Old criticisms of Geithner's new bank plan

Tim Geithner's toxic-waste disposal plan doesn't come out till later today, but that hasn't stopped the criticism. Details of the plan for a public/private partnership for purchasing assets leaked out on Friday and Saturday -- see the Journal and Brad DeLong's FAQ -- and the carping started soon afher. (The Treasury Secretary is now tagged constantly with that hard-won adjective: "embattled.") Three points, in particular, have been made against Geithner's plan.

The first worry is an old one: The Geithner plan is premised on the notion that the assets in question are undervalued rather than worthless. This is (part of) Paul Krugman's view: "The Obama administration is now completely wedded to the idea that there's nothing fundamentally wrong with the financial system -- that what we're facing is the equivalent of a run on an essentially sound bank." But if the banks are insolvent and the assets are worthless -- and there is no profit to be made -- then the government is just throwing money into the abyss.

The second worry is about whether or not the private sector will participate. As the Journal reported over the weekend: "Whether these programs will work as anticipated depends in part on how Wall Street investors react to the AIG furor this week. Congress is moving to clamp down on anyone receiving financial aid by severely taxing bonus payments." No private sector participation means back to the drawing board.

The third worry is that the government will be subsidizing excessive risk taking. The Geithner plan works by providing non-course loans to the private investors. The fear here is that this gives the investors an incentive to overbid when the assets are auctioned off: If they spend a lot of money and the assets happen to go up in value, they will turn a profit