Slow Down and Get This Right

Physicists, historians, and economists talk about "path dependence." Something that is far from ideal persists, only because we are stuck with a particular path. A favorite example is the QWERTY typewriter -- it is far less efficient than other arrangements of letters, but we all learned on it and are too lazy to change. Another is employer-provided health insurance. No reasonable person would design such a system for today's economy, but we're stuck with a whole infrastructure that resists reform.

Watching the Democrats and the Paulson hearings, I thought of path dependence. Paulson has defined the path. Democrats, many Republicans, and really angry constituents don't like this plan, but legislators haven't quite mustered the nerve and imagination to propose a wholly different approach. They have bought Paulson's argument that something has to be done very fast, and the most they can think to do is add embellishments. That's not good enough -- and there are whole other paths.

My worries are both substantive and political. If the plan doesn't work, we are out $700 billion and the crisis of confidence will deepen. And Democrats may well get enough of their demands met that the failure could seem their fault rather than that of the plan's core approach.

Congress should not be stampeded into acting. Lawmakers should take more time to think about alternatives. The need for urgent action was based on two faulty assumptions.

The first was that Congress had to act-now! -- or the whole system would collapse. But wait a minute. Some parts of the system are indeed clogged with bad mortgage paper. But businesses are getting loans. Citizens are cashing checks. Homebuyers are taking out mortgages. Investors are buying and selling stocks. If another big bank faces a crisis in the next three weeks, Paulson and Bernanke will just do another ad hoc rescue.

The second assumption is that Congress must adjourn this week or next. But the senior members of the key committees of both parties all have safe seats.

So consider the Kuttner Plan, as an alternative to the Paulson plan:

First: Congress creates a select committee made up of senior members of the House Financial Services Committee and Senate Banking Committee and a few other expert legislators. The rest of Congress adjourns. The special committee interviews experts, holds hearings, and reports back Tuesday October 14, the day after Columbus Day. Congress comes back into emergency session and acts by the end of the week.

Let's assume that Democrats get the other major provisions that the public interest requires. These include:

--Limits on executive compensation

--A companion economic stimulus package

--More help for distressed homeowners

--An option for government to get some stock in companies it helps.

--An oversight panel to approve Paulson's proposed deals.

But what about the core of the Paulson plan itself? Here, Congress needs to think further outside the box. Paulson's basic concept is that government buys $700 billion worth of dubious mortgaged-backed securities and holds them for a time until normal markets resume functioning. He contends that this approach is both necessary and sufficient.

The plan has three larger purposes: recapitalize banks; get bad paper out of the system; and restore confidence generally so that the downward spiral ceases and the frozen credit markets unlock.

However, Paulson's approach is not the only way of fixing what's broken. At the heart of the problem is that the many of the exotic mortgages that were the underlying basis for additional layers of derivative securities are not going to be paid back. These securities include bonds backed by the mortgages, insurance contracts guaranteeing the bonds against default, and other exotic kinds of "derivatives." They are valued at many times the mortgages themselves, thanks to the miracle of leverage. But as the leverage goes into reverse, the capital of many investors such as banks, insurance companies, and investment banks is being wiped out-far beyond the underlying value of the mortgages.

Paulson's approach is top-down-rescue the banks. But it's actually more efficient to rescue the homeowners by stopping the foreclosures. Refinancing the mortgages would allow the bondholders to recoup some percentage of their investments. For a lot less than $700 billion, we could refinance every mortgage in America that is at risk of foreclosure. Along the way, we could keep people in their homes and shore up the collapse in housing prices. Paulson's plan does neither. Markets would begin loosening up, as in Paulson's plan, but the route would be bottom-up rather than top-down. Homeowners would be the primary beneficiaries rather than the incidental ones. With Paulson's approach, the wave of foreclosures continues, reducing the likelihood that the government gets its money back.

Congress should spend three weeks taking testimony from dozens of experts, and comparing the two scenarios. Hold comprehensive hearings before you legislate. Imagine that.

A second issue is what form the recapitalizing should take. Instead of just taking bad paper out of the system, government could assume get some rights of ownership for its $700 billion. Consider, as a counter-example, the FDIC. Paulson has given every large and unregulated financial institution in America an implicit government guarantee. The FDIC, by contrast, gives explicit guarantees, but these guarantees are conditioned on regular examinations of their investment policies, their management, and the quality of their assets. When an FDIC-insured bank fails because of dumb policies, the government doesn't just buy its bad paper and give management another chance; the FDIC often takes it over and cleans it up. The government can't take over every failed financial institution, but it would be salutary if it took over a few, at least as a powerful minority shareholder.

