanwhile, Joe still lives in his house, as a renter from the government, paying $10,000/year. So in the short run, Joe's cash flow situation improves. There is a sign in Joe's lawn: "For Sale by [some government agency], $200,000." It stays there indefinitely.
How does this help us with the current financial crisis?
Well, first, it should help banks, or whoever owns, or will buy, mortgage-backed securities. If they can get all the distressed borrowers to take the deal, they get 95 cents on the dollar, which is better than most of them expect now. Borrowers don't have to take the deal. But since many of them probably will-- perhaps some banks will sweeten the deal to get them to take it-- mortgage creditors can focus their enforcement efforts on the hold-outs, making-- perhaps-- a credible threat of bankruptcy proceedings, or whatever, against this reduced lump of deadbeat borrowers. This should revalue some of the mortgage-backed assets that are dragging down the balance sheets of financial institutions. And while it could take the government a long time to set up the administrative apparatus to carry out this plan, the mere announcement of the numbers -- "80 / 95 / 5" -- would induce markets to anticipate the plan and to start revaluing the assets.
Second, I'd suggest an asset purchase plan, but with the government deliberately setting such a low price -- say, 30 cents on the dollar -- that not too many of the assets will be sold. They might, nonetheless, take care of the "lemons" problem: since only the very worst assets will get sold at this price, buyers will be a bit less fearful about the quality of the remaining assets. By not selling to the Feds, holders of MBS can credibly signal to the markets that they think their assets are worth more than 30%. Moreover, to avoid stepping into the inappropriate role of private speculator, the government should do so in a way that precludes all possibility of the taxpayer making any money, namely: the government should pre-commit to selling any of the securities at the same price it bought them at if there are buyers who will take them. If there is a liquidity problem in the financial sector, once markets begin to recover this is, in effect, leaving money on the table, which will help to recapitalize the financial system, but not by rewarding those who followed herd mentality into leverage. Rather, it's those who held onto their cash who will reap windfalls.
So the taxpayers will lose money twice-- maybe a lot in buying real estate, a little in buying asset-backed securities-- and will end up owning (a) a stock (hard to say in advance how big) of homes that have recently lost value, and are still inhabited by their financially-distressed former owners, and (b) debt from this same class of people. Minimizing further losses to taxpayers will involve (a) managing a whole lot of rental real estate, and (b) collecting debt from people with poor financial records. The government has no comparative advantage at all in the first; it may have some in the second.
Oddly, though, the government's lack of comparative advantage in rental real estate may have its upside. Landlords who rent property have a problem: renters don't have a personal interest in maintaining the property. If they don't figure out some way to resolve this contracting problem, the property will be neglected, deteriorate, and lose value. Yet in this case that might be a good thing, because it in effect destroys some of the housing stock. One "modest proposal" of Tyler's (I can't find the link) was to destroy some of the housing stock in order to reflate home prices. Turning a lot of homeowners into renters is a way of doing that, but less inefficiently. To seize Joe's house and demolish it takes effort. If Joe stops mowing the lawn, that's a reduction of productive effort in a sector characterized by over-supply. If Joe's house loses value, the taxpayers lose more money, but other houses will gain in value, so home prices get reflated.
As for collecting bad debts, here the government can do things private creditors can't. Like garnish wages. The government is hard to run away from. In this case, though, I think this could be the opportunity for a sort of middle-class welfare reform. Enter paternalism. Operating through both public and private (e.g., NGO) agencies, we could-- in the course of the next few years-- try to have stern talks with people who took on too much debt. When the holiday runs out, will you have the money to pay? Are there lifestyle changes you can make? Should you consider a different career? Maybe you should be an oil-rig worker instead of a schoolteacher? Should you consider relocating to a place where the economy is better? Job training programs have been duds in the past, but they might work this time because a different class of people is under the gun; a lot of people with college educations are in financial distress now. We can require these people to put their names in databases that are accessible to employers in labor-scarce places and industries. Forbearance on debt can be conditional on demonstrated job search effort, and jeopardized by refusing job offers. Gradually, we'll unwind the bad debt, but, beyond that, we'll mobilize the majority, who used debt responsibly, against the profligate minority.
Meanwhile, to recoup some of the money spent bailing out distressed homeowners, this would be a good time to enact the homebuyer visa.