Wednesday, April 8, 2009

Our Toxic Legacy

I was starting to think that the Obama administration lacked the will to impose tough solutions when they are necessary. Their recent treatment of the auto industry restored that hope. It does, however, raise the question: Why is Wall Street not being treated the same? Instead of cleaning up the banks, the administration seems intent on throwing money in their general direction until their health improves.

The latest scheme to drive up the the price of toxic legacy assets is probably the worst possible type of solution. It's less efficient than simply giving the troubled banks more money for free, but essentially amounts to the same thing otherwise. You can see recent posts by Paul Krugman, Willem Buiter, and others: Geithner Plan Arithmetic , The new toxic and bad legacy assets programs of the US Treasury: surreptitiously squeezing the tax payer and the Fed until the PPIPs squeak , etc.)). It's simply a terrible idea to reward failure in this way.

Fairness considerations aside, the consequences for rewarding spectacular failure with loads of bailout money are dire. The lesson banking executives would learn from that is that they should continue taking enormous unnecessary risks, because the downsides are born by someone else.

Luckily for us, there are alternatives. Although the economy certainly depends on the availability of credit and a healthy financial sector, there is nothing that says the individuals who failed so miserably last time are indispensable, nor does it really matter which banks survive relatively intact as long as there is enough of a financial sector left at the end. Even if we commit to saving the current banks, there is nothing that says we have to save their executives, shareholders, and unsecured creditors.

There is a myth going around that the people who failed the first time around are the most knowledgeable and able to fix the situation. Why? This assertion is usually made without any supporting evidence, let alone proof. If someone in 2005 had suggested that Michael "heckuva job" Brown was the best person to fix FEMA after its disastrous mishandling of Hurricane Katrina, they would have been laughed at. Why aren't we laughing now?