For the long term, which means early in the next administration, Congress needs to re-regulate America's financial markets, so that this sort of needless crisis is never repeated. For now, it needs to get this emergency rescue done right. It cannot possibly do that rescue in a week.

If Paulson's arrogant tactic of demanding instant action because of impending catastrophe sounds vaguely familiar, it's because it evokes how the same Bush Administration rushed through the USA Patriot Act. But after 9/11, American citizens were terrified and willing to give the Bush administration whatever it wanted. And Congress totally caved. This time, citizens are frightened-but also outraged and less easily fooled, and they're holding Congress's feet to the fire to slow down, not to speed up.

The select committee should invite testimony from both presidential candidates and their running mates. That would be Barack Obama, John McCain, Joe Biden, and Sarah Palin. The responses should be unscripted, and aired in prime time. Especially Palin's.

Robert Kuttner, co-editor of The American Prospect and Distinguished Senior Fellow at Demos, has just published Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency (Chelsea Green). He is blogging daily about the election and the economic crisis at www.obamaschallenge.com.

Comments

[aofh]

Great piece. I think, though, that "path dependence" is playing havoc with American politics in more than just economics. It's crazy that even people who seem to know better, and who may even recognize that they are in it, get caught and can't stir out.

[srbeckman]

Agreed.

"But what about the core of the Paulson plan itself? Here, Congress needs to think further outside the box. Paulson's basic concept is that government buys $700 billion worth of dubious mortgaged-backed securities and holds them for a time until normal markets resume functioning. He contends that this approach is both necessary and sufficient."

Yes, therein is the latest BIG LIE foisted on us by the Bush Administration. And, as always, it just takes one. Your proposed solutions are in line with what I agree would be a much more responsible approach to resolving this situation. Very well-stated,

[rmreddicks]

"If Paulson's arrogant tactic of demanding instant action because of impending catastrophe sounds vaguely familiar, it's because it evokes how the same Bush Administration rushed through the USA Patriot Act"

Exactly. Before it was demanding control of oil. Now it's a brazen act of demanding that their humans bend over or we're taking you money anyway. Goodbye to the bushists and all that.

[WmC]

Yep. It's pre-emptive trickle down economics. Which is to say: the two worst features of the Bush reign combined in a single act. A final going away present, as it were.

[veracity]

Another excellent post by Mr. Kuttner, in the tradition of (former?) Republican Kevin Phillips writing "WEALTH & DEMOCRACY in America" which simply posits that EVERY major fortune in America was amassed in CLOSE COOPERATION with the GOVERNMENT, including colonial and revolutionary shipping fortunes smuggling past the Royal navy customs officers and war-time embargo, and of course the great, vast fortunes created in America from the slave trade, including those Northern shipping companies, who partially funded the next big wave of US fortunes in industry, railroads, and oil.

Once again, I'd like to point out that THE major characteristic of THIS financial crisis is that it is....

A CARBON COPY of the 1980s Savings & Loan debacle, which led to the Bush1 DEFICITS, which led to the Bush-1 RECESSION, which led to Timmy McVeigh bombing the US govt. building OKC when he couldn't get a lousy job in upstate NY after being involuntarily discharged from the Army following his (honoable) combat stint in Gulf War1.

Except that THIS economic crisis - the Bush-2 DEFICITS & BUSH-2 RECESSION - comes at a time when we are LOSING the Iraq/Afgha­n/Pakistan OIL GRAB wars, and at a time when America is FAR MORE DEPENDENT on FOREIGN OIL and FOREIGN CAPITAL than we were in 1980s.

(Not to mention, NUCLEAR PROLIFERATION has GREATLY ACCELERATED under the soulless Neo-Cons since Pres. Reagan signed TREATIES _eliminating_ entire catagories of nuclear weapons!)

[robbep]

It is time for us to get rid of these democratic and republican sell outs! If this is such a crisis then why do you rush a solution thru just to have a solution? I wld think that the congress wld have learned from Bush's earlier rash decisions and they wld be leery of jumping over the cliff with him again. We didnt get in this mess in a couple of days and we wont get out of it over nite. Responsible leadership shld say lets take a step back and analyze what we are doing and what we want to accomplish. I have not heard one person say if we give the banks the money they will lend it out, if they hold onto the cash then what is the purpose of the bailout? The loss of jobs and crdit have been a reality in communities across this country and no bailout was proposed then so why now? The old saying haste makes waste will come to fruition if we rush this thru.

[joebaggadonuts]

Its too little too late. But they will do it to pretend that they are strong men and women protecting the American Consumer(tm).

