November 12, 2008 3:25PM

Helicopter Paulson

Government equity investment or rescue of the broader (non‐​financial) economy is a mistake. It will damage economic efficiency in the long‐​term by diluting the value of private shareholders and reduce incentives for cost cutting and product quality innovations.

Of course, the current focus is not on long‐​term incentives but on how to shorten and moderate the current economic recession. The constantly changing mix of initiatives from the Treasury suggest:

1. A lack of knowledge/​vision about what to do–so they’re throwing money at everything that moves in the hope that something will work. These ex‐​Goldman Sachs personnel that make up the Paulson team are probably not economists–and certainly not good ones. The majority are probably MBAs with little understanding of how things really work in the economy. They probably have a microeconomic firm‐​specific orientation and management skills that are unsuited for their current responsibilities. If I’m wrong, I’d be very surprised. If I’m right, it’s showing.

2. An attempt to assuage competing political constituencies and provide benefits to potential future supporters.

3. An attempt to distribute wealth to those people/​firms that the next Congress and president won’t support–by tying their hands through government ownership of firms.

4. A deliberate and cynical attempt to damage the economy even more to make life difficult for the Obama administration.

I think # 4 is cynical on my part. But although unlikely, it is not impossible given how polarized the political atmosphere was during the GW Bush presidency.

Broad government involvement in private firms to solve the economic crisis is a dangerous turn. The shareholders in these firms took risks and should bear the consequences of their decisions. If they sink, the economy may recover faster as other businesses are created over time in non‐​housing and less energy intensive sectors. Supporting existing, inefficient firms run by poor decision makers is likely to prolong the recession because keeping those firms and their managers afloat won’t help to restore market confidence. And, this policy will encourage future investors/​managers to take even riskier decisions under expectations of yet another government bailout if they fail. Finally, government debt‐​financed wealth injections are worsening the nation’s finances–we’re already swimming in huge and unpayable entitlement obligations to a growing number of retirees, disabled, poor, and the sick.

The government purchase of securitized auto loans is probably intended to insure auto company creditors, who would otherwise become bankrupt and prolong the credit‐​flow freeze. It’s another source of bad assets on bank and non‐​bank financial firm portfolios that’s contributing to the market failure in that sector. I’m more sympathetic to the original TARP idea than government officials seem to be. That way the government’s involvement in the private sector will be limited and it will remove bad assets from their balance sheets–which are responsible for the pervasive uncertainty among financial market players and is causing the credit freeze. But under TARP, government officials don’t get to choose whom to support–they must buy up assets from whoever is currently holding them–be it domestic or foreign firms, “friends and relatives” or “strangers and enemies.”