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Which world are we in?

Richard Baldwin, Professor of International Economics at the University of Geneva, in Switzerland, has the following to say at

Crisis roundtable: Which world are we in? | Free exchange |

It seems that banks and bank-like financial firms have two fundamental problems:

1) An investment problem.

They have investments that cannot be traded at anything like face value, for one of two possible reasons:

  • the toxic assets turn out to be bad investments that must be written off (ie, what we are seeing is fundamentally an insolvency problem), or
  • the toxic assets will pay off eventually (ie, this is fundamentally a liquidity problem)

These are two fundamental states of the world that really matter for the design of the policy response—and no one really knows which one we’re in.

2) A leverage problem.

They don’t have enough capital to ride out short- and medium-term fluctuations in their assets and liabilities.

Art is an extremely intelligent man, and I’d like think I’m pretty smart too … we agree on a lot of things; but with the bailout we seem to have a fundamental disagreement.

Art thinks it’s an insolvency problem. I think it’s primarily a liquidity problem. Time will tell which one of us is right.

Professor Baldwin goes on to say:

Under either plan, the bailout-or-not issue boils down to the unknowable state of the world. If this is the mother-of-all-liquidity problems, then the taxpayers would profit from the assets that they bought (directly under the Paulson plan, or indirectly under the Calomiris plan). If this turns out to have been the mother of all bad investments, then the taxpayers lose—again under both plans.

The real difference between fixing the leverage problem indirectly (Paulson) or directly (Calomiris) is the future shape of the financial sector. If financial firms are largely publicly owned for a few years, you can be sure that the wild-ride pay packets are a thing of the past. Moreover, the American Congress may be tempted to use its shareholder position to investigate the perpetrators of this toxic-waste spill and maybe try to get them to fund an Exxon-Valdez-sized clean up fund.

You can read the details of the Calomiris Plan by clinking the link.