The Johns Hopkins economist Christopher Carroll has an interesting blog entry describing rescue plan which has been proposed by economists  which is better than Paulson’s, and expressing puzzlement about why this alternate plan has been completely ignored in Washington. This plan involves temporary nationalization, something that was done by Sweden when it had a financial crisis in 1992.

In talking to people involved in the inside-baseball political side of the discussion on Capitol Hill, I get the impression that they are very unhappy about being asked to sign on to this bill, but are planning to do it because they have been told that if they don’t sign on the dotted line then the apocalypse is around the corner.

The KEY point that I think is not penetrating from the economists to the Congress is that what sticks in our craw is ONE SPECIFIC ASPECT of the Paulson/Frank plan: Its focus on having the government buy up the toxic subprime securities. This is close to a pure bailout for Wall Street, and there is NO REASON that any of us sees that this has to be the core of the rescue plan. I think you could get near-unanimity from economists, from across the political spectrum, in FAVOR of a simple, easy-to-do alternative that would be both more economically sound and more politically palatable: The Federal government should do, with respect to the banking sector as a whole, what Warren Buffett did last week in his investment in Goldman Sachs.

Buffett did not become the richest man in the world by making bad investments. The money he provided to Goldman was emphatically NOT a bailout. It was a prudent investment – he thinks he will make his money back, and much more. The taxpayer should follow his lead and take a similar stake in the financial industry.

This is the essence of the concrete plans that conservative, moderate, and liberal economists have been proposing (cf. Zingales and deLong). I think the reason these ideas have not made more headway on Capitol Hill is simply that the proposals are written in terms that are too technical for members to realize that they are all basically saying the same thing: The right way to recapitalize the financial system is by investing money in the system as a whole, so that the taxpayer benefits when the economy recovers. This is not a new idea; it is basically what Sweden did in 1992 when it faced a financial meltdown, and it worked out OK in the end for the Swedish taxpayer (at least compared with the alternatives). Just like Warren Buffett, the taxpayer might even ultimately make money on the deal.

At the risk of making eyes glaze over, let me sketch one way of doing this (which is basically similar to the more concrete and detailed proposals of others): The taxpayer could approach each financial institution that is in trouble and offer them a take-it-or-leave it deal: You need capital and we have capital. We’ll either lend you the money you need (in exchange for being first in line for repayment out of any future profits, and in exchange for your cutting your dividends to zero until your capital is restored), or we’ll buy preferred shares in you in an amount directly proportional to shareholder equity from your last audited financial statement (again, you must cut dividends to zero until you are healthy again). This solution is not perfect, but I am assured by people who should know that it is something that could be organized very quickly and would provide the needed capital. The plan would need to specify, in an ironclad way, that the taxpayer’s stake would be sold off (at a profit) when the system regains its footing.

Carroll offers an explanation for why this plan is not getting any traction in Washington (the Republicans proposed an alternative plan, but not the Democrats!):

What is mystifying to me and many other economists is why there seems to be such resistance to the Zingales/deLong/Buffett plan by people who do not seem to be able to offer a coherent rational argument for why it would not work, and an insistence instead that the taxpayer should buy the toxic assets directly. I can think of only one potential explanation: A rigid ideological opposition on the part of Henry Paulson to taxpayer ownership of even one dime of the financial sector. If this is the right explanation, it is scarily reminiscent of the rigid ideologies that led to catastrophic errors of policy judgment during the Great Depression. A lot of conservative economists, who share Paulson’s presumed predilictions in this regard, have seen the light and now feel that the Zingales/deLong/Buffett plan is the best of a bad set of options. Why doesn’t Henry Paulson agree?

(I should note, in fairness, that Paulson has moved somewhat in this direction; the latest versions of his plan involve taxpayers getting some ownership stake in exchange for their purchases of the toxic assets. But if he is willing to compromise in that regard, it is all the more mysterious that there is still an insistence on buying the toxic assets).

Why Washington wants to buy the toxic assets even though this is not required to get the financial sector back in order is obvious to anyone but an economist. Economists, like other American social scientists, do not as a rule progress beyond the view of the role of the US government that we get taught in grade school: that its purpose is to serve the American public. As we have seen all too well in the last eight years, its real role is to plunder other people’s wealth to transfer it to the very wealthy (see Free Lunch). And this is precisely what the Paulson plan does, on a massive scale (without solving either the problem of the undercapitalization of banks or that many houses are now worth less than the mortgages taken out to buy them).

