Quasi-fiscal scoundrels, Part 2

Alan Greenspan is right (for once). He recently made the obvious but important and oft-conveniently-forgotten point, that the least harmful way of intervening to help US homeowners saddled with mortgages they cannot afford when the early teaser rates on their mortgages re-set to much higher levels, is to give them direct financial aid. This is the opposite of what Treasury Secretary Hank Paulson is peddling.  Paulson proposes an interest rate freeze on some subprime loans, preventing the teaser rate resets for five years. Greenspan’s statement was very much to the point: "It’s far less damaging to the economy to create a short-term fiscal problem, which we would, than to try to fix the prices of homes or interest rates".

Paulson dismissed Greenspan’s argument that it would be better to provide cash aid to homeowners than freeze rates on subprime loans. “I don’t think what we need is a big government bail-out”. The Greenspan – Paulson argument pits the economics of Ann Raynd and Milton Friedman against those of Jozef Stalin and Hugo Chavez.  Raynd & Friedman win.

I argued in an earlier contribution on the US Treasury proposal for a quasi-fiscal bail-out of some of the US subprime mortgage borrowers, that there were two things wrong with Paulson’s proposal.

First, there is no valid argument based on poverty relief or on fairness/distributive justice, for bailing out subprime mortgage borrowers.  They borrowed imprudently and took on home loans larger than they could afford. They should live with the consequences.  There are many Americans who are poorer than these financially challenged subprime borrowers, but who won’t get a dime of financial relief in their Christmas stockings from uncle Sam. This includes the countless homeless in the US – those who have no roof over their head of any kind, owner-occupied or rented. If the government wishes to help the poor, it ought to do so on budget. Even if some of those who imprudently took on subprime loans are now threatened with the loss of their homes, or even with poverty, this is no reason for rewarding and subsidising this particular form of imprudence.  There should be proper assistance and relief for all the poor, but no special aid ‘pots’ for those who are threatened with poverty because of their own greed and ignorance. That would be both unfair and incentive-corrupting.

If there was mis-selling of subprime mortgages to unsophisticated borrowers and if this amounted either to negligence by the originators or to deception or fraud, the civil or criminal courts are the places to deal with these matters.

The same no bail-out argument applies to institutional borrowers like banks and other financial institutions also, and not only in the US.  Keeping Northern Rock and its shareholders afloat at taxpayers’ expense/risk is an inexcusable misuse of UK public funds to avoid political embarrassment.

Second, if despite the previous argument you are going to engage in a government bail-out, do it openly, transparently and on-budget, through explicit cash payments to designated beneficiaries.  Without the truth, there can be no accountability.  Don’t hide the fiscal reality of a tax on the subprime mortgage lender and a cash payment to the subprime mortgage borrower, behind a government intervention in the price mechanism – a prohibition of re-sets of teaser rates to the new scheduled higher levels.

The US Treasury proposal combines the transparency-enhancing miracle of off-budget and off-balance-sheet financing with the incentive-improving subtleties of Soviet central planning.  It deserves a  swift, disrespectful burial.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

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