A Better Bailout Bill

There is so much fear wrapped up in this financial crisis that government leaders are willing to support anything, even if this means the bailout bill was concocted mostly between Henry Paulson and his former colleagues as Goldman Sachs.

It is true that action is needed to contain the financial crisis. Many of the most gifted economists--Paul Krugman, Lawrence Summers, and Joseph Stiglitz, for instance-are now in favor of a bailout. Stiglitz, a Nobel Laureate, is the pioneer of "moral hazard" theory, so it's hard to argue that this group doesn't understand the dangers of public largesse.

However at the same time many of the smart people who support this bill do so regretfully. Krugman calls it a "stinker". Stiglitz says it's a "very bad bill" that is "critically flawed." Even ex Treasury-Secretary Summers agrees that the "regretful" bailout is far from a complete remedy for our economy's ills.

Both expert opinion and simple intuition suggest the primary flaw with the proposed bailout is that it exposes the government to extreme risk without a guarantee the taxpayers' money will be returned. Instead of copying Warren Buffet and buying preferred stock and warrants in distressed companies at bargain prices, we're buying "toxic assets" no private investor wants.

While the securities the public is about to buy are assets that may appreciate, in the current tumultuous credit market this is far from a certain outcome. By contrast, having actual equity in these troubled firms (the Swedish model) would allow the government to act as far-sighted shareholders and get institutions on the right track.

We need to provide public leadership for these troubled firms, while simultaneously eliminating the regulatory failures that led to this situation. Buying preferred shares in banks gives these institutions the capital they dearly want, but also the leadership they direly need. Meanwhile, the market must be supervised more closely, and the amount of leverage firms are allowed to take on must be curtailed. Under this plan, Wall Street would emerge healthier while Main Street would emerge wealthier.