If you look at the real economic numbers as opposed to the financial idiocy, you see the underlying economy is NOT strong, but weak and weakening. Increasing our debt load another trillion is NOT going to help matters. What we really need is bankruptcy reform to help people return quickly to productive lives once this financial tidal wave rolls over us.

Oh, and Single Payer medical insurance would cost lots less than this "package". So would a plan to electrify the transportation system and fix the bridges and schools of this nation. We should be planning for the aftermath of this tsunami and stop this insanity of throwing good money after bad debt.

[Sundialsvc4]

I'm amused by... "the government buys back all that questionable paper..."

With what, exactly??

[beef33]

I read your book "The Squandering of America" and a lot of what you said has come to fruition. This all seems like closing the barn door after the cow is gone. It seems odd that anyone would even listen to Bush at this point. He has been an unmitigated disaster and this smacks of the boy who cried wolf once too often. I say let the wolves devour him. No way congress should let he and Paulson rush some hurried up 700 billion dollar package that gets his rich pals off the hook. As yo say hold off and go slow. Also my own thought is that they loaned the money thinking they were going to juice people for high interest but that has blown up in their faces. Too bad I say. Sell the collateral and take the hit. Why should we bail them out at all. No one has been there to help me when I have tough times. I have to cut back and make it work. Anyone who listens to Bush is just drinking kool aid at this point.

[boogiewoman]

I just got back from the Casino. I lost about 5 grand. Mr. Paulson can I get that money back in time to go back tonight? Oh yea my friends want to go also. I know how you like to help out your buddies.

[zjr909]

In all of this, one thing may emerge the clearest of anything: Congress' utter contempt for the citizens of this nation. They may cave in and agree to everything the Administration wants - so they can declare recess to go home and campaign. Just think about that a minute: they may pass a deeply flawed piece of legislation that will disrupt countless peoples' lives in order to go out and convince these same people to vote for them again. It's almost the stuff of a comedy skit, like some sleazy used car salesman who tells you when you notice the wheels falling off the car you just bought that he's streamlined it for you, which is why you should thank him for selling it to you. And, sad to say, a lot of customers/voters will thank him come November 4th.

[leftLibertarian]

Congress should do Nothing.

There are already laws in place and the courts to handle what is going on.

If these dead beat Titans of Wall Street can't pay their bills, seize their assets. They could go to bankruptcy court. The investors could file suit, criminal or civil charges.

The taxpayer should not be fleeced out of ONE CENT.

Let the laws and the market decide.

[blaising]

Uh...just called my bank...told 'em I couldn't pay my mortgage this month 'cause I neede to take some time out from work to deal with my inability to pay my mortgage this month....

[mergina]

I am just an average American but GODDAMMIT I want to know who is responsible for allowing this to happen and I want to know WHEN THEY WILL BE BROUGHT TO JUSTICE?

[researcher]

the demos are in on this

just like iraq war vote

americans wake up all must go

the wall street guys will make billions for stealing billions

good deal if you can get it

easy to do with americans

been sold a b ill of goods called deregulation

the old trickle down theory move

pure genius on reagan's part

americans bought it hook line and sinker

still buying it

[Mogamboguru]

The "demos" are NOT in on this.

Stop crying "The sky is falling!" - for God's sake, because this is exactly, what Boosh wanted to trigger.

Stay calm and let the Democrats do, what has to be done in Washington.. In a week from now, you will be ashamed of your today's posting.

I will monitor this and will remind you then of the moment, when you were about to lose your head - aka, today.

[leftLibertarian]

"
Stay calm and let the Democrats do, what has to be done in Washington."

Do you really think that the Democrats will do what is right - which is to do Nothing?

[ivangoldstein]

I agree. The Dems appear in on it. Pelo si wants this bailout and just wants to make sure Republicans go along! This is insane. This is straight up extortion and any politician that votes for it should be tarred and feathered.

If the private banks need to get debt off their books GO TO BANKRUPTCY court like everyone else. If no banks are left then don't use money to give to Goldman Sachs, use it to open PUBLIC BANKS across the country that can keep credit lines open to citizens and small business.

[planetjeffy]

Slow down and don't get ripped off. The value of all the subprime loans is 1.3 trillion. 25% are in foreclosure or late. The gov't should buy all the bad loans for 325 million. All of the sudden, banks and insurance companies are fine, stocks are fine, homeowners are fine....Then refi the 325 million and try and keep everyone in their home. This was done during the depression. 80% paid off their homes in 15 to 20 years. That means, this would cost us only 65 billion, instead of a trillion dollars. STOP THE SCAM - THE TRANSFER OF ALL WEALTH TO BUSH AND HIS BUDDIES...STOP THE SCAM!!!!!!