By Christopher Carroll

Economists of all stripes remain puzzled about how Treasury Secretary Henry Paulson’s Troubled Asset Relief Plan is supposed to fix the American financial system.

What is not in dispute is that the crisis has been triggered by a collapse in confidence about how much of their debt subprime borrowers will repay.  (This affects financial stability and the real economy because bankrupt banks cannot lend, even to sound borrowers.)

An example might help clarify the root of our confusion.  Suppose that as of Tuesday, August 24, 79 AD , the Bank of Rome had lent a total of $110 million to citizens of the Roman Empire, funded by deposits of $100 million.  Result: Bank of Rome has a net value of $10 million.  On Wednesday, the eruption of Mount Vesuvius engulfs properties mortgaged by the Bank of Rome to the tune of $20 million.  Result: The Bank of Rome is bankrupt; its depositors can expect to get back at most 90 percent of their money, and the bank cannot lend any new money even to the profitable and creditworthy Marcus L. Crassus Corporation.

The reason the Bank of Rome is bankrupt is that there has been a collapse of confidence that the (now extinct) citizens of Pompeii will repay their mortgage loans.

It is not clear, fundamentally, how this situation differs from the one confronting American banks now. Read more