Nobel Prize-winning liberal economist Joseph Stiglitz points out that the Treasury Secretary Tim Geithner's plan to have the government subsidize investments in "toxic assets" creates a serious moral hazard: Private investors will pocket any gains, while the federal government promises to cover virtually all potential losses:
Professor [Joseph] Stiglitz on Tuesday led a list of well-known economists and high-profile industry figures who have said Treasury Secretary Tim Geithner's toxic asset plan may not be as successful as it first seems.
The plan involves ensuring up to $100bn of government funding is matched by private investors, with the monies combined and leveraged up, in some cases to by as much as 20:1, with the help of the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), to buy pools of unwanted assets.
Professor Stiglitz, speaking at a conference in Hong Kong, said that the US government is essentially using the taxpayer to guarantee the downside risks, namely that these assets will fall further in value, while the upside risks, in terms of future profits, are being handed to private investors such as insurance companies, bond investors and private equity funds.
"Quite frankly, this amounts to robbery of the American people. I don't think it's going to work because I think there'll be a lot of anger about putting the losses so much on the shoulder of the American taxpayer."
As Stiglitz suggests, this privatization of profits combined with socialization of losses is likely to incentivize overly risky investments that taxpayers will be left holding the bag for. It may also lead to misallocation of resources, as investors transfer funds from more economically efficient uses in order to take advantage of Uncle Sam's blank check for investing in "toxic assets." Jeffrey Sachs, another prominent liberal economist, makes a similar point in this Financial Times piece (free registration required).
Ironically, the moral hazard created by the Geithner plan is similar to the incentivizing of risky mortgage investments by the government's backing of Fannie Mae and Freddie Mac, which played a major role in causing the financial crisis in the first place, as economists Peter Wallison and Charles Calomiris describe in this paper. Wallison deserves some credit for warning about this danger back in 2005.
Both parties deserve blame for the policy of federal backing for dubious mortgages and investments. Certainly, President Bush didn't help matters when he, in his own words, "use[d] the mighty muscle of the federal government" to promote the issuing of risky mortgages.
Barack Obama, however, promised to break with the failed policies of the past, and often criticizes those who he claims advocate "the same failed ideas that got us into this mess in the first place." Ironically, he has now embraced some of the worst of those ideas himself.