Though the Bush administration’s Financial Rescue Plan went down to a stunning defeat Monday, it appears likely that a few modifications will yield Financial Rescue Plan 2 and another vote in Congress, as soon as today.
Before FRP2 is offered, it is worth reflecting on why FRP failed. The most basic reason, I believe, was that it was a blank check for the Treasury Department to spend an enormous amount of taxpayer funds. It is a hopeful sign for our democracy that Congress has not written that blank check. Congress may yet live up to its role, under the Constitution, to govern, and not simply to pass all authority to the executive branch.
Of course, the House vote was driven more by fear of voter backlash than constitutional principle. Voters are justifiably outraged that the government might shovel out taxpayer dollars to rescue the very firms that caused the financial crisis. I share that outrage.
Yet, there really is a crisis that must be arrested. We must not permit financial collapse to bring down otherwise sound companies that provide employment opportunities for all Americans.
The idea that the federal government can deal with the financial crisis by buying up the bad mortgage paper is deceptively attractive. I am reminded of the widespread public support for wage‐price controls in 1971. What could be simpler than passing a law to prohibit price increases?
Details matter. It was impossible to administer wage‐price controls to yield the desired result, as demonstrated by several thousand years of experience with that approach. Can Treasury’s rescue approach actually work?
An essential detail is how Treasury will price the mortgage paper it will purchase. If the price is too high, taxpayers will end up providing a large subsidy to banks, and as that becomes obvious the plan will collapse politically. It has been said Treasury will employ “some sort of reverse‐auction procedure” to ensure that it will not overpay. What sort? No one has yet pointed to actual experience to show how the reverse auction or any other pricing scheme will work. No one has even provided a reference to a journal article to show how the auction should be designed in these circumstances, with highly heterogeneous and risky paper to be auctioned.
We do have extensive journal literature on the market implications of asymmetric information. Banks know more about the paper they hold than Treasury can know. Banks will sell the worst paper to Treasury and hold onto the better paper. It appears the plan will create a market rigged against the taxpayer.