Some observations (in addition to Professor Krugman's criticism of the Geithner plan) that indicate that the Geithner plan is going to cause serious damage to the economic recovery

Introduction

The Geithner Toxic Asset Plan is expected to be announced tomorrow (Monday, March 23, 2009). The details of this plan has been released in advance to the media and to professional economists. An FAQ on this plan has been posted by Professor Bradford DeLong on his blog site. The broad outline of the Geithner plan is as follows:

Through some selection process, the government chooses several hedge fund managers as partners to form a public-private partnership entity. The hedge fund managers invest 30 billion dollars. The government invests 150 billion dollars (this money comes from the remaining TARP funds). This public-private partnership entity then borrows about 820 billion dollars from the Federal Deposit Insurance Corporation (FDIC). The loan from FDIC has no recourse. That is, if this public-private partnership fails at some point in time, the FDIC would not be able to recover its loan. Anyways, note that the contributions from the government, the hedge funds and the FDIC add up to a total of 1 trillion dollars. Now, the public-private partnership entity uses this money to buy the toxic assets from the financial institutions. It is estimated that the financial institutions hold about two trillion dollars (in book value) of toxic assets on their residential and commercial mortgage portfolios.

The Geithner plan proposes that the public-private entity indefinitely hold the toxic assets that it plans to buy from the financial institutions with its 1 trillion dollars of funds. The plan's line of reasoning is as follows. After the economy gets out of recession, there would be robust growth and employment opportunities in a year or two. At this point, the toxic assets would fetch decent prices. Then they could be sold off in the market. Note that the Geithner plan allows for the possibility that these toxic assets would never rise back to their break-even prices, in which case, they would have to be held to maturity. Meanwhile, by holding the toxic assets patiently until such a time of profitable prices or until maturity, the public-private entity collects the payments made by home-owners on those tranches of their mortgage loans, that correspond to these toxic assets. In this way, the public-private partnership entity is expected to make money, and its profits are to be shared between the government and the hedge fund managers in the same ratio as their capital investment (i.e., 150:30).

In September 2008, when the toxic asset purchase was first proposed by the then Secretary of Treasury, Henry Paulson, the main criticism of that proposal focused on the pricing of the toxic assets. If the government pays too much for these assets, then the taxpayer has to bear hundreds of billions of dollars in losses. On the other hand, if the government pays the going market price for these toxic assets, then the financial institutions would be effectively insolvent, because the toxic assets are being valued at fire-sale prices in the market. To address this criticism, the treasury has formulated a public-private partnership this time around. The treasury's argument is that since the hedge fund managers have an interest in seeing the public-private partnership entity succeed, having invested 30 billion dollars of their own money, these managers are properly incentivized to ensure that the correct price is being paid for the toxic assets.

In his criticism(s) of the Geithner plan, posted on his New York Times blog-site, Professor Krugman raises two main points. The first is that the Treasury has bet that the toxic assets are trading at fire-sale prices now, only because of a temporary panic in the markets. This temporary panic was caused by irrational fears of bankruptcy and has led to a liquidity freeze. The Treasury believes that once the toxic assets are taken off the books of the financial institutions, they would not be paralyzed by fears of bankruptcy. They would go back to lending, and the credit crunch would somehow go away. However, as Professor Krugman points out, the financial institutions have indeed made a lot of 'lousy' loans. And with house prices falling, unemployment rising and consumer spending falling, the home-owner is under increasing pressure to foreclose. The dire economic situation, if it continues for long, would drastically increase the number of foreclosures.

The risk of foreclosures are reflected in the largest proportions onto the lowest tranches of the mortgages, which are exactly the same entities that constitute the toxic assets carried by the financial institutions. Hence the uncertainty in the economic conditions bear directly on the uncertainties involved in pricing the toxic assets. So, there is no way of knowing for sure what the correct value of these toxic assets are. There is a real possibility that the prices of the toxic assets drop down by 18% or more after the public-private partnership entity purchases these assets. In such an eventuality, the public-private partnership entity is insolvent, since it has financed its investment at the leverage ratio of 820:180. Thus, as Professor Krugman argues, we are again back at the same problem of the insolvency of the financial institutions that this Geithner plan is supposed to solve.

