“[T]he House's "Emergency Economic Stabilization Act of 2008" [is] a bureaucratic nightmare that fails to use auction markets in a way that will minimize both taxpayer and systemic risk. The key flawed provision states "The [Treasury] Secretary is authorized to purchase, and make and fund commitments to purchase, troubled assets from any financial institution as are determined by the Secretary."
Excuse me, did I read "any?"
The Senate spelled it out more clearly: "troubled assets are not limited to mortgage related assets but could include auto loans, credit card debt, student loans or any other paper related to commercial loans."
"Any other paper?" Heaven help us! ....
Auction designers should immediately note that we are talking about a market with one buyer and many sellers of a hodge-podge of items. The mechanism that will be used is a "reverse auction" -- with sellers competitively submitting asking prices to sell Treasury a heterogeneous mix of good, some sour, apples and oranges whose content is better known to sellers than the Treasury. ....
Treasury has no expertise in this ridiculous new venture. ....
Treasury action should focus on providing capital to individual banks and mortgage companies in return for debt, convertible bonds and equity and warrants to be negotiated. This is dangerous enough for the taxpayer, but here Mr. Paulson has previous experience.”
Vernon L. Smith, "There's No Easy Way Out of the Bubble", Wall Street Journal (8 October 2008).
http://online.wsj.com/article/SB122351051370717359.html
Vernon Smith, professor of economics and law at Chapman University (Orange, California), received the Nobel Prize in economics in 2002 "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms".
As Vernon notes, the Treasury has expertise in the regular auctioning of its own securities, which are identical in terms of content and maturity. The only unknowns are the final clearing price and which buyer among thousands is going to be the one that walks away with the security. In the case of the bailout, we have a reverse auction where one buyer, the Treasury, faces thousands of sellers bringing to the Treasury all kinds of securities, many of dubious and unknown content and value. Here the Treasury must set a price for each and every security put forward when it doesn’t have the slightest idea what it is buying. In this situation, risk of error is extremely high and, more importantly, distortion of prices in the wider market for securities possible, even likely.
It should also be noted what should be wanted is a smooth transition to a new structure of asset prices consistent with the fundamental economic circumstances of the U.S. economy as we go forward from here. We know that the upward trend in housing prices compared to the general price level was simply not sustainable over the longer-term and some downward adjustment was required. Housing prices no doubt affected prices for all other capital assets, raising them in relation to other kinds of produced goods and services in the economy. Needless to say, the distortions in the prices of capital goods also led to distortions in the payment of factor rewards for those engaged in the financial services industry, with excessive profits and absurd compensation for investment bankers and other executives.
It is not clear exactly what the new structure of prices across the entire range of goods and services should be. In addition to the distortions caused by artificially high housing prices, any new price structure should also to take into account distortions caused by a policy-induced overvaluation of the dollar-exchange rate, which lifted domestic prices in relation to prices of imports, leading to our huge balance of payments deficits and the destruction of some of our manufacturing base. Fiscal deficits also contributed to the distortions by attracting foreign saving and allowing the country to live beyond its means for so long. Were one to guess, adjustments of relative prices between sectors and products in the economy could be as large as 10 to 20 per cent (e.g., the price of housing is 20 per cent too high compared to the price of apples and all other goods and services and must come down), which would involve a wrenching adjustment to present patterns of production, expenditures and incomes and would take many years to effect.
Given that we know housing and asset prices are too high, the question can be asked as to why policy is trying to prop up these prices. It would probably be wiser to acknowledge that they have been too high and allow them to fall, even drop precipitously, at least for a while before trying to stabilize the market. When acting to calm the markets down, policy should recognize that in the overall structure of prices in the U.S., capital assets (and the prices of equities based on them) should be lower than they have been and that there is a need to weed out the most toxic of these assets before establishing any new set of relative prices.
Two questions are now before us. Smith points to the technical problems before the Treasury in actually implementing any policy. In essence, this is the question “How should we go about restoring stability to the financial system?” That is, of course, a key question. But a more important question is “What do you want policy to do, re-establish some stability in what is an unsustainable situation or create conditions which reflect long-term economic fundamentals and provide the basis for the continued prosperity of the American people?”
Via Larry Willmore and Greg Mankiw.
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