Is Paulson wrong? (updated x2)

The short answer is yes, at least according to Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the Graduate School of Business in the University of Chicago. Over at Marginal Revolution, Tyler Cowen points us to this piece, Why Paulson is wrong?, by Zingales. Zingales writes

The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

His way of dealing with the current problems?

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.

Update: A copy of the Zingales article is now available at VoxEU.org.

Update 2: Others think that Paulson is wrong as well. Mike Mandel summarises for Business Week's Economics Unbound blog.