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.