Financial Frustration

Sat, 20 Sep 2008 13:53:15 +0000

Doug Elmendorf identifies my key frustration with the policy response to the financial sector meltdown, when he writes the following in the middle of a very thoughtful and clear discussion of the government's options:

A second problem with buying troubled debt is that it provides the most help to the financial institutions that made what are, in retrospect, the worst investment decisions. Banks that stayed clear of this debt or sold such debt at cut-rate prices earlier this year in an effort to move beyond the crisis would receive no direct gain from such a program, while banks that made the biggest commitments to low-quality mortgages and have delayed dealing with their balance-sheet problems would be the biggest beneficiaries.

This is the biggest problem in the financial sector: that through greed, corruption, or just incompetence, a large number of institutions have negative net worth and are widely connected through borrowing to other institutions that don't yet have these problems and didn't go courting them. Insurance exists to provide ex post transfers from those who were lucky to those who were unlucky in a group of ex ante similar entities. It does not exist to provide transfers from those who were careful to those who were stupid. The government should be doing its level best to make sure that greed, corruption, and incompetence are punished, not rewarded.

The government should not be using its lending authority to reinforce these institutions with taxpayer funding. It should be using that lending authority to help cushion the impact of their failure on institutions who engaged in more prudent lending policies, and even then, it should be doing so by buying assets at a discount, not a premium.