Paulson's Plan - Good or Bad?

It is impossible to answer this question, but I'll give it a go...

First, the plan is still being crafted so there really is no way to see how it could work, but I've worked through the logic with a colleague and this is what we've come up with. (This is all largely dependent on trust in Paulson and Bernanke, something that should not be given lightly, if at all - particularly Paulson).

1. They are not going to literally buy all the bad assets of banks if the plan works.

• $700 billion is only 5% of outstanding mortgages. There are far more than that in bad assets - bad assets refers to mortgages that won't be paid (people walk away or go bankrupt). Way too many people bought way too much house in the last 6-7 years (or took out HELOCs or other second mortgages) to think that the default rate will slow down any time soon.
• They are just trying to discover the "true" market price of the assets that banks are holding. This can be pretty complex, but banks are holding mortgages, mortgage-backed securities (MBS's), and credit default swaps (CDS's) - all difficult to value. Most banks think their assets are worth more than they could sell them for, so they won't sell. The key is figuring out the true value of the assets (are they all worthless, probably not even close - but what are they worth? Because no-one knows, nobody is willing to bid on the assets). If the Treasury starts buying these assets, then others may also start buying them. Think of it this way, if the Treasury (somehow, there are ways but this is where it's a secret until after they get the money) figures out the "true" price of these assets, then private equity (very wealthy investors) will have some incentive to get into the market and buy some of these assets near that price, because they will be priced "cheaply". This will be a good thing for the market, the economy (sort of), and taxpayers since they will not be buying tons of toxic assets.

2. So Treasury works out a plan to price these bad assets, by buying some of them and establishing a price. Others enter the market (there are billions of dollars potentially getting in the market) and buy more of the bad assets (this is why Paulson and Bernanke insist on so much money, they need lot's of participation in the market and they want to encourage this by showing the big wad of cash). All of this helps banks clear up their balance sheets and gets the banking system functioning again.

Okay, so what happens next? Probably inflation and lot's of it, though maybe not. There'll be another asset bubble, everything will seem fine - or even great, and eventually (6 months - 6 years later) that'll burst and we'll go through the Depression that we are now trying to avert.

Another potential short term outcome is that the plan will seem to work until everyone realizes that housing prices are still slipping. This would mean two very bad things are occurring: the value of all those assets that Treasury bought would be plummeting and there would be another round of bailouts necessary. This would be deflationary and lead to a recession/depression.

I don't think the plan will work, though it could sort of help for the short run. At best this is kicking the can down the road. Unfortunately, all of these problems won't go away until housing prices bottom out (in line with some historic valuation measure, like a ratio of cost of home ownership to cost of renting or the ratio of median home price to median income) Any solution that involves preventing housing prices from falling further will only prolong the inevitable.

It's a difficult prescription, but the economy needs to transition to a less credit driven economy with a drop in consumption spending and an increase in savings/investment - that is investment in real productivity, maybe investment in infrastructure. Our great success over the past couple of decades has been an illusion: credit-driven growth in our financial services industry along with earlier growth in the tech bubble in the 1990s - also due to increasingly available, cheap credit.

So this means a fall in GDP (or at a minimum, a slowdown in the growth rate of output, GDP). That is a recession, and that in turn means unemployment.

What can be done to improve the situation? I'll try to cover that next time, but it involves massive government spending.

Please email if you want me to clarify any of this, I'm happy to do it if I can.