Wednesday, 15 October 2008

Time for “Plan B” to deal with the financial crisis

Previously I have commented on the article by University of Chicago economist Luigi Zingales on Why Paulson is wrong? Now Zingales says it's time for "Plan B" to attack the current financial crisis.

Zingales opens his "Plan B" by saying
After pointing a gun to the head of Congress, threatening a financial meltdown in case his plan was not approved, Treasury Secretary Hank Paulson has finally arrived at the only logical conclusion: his plan will not work.
He goes on to say
Desperate for a Plan B, Paulson is slowly warming to the suggestion of many economists: inject some equity into the banking system. Unfortunately, it is too little and too late. The confidence crisis currently affecting the financial system is so severe that only a massive infusion of equity capital can reassure the market that the major banks will not fail, recreating the confidence for banks to lend to each other. The piecemeal approach of 100 billion today, 100 billion tomorrow used with AIG will not work. It will only eat up the money, without achieving the desired effect—without reassuring the market that the worst is over. Simply stated, nothing short of a 5% increase in the equity capital of the banking system will do the trick. We are talking about 600 billion.
But, according to Zingales, that even if the government is willing to spend this kind of money, there are still three problems.
  • First, to restore the necessary confidence, a capital infusion needs to reduce a financial institutions’ risk of default to trivial levels.
  • Second, a capital infusion does not address the root of the problem, which stems from the housing market. If homeowners continue to default and walk away from their houses, the banking sector will continue to bleed and additional equity infusions will be needed.
  • [T]he third and most important problem. If we bail out Wall Street, why not bail out Detroit (probably another 150 billion) and Main Street? In fact, Senator McCain has already talked about buying out the defaulted mortgages to keep people in their homes. Even if we limit ourselves only to the subprime mortgages, we are talking about $1.3 trillion. Where do we stop?
Because of this we need a Plan B, which Zingales outlines here (pdf).

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