The second point that Professor Krugman makes is that the hedge fund managers are only investing 30 billion of the total 1 trillion dollars of funds raised by the public-private partnership entity. With their investment amounting to only 3% of the whole venture, the hedge fund managers would take to reckless gambling, precisely in the same way that got us into this severe financial crisis in the first place. Believing that they have massive profit opportunities before them, these hedge fund managers are going to overpay for the toxic assets. Then the risk of the overpayment would be borne largely by the FDIC and the government, because they have supplied 970 billion dollars out of the 1 trillion dollars of funds. While I agree, most certainly, with Professor Krugman on these two main points that he raises, I do not agree with his conclusion that the solution is to nationalize the banks.

My analysis of the Geithner Plan

My analysis of the Geithner plan starts with asking where do the 820 billion dollars for the FDIC loan come from. This money comes directly from the drastic rise in consumer saving from 0% to 5% in the last few months. Fearing a severe downturn, consumers have been cutting back on their spending. This belt-tightening has led to surplus money in savings and checking accounts. Now, in a sane world, this would be considered as a remarkable achievement. It would be a testament to the free flow of information in a democratic society where citizens are well-informed about the economic conditions that afflict them. However, the liberals have been suggesting, based on Keynesian economics, that the rise in savings, while good for individual households, is bad for the economy as a whole, since cuts in consumer spending could prolong the recession. Because of these confusing leads from the policy-makers about how to treat the rise in household savings, there is no general consensus that the savings be handled prudently. Hence the Treasury has felt free to take these hard-won savings and invest them with the public-private partnership entity.

Imagine a world without central banks. In that world, in the event of a recession, people would worry about their financial situation. Consequently, they would cut back on their spending and save more. Anticipating a slowdown in sales, corporations, in turn, would postpone or cancel their plans for business investments. These decisions by the consumers and the companies increase the supply of funds, and reduce the demand for loans. As a result, the interest rate on loans drop down. When they have dropped down sufficiently, companies realize that their business plans are now more viable because credit is available more cheaply. Simultaneously, consumers find that shops are announcing price cuts and discounts on their products. Thus business investments and consumer spending are encouraged, which results in the economy getting out of the recession.

However, sometimes when the recession is particularly hard, there is a serious danger that the self-correcting process described in the previous paragraph could become a self-destructive process instead. If the companies cut down too much on their production, they could lay off a large number of employees which could result in a drastic reduction in consumer spending. Such negative developments could also feed on the psychology of the people which could lead to a panic. The companies lay off even more people, and for lack of income, consumers spend even less, and the crisis feeds on itself in this way.

The first function of a central bank is to maintain calm among economic participants by providing them with reliable price signals and other important information about the economy. The second function is to provide price stability. Only as a third function, the central bank should try to speed up the above self-correcting process by easing its monetary policy slightly more quickly than the markets would do by themselves. However, the Federal Reserve has already cut interest rates to a range of 0 - 1/4% long before a recovery is in sight. The Federal Reserve Chairman showed up at the US Congress in September 2008, along with the then Secretary of Treasury, Henry Paulson, to argue in favor of the $700-billion TARP bailout package. The Federal Reserve spent hundreds of billions of dollars bailing out struggling financial institutions like Bear Stearns, AIG, Citigroup, etc. In addition, hundreds of billions of dollars have been spent to purchase loans, commercial paper and asset-backed securities directly from the market. Recently, the Fed has announced plans to spend an additional $750 billion for purchasing mortgage securities, and $300 billion to purchase treasury securities.

A consequence of all this expansionary monetary policy is that the Fed's balance sheet is expected to increase from $900 billion a year before to $4 trillion a few months from now. These actions of the Federal Reserve demonstrate that the Fed has been emphasizing its third function (trying to speed-up a recovery, even though one is not in sight), at the expense of its first function (reliable information on the economy). As a result of its arbitrary meddling in the economy, severe distortions in the price signals have resulted. Moreover, the vastly expansionary policy followed by the Fed has encouraged China to announce its own fiscal spending program of 4 trillion yuan. Soon, other emerging market economies are going to follow suit. And in the long run, they are going to emerge stronger, because they do not need to spend all their money on a financial crisis.

In the fiscal front, the situation is slightly better. The stimulus bill has been sensibly re-designed to provide structural re-adjustment rather than a stimulus by back-loading much of it to 2010. Its size has been cut down to $800 billion. However, the fiscal deficit for 2009 is expected to be at an unprecedented level of 1 trillion dollars. In short, neither the Federal Reserve nor the government has much more room to plan for further spending, apart from the spending programs they have already announced.

Next, let us turn to the private sector. Recall that in Question 1 of my "FAQ on the Current Financial Crisis", I had explained that the financial crisis is concerned more with the accumulated capital of the American economy rather than its working capital. At that time, I had cited this factor as the reason why the real economy was so resilient throughout the fall of 2008, even while the financial institutions went down one after another. A large portion of the accumulated capital has been tied up in mortgage investments. The investments that the Wall Street banks had made in the securitization of mortgages return at least 20% on their capital (assuming just 24 to 1 leverage ratio, and 0.8% difference between the interest rate paid out and that received). Even in a boom time, this investment is a hugely lucrative venture. Hence the financial institutions have always held on to the good assets in their mortgage portfolio, because these good assets provide great returns on minuscule risk.

The lowest tranches on the mortgages which carry significant risks are the ones very difficult to put a value on. These are the toxic assets. Before the crisis set in, the Wall Street investment banks had been trading them from time-to-time for liquidity purposes. When the mortgage crisis hit, the market for these toxic assets dried up. However, the investment banks didn't trade with their good assets in lieu of their toxic assets. Similarly, even if the Geithner plan buys up the toxic assets from the financial institutions, they are not going to start trading with their good assets. They are going to hold them since these assets provide over 20% profits on their capital, and there are not many business investments that can provide such huge returns steadily. Hence the accumulated capital of America that is tied up with mortgage securities is going to continue to be tied up. There is no reason why the credit crunch, which the liberals feared so much in the latter half of 2008, would not persist.

In recent months, the working capital of the American economy, i.e., the funds available with the community credit unions, the commercial banks, and the credit card companies, has been getting depleted because companies have been announcing drastic fall in their profits in view of the severe recession. Until a few months ago, profits of small businesses and corporations constituted the main source of savings in the American economy, since household savings had been at 0%. As I explained above, neither the government nor the Federal Reserve is in a position to add substantially to the working capital since they have already committed to a lot of spending, a large part of which goes towards unfreezing the frozen accumulated capital. However, for an economic recovery it is the working capital that is more relevant than the accumulated capital.

Thus the only saving grace has been the rise in household savings from 0% to 5% in just a few months time. The Geithner plan proposes to take away this savings which would go towards the working capital under normal circumstances. By investing this money in mortgage securities, the Geithner plan ties up this money with the accumulated capital of the American economy, which is already frozen because the financial institutions are hoarding their safe assets. Thus the Geithner plan would seriously damage the economic recovery, and I recommend that it be amended substantially.

Please hire me for an academic position

I request the Professors to provide me with full-time academic employment so that I can carry out my investigations of the prolonged crisis in the American economy in a more effective manner. Currently, I am working full-time in the US software industry. Hence if I could get a post-doctoral position or a tenure-track position at the Economics Department of a top university in the US, I could devote more time to the current economic crisis. I have many new ideas in economics that I could pursue seriously if I had an academic position. I have already written more than 18 articles on economics since 2008. I have received favorable comments on my articles from several Professors -- four of whom are Nobel prize winners in Economics. All my articles, along with comments from the Professors, can be accessed at my blog-site: http://selvasblog.blogspot.com