Is the US taxpayer being forced to surrender to Wall Street?

I don’t like thinks that sound like conspiracy theories – and the title of this post does! However, I am starting to get the impression that this is one situation where it may actually be the case. Overall it stinks like socialism for the rich (good cartoon here, good article here)

Two articles from Bloomberg this morning have pushed me into this view:

Bernanke Signals U.S. Should Pay More for Bad Debt

Bernanke Says Normal Markets Needed or Growth to Halt

As Felix Salmon states here, Bernanke’s interest in paying the hold to maturity price for assets just doesn’t make sense when a good proportion of the assets aren’t going to mature – and even if they wish to take into account risk, the US Treasury does not have time to sufficiently evaluate the risks.

Surely the aim of the bailout should be to do as little as possible to ensure that credit markets start functioning again – in this sense, over paying for assets seems excessive.

Furthermore the package also needs to take account of the distribution of risk – paying the hold to maturity price for Wall Street assests appears to place all the risk on the taxpayer, while leaving the majority of the return in the hands of Wall Street. Not only is this not fair – but surely it will promote risky behaviour by market participants in the future, given that they will simply expect the government to pick up the tab.

In my ideal world, I would want the US government to force financial institutions to report fully report there exposure to subprime debt and then I would get the Fed to temporarily pump liquidity into the system. This way, the asymmetric information problem is “gone” (this of course assumes that those that are holding assets have better information about their risk profile 😛 ), and market prices can shift to represent the underlying value of assets.

If this was legally possible (which I doubt it is) would this lead to a contraction in US economic activity now – yes it would. However, it would also lead to a more efficient allocation of resources, and would force those who took on risks to actually face the consequences of these risks.

Also: Hold to maturity pricing is defended here. In this case, the holding price includes risk – and as a result the only reason it is above the “fire-sale” price is because of a lack of liquidity for the private firms, which forces them to sell at a loss and shut down in the “long-run”. In this case hold to maturity pricing is better for the market in the long-run.

However, we still have the essential problem that the US government does not know the associated risks – and may not be able to get the firms to reveal this information (as the revealed price is assumed to be too low according to the government). As a result, there is a significant potential for the government to “pay over the odds” – something I think is fairly unfair. I guess we will see what will actually happen!

Finally: I like this suggestion put forward by Greg Mankiw. Given that the problem is also one of liquidity the suggestion of getting the government to cancel dividend payments allows firms to improve their balance sheet without the negative signaling effect. Fundamentally, it is the government solving a prisoners dilemma – one of the things it is most useful for 😉

Update: Other New Zealanders discuss the bailout at Anti-Dismal and the Rates Blog.

And don’t forget: A consensus in economics?