The purpose of the Paulson plan is not to rescue the financial sector—a later plan developed by the next administration will have to do that—but to rescue the paper gains that very wealthy investors had made which have recently disappeared. (It’s possible that Carroll is using snark when he says it is “mysterious” that there is “an insistence on buying the toxic assets”, but I don’t think he is. Also, he doesn’t mention that Buffett supports Paulson’s plan. Evidently, Buffett doesn’t find that what’s good for Buffett is good for the American people. It’s also interesting that in an interview with Amy Goodman, Paul Krugman says that “temporary nationalization in a financial emergency is always the way to go, but the word “nationalization” nowhere appears in his column of the same day.)

Update [2008-9-29 20:53:13 by Alexander]:

A column by James Galbraith, together with the fate of Washington Mutual, made me realize what I suppose should have been obvious to me: that there is no urgent need for major new legislation in order to follow the alternative approach to the bailout/giveaway plan I have been advocating. That the FDIC was able to seize WaMu and then sell it off shows that it already has all the authority it needs to “rescue” banks. (WaMu’s shareholders and bondholders got wiped out.) As Samuelson argues, just a few changes are required in order to prepare for a major financial crisis:

The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold assets like that all the time. They’re called “loans.”

With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn’t, the FDIC has the bridge bank facility to take care of that.

Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund — a cosmetic gesture — and as much money into that agency and the FBI as is needed for examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary — as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can’t save everyone, and those investors aren’t poor.

With this solution, the systemic financial threat should go away.

Apparently, the reason why Samuelson calls increasing the FDIC fund a “cosmetic gesture” is explained by the following:

The FDIC does not and will not run out of money. Like all federal trust funds, the FDIC’s insurance ‘trust fund’ does not exist. The reserves shown in the fund simply evidence the amount of money contributed by the banking industry into the fund. Like all federal trust funds, the cash raised by FDIC insurance premiums goes into the Treasury’s general fund. When the agency needs cash, then the Treasury makes the money available. When the positive balance shown in the FDIC insurance fund is depleted, the FDIC simply runs a negative balance with the Treasury, a loan that the banking industry will repay over time. Indeed, the FDIC is preparing to raise the industry’s insurance premiums to generate even more cash to deal with the rising levels of bank failures. Also, in the remote chance that the FDIC ever reached the statutory borrowing limit from Treasury, the Congress will simply raise the limit.

These measures should serve to calm any feelings of impending financial collapse. Dealing with our remaining economic problems could then be safely left to the next president.

Update [2008-10-1 13:2:44 by Alexander]: As Kos notes, The Hill reports that George Soros has proposed this kind of rescue plan:

Soros has outlined his plan in an opinion editorial in the Financial Times and circulated a concept paper among decision-makers.

Specifically, the liberal philanthropist has proposed that government funds should be used to recapitalize the American banking system by purchasing equity in banks and investment firms.

Democratic Rep. Jim Moran (Va.) scheduled a meeting Tuesday afternoon with Robert Johnson, a former manager of the Soros Fund Management, to discuss the proposal.

Moran compared the proposal to Warren Buffet’s $5 billion investment in the investment firm Goldman Sachs Group in return for preferred stock and warrants to buy common stock at a discount.

Soros has also contacted Sen. Barack Obama’s (D-Ill.) presidential campaign to share his views on the financial crisis and the best way to solve it.

Soros writes:

Since Tarp [Paulson’s Troubled Asset Relief Programme] was ill-conceived, it is liable to arouse a negative response from America’s creditors. They would see it as an attempt to inflate away the debt. The dollar is liable to come under renewed pressure and the government will have to pay more for its debt, especially at the long end. These adverse consequences could be mitigated by using taxpayers’ funds more effectively.

Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve – effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.

Let us see if the Democrats will listen to reason. If they’re true to form, they’ll admit that Soros’s plan is better, but will not try to enact it instead of Paulson’s plan because “We don’t have the votes.”