ZOMBIE IDEAS

Original Link: http://www.washingtonmonthly.com/archives/individual/2009_03/017393.php

by Steve Benen

We've been waiting for a while to see the details of the Treasury Department's plan for dealing with the financial industry's toxic assets. The administration reportedly won't formally unveil the policy until Monday, but the New York Times and Wall Street Journal have obtained quite a few details about what to expect.

The trick, at this point, is finding someone -- anyone, really -- who thinks the Geithner plan is a wise, prudent approach to the problem.

Paul Krugman argues that "zombie ideas have won," and described what we know of the Geithner proposal as an "awful mess."

The Obama administration is now completely wedded to the idea that there's nothing fundamentally wrong with the financial system -- that what we're facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

To this end the plan proposes to create funds in which private investors put in a small amount of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad -- I mean misunderstood -- assets. This is supposed to lead to fair prices because the funds will engage in competitive bidding.

But it's immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating -- deliberately! -- the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn't, that's someone else's problem.

Or to put it another way, Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard.

This plan will produce big gains for banks that didn't actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized.

Dean Baker is discouraged. Calculated Risk isn't happy. And John Cole summarized the big picture this way:

The Illness- reckless and irresponsible betting led to huge losses
The Diagnosis- Insufficient gambling.
The Cure- a Trillion dollar stack of chips provided by the house.
The Prognosis- We are so screwed.

Oh my.