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"Panic or Insolveny"

The new plan seems to make sense if and only if the principal problem is illiquidity.
Two contrasting views have been held on what ails the financial system.
The first is that this is essentially a panic.
The second is that this is a problem of insolvency.
Martin Wolf, Financial Times 10/2 2009

Under the first view, the prices of a defined set of “toxic assets” have been driven below their long-run value and in some cases have become impossible to sell.
The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses.
This was the rationale for the original Tarp and the “super-SIV (special investment vehicle)” proposed by Henry (Hank) Paulson, the previous Treasury secretary, in 2007.

Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities.

Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so

But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best.

The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a “no brainer”.

Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers.

Why then is the administration making what appears to be a blunder?
It may be that it is hoping for the best. But it also seems it has set itself the wrong question.
It has not asked what needs to be done to be sure of a solution.
It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints:
no nationalisation; no losses for bondholders; and no more money from Congress.
Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate?

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