The Bailout Bill: What Should Congress Do?

There are two reasons to hate the Bailout bill. One is that it does the wrong thing; the other is that it gives the Treasury Department too much discretion. One internally consistent view is that nothing should be done. Another view, internally inconsistent but much more popular, is that the Treasury should be given even more power but that it should have less discretion. Not only should Paulson have the power to buy up mortgage-related assets; he should also have the power to make equity investments in distressed firms. Yet at the same time these critics—Paul Krugman is just one of many—say that the Bush administration is a bunch of clowns who can’t be trusted. Paulson seems like a smart person but so did Rumsfeld and Cheney. How will he resist the temptation to pay too much for mortgage-related assets, so as to give a big windfall to millionaires? A good point. So then why give the Bush administration even more power than it is asking for?

Well, there is a way to square this circle. We give Treasury unlimited power but then we insist that it be subject to checks and balances. At this point, critics become vague. What are these checks and balances to be? We could imagine that whenever Paulson buys an asset or an equity interest, affected parties could challenge the purchase in court. Litigation would ensue, with the judge trying to determine whether Paulson paid too much. For equity investments, the inquiry would be even more complicated, with judges needing to determine whether an entire firm is a good investment rather than a more-or-less fungible asset. Judges are hopeless when it comes to making pricing decisions like these. Other types of review mechanisms could be imagined; perhaps they will be staffed with independent experts. But as oversight mechanisms are piled on, the flexibility needed to restore confidence will be lost. Perhaps there is an optimal tradeoff between flexibility and review but I have seen no serious discussion of this issue by proponents of alternative plans.

Meanwhile, the Democrats have good reason to worry. Under the current plan, if Paulson pays too little for an asset, he won’t stop the business from going under. If he pays too much, he enriches its shareholders. He has every incentive to pay too much and generate a class of grateful investment bankers when taxpayers won’t be able to tell in any event, in the process avoiding a financial crisis but generating large costs way down the line and considerable distributive unfairness in the short term. Democrats in Congress are responding not by making it impossible for Paulson to pay too little or too much -– as I have said, it simply has no way of doing that by statute because the pricing decision is a seat-of-the-pants judgment that can’t be dictated in advance and can't be reviewed by courts after the fact. Instead, Democrats are preemptively playing the distributive game that they fear that Paulson will be tempted to play, and ensuring that their constituents will get a piece of the pie —- so far the idea of restrictions on foreclosure has been advanced, as has a “stimulus plan” which will presumably pay out cash to moderate- and low-income people whose votes Democrats want to lock up. In effect, the Democrats are willing to swallow the agency costs of the plan but ensuring that transfers to Republican constituents will be balanced by transfers to Democratic constituents.