How to Bailout

I haven't done too much on recent market nonsense, as I don't really know what's going on anyway.  If that's the sort of thing you're into, there are many, many good places to look at that right now.  

I was impressed by this suggestion by Mankiw, however.  Everyone agrees that the deleveraging of financial institutions sparked by falling asset prices and rising counterparty risk has thrown financial institutions into a frenzy.  It's hard to get a loan these days, and uncertainty and panic are pretty widespread.  

The Paulson Plan attempts to combat the uncertainty through a massive government intervention to purchase illiquid assets.  This both injects liquidity into the system and helps set a market price for mortgage based assets.  The whole point of securitization was to better price certain risks and spread them to those best able to bear them; this plan would help price the prices of those assets which are now currently in a free-fall and place them in government control for a few years.

There has been a lot of criticism against the plan from the conservative, theoretical side.  Their complaint is that the goal of any financial rescue should be to identify the solvent and unsolvent institutions, and recapitalize the decent ones, rather than bailing out the firms which made the worst mistakes.  There are ways to coordinate firms raising capital on their own--eliminate dividends, borrow from the Fed--but the government could also take an equity stake in the bank.  The nice bit about giving banks cash is that every dollar of fresh capital can support $10 or so of debt, improving the capacity of banks to deal with liquidity concerns and bad assets.  The government also has a better up-side with their investment than in the garbage housing pile.  

The critique of that view is that equity positions deter private investors while giving governments undue power over banks.  Without going to much into further levels of arguments, here's Mankiw's plan:

Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date.

This is nice as you get the benefit of fresh capital injections into failing banks, without deterring other investors.  While it is difficult to separate the good banks from bad (and nearly impossible to figure out good mortgage assets from bad), this way you rely on the aggregate assessment of vulture investors.  Obviously the judgement of investors has not proved to be great, but it can be presumed to be better than that of a politically-motivated body.  This is great for private firms--which piggy-back on the government--while reducing search costs and the risk of capital impairment on the part of the government.  Traditional libertarians are of course against any measure that involves government spending, but I tend to be more concerned about the impact of government than its sticker cost, and this seems a great way to prevent total financial collapse without having the Treasury bear all of the costs and none of the gains.  Such a plan is also likely to make money over time, and the borrowing necessary for a deal is unlikely to have any impact given the massive demand for relatively safe T-bills.  I really have nothing against the government doing this far more often if it cuts my taxes.  There hasn't been any discussion of this idea; I'll be interesting to see if this gets any traction.