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Charles Wheelan, Ph.D. The Naked Economist

Charles Wheelan, Ph.D., The Naked Economist

Government Must Act to Protect Economy's Innocent Bystanders

by Charles Wheelan, Ph.D.

Posted on Tuesday, September 30, 2008, 12:00AM

Should the government intervene to stabilize the financial markets and bring sanity to the escalating mortgage-induced turmoil? Absolutely.

The reason is straightforward: The financial rot is spreading to infect otherwise healthy firms, which poses a risk to people far and wide who bear no culpability for what's going on. The purpose of government is act on behalf of citizens in ways that make us better off. Stopping a financial meltdown is perfectly consistent with that mission.

Is this a "bailout" for homeowners, banks, and firms who did stupid things? Maybe. I suspect that the Treasury plan might leave some of them better off than if we do nothing. But we shouldn't let our eagerness to punish the wrongdoers blind us to the benefits of stopping their idiocy from making us all worse off.

The Fire Next Time

Here's the best analogy I can offer. Suppose a guy down the street has been smoking in bed for the last 20 years. That's a stupid, irresponsible thing to do, and lots of people have told him so.

He just happens to live next to another idiot who stores containers of gasoline in his garage. He, too, ought to be fully aware that this is a foolish thing to do.

Predictably enough, the guy smoking in bed starts a fire that explodes in force when it hits the gasoline-filled garage next door. Now there's a hell of a blaze going on. If these two guys lived alone in a remote area of rural Montana, we wouldn't have much to discuss. But they don't. Instead, the fire is spreading down their residential suburban street, burning houses where nobody smokes in bed or keeps gasoline in the garage.

Damage Control

That's about where we are right now with the financial crisis. The question isn't whether we should rush to save the morons responsible and put ourselves at risk in the process. We shouldn't. The question is whether we should intervene to save the rest of the neighborhood. We should.

The fire department may end up helping our smoker and gas-can man just because it's an unavoidable part of fighting the larger fire. That's unfortunate, but it's not a good reason to call off the fire department. I don't get enough utility out of standing amid the smoldering ruins of their houses to justify the risk that the same thing may happen to my house a few hours later.

If you want to fine these guys, or put them in jail, or take away what's left of their property -- fine. That seems perfectly appropriate. But just make sure you take care of the fire first, because that's what's dangerous here.

Exit Strategies

To be honest, I don't know the exact details of how this Wall Street "fire" ought to be fought. I suspect it should involve two simultaneous strategies:

1. A government fund to buy distressed derivatives, which would inject capital into the system and provide some mechanism for pricing these opaque securities. The first step toward recovery is making the securities liquid again, meaning that they can be bought and sold at a predictable price, even if it's a low price.

2. A government fund to buy mortgages in foreclosure, or at risk of foreclosure, from lenders at a discounted price. So if I've got a $200,000 mortgage and I can't make the payments anymore, the government would buy it from my lender for something like $180,000. The lender still gets a haircut, but probably ends up better off than taking on the administrative expense of foreclosure and then having to sell the house in a dismal market.

The government would then restructure my loan with terms that I could afford, such as stretching the payments over 40 years instead of 30, or perhaps even lowering the value of the outstanding loan.

As a homeowner, I, too, should have to pay a price for borrowing more than I could afford. The government should be entitled to any profits on the eventual sale of my home up to the amount of whatever break they've given me. So if the Treasury knocks my mortgage down from $200,000 to $160,000, and I'm eventually able to sell the house for a profit, I should send a check to Uncle Sam at closing for $40,000 -- plus interest.

That's the essence of a sensible plan: Restore stability to the housing market at realistic prices; and inject liquidity into Wall Street, again at realistic prices. Just to stop the fire from spreading.

Act Now

One of the curious things about economics is that if everybody thinks something bad will happen, then something bad will happen. This morning, my wife asked me if we should avoid the $2,000 hotel bill for our Christmas travels and stay with my mother-in-law instead (no small sacrifice). I said yes -- a perfectly rational response as our stock portfolio plummets along with everyone else's.

But we're merely contributing to the economic slowdown. The hotel that would've had our holiday business will cut back on spending, or even lay off employees. And those employees will cut back on their holiday spending. Which will hurt the retailers, which will drive their stock prices down, and so on -- despite the fact that none of these people had anything to do with the mortgage mess.

The best economic lesson right now -- or at least the most accessible one -- comes from Jimmy Steward in "It's a Wonderful Life." He knew a bank run when he saw it and was willing to put his own capital at risk to stop it. The U.S. government ought to do the same. It will make us all better off in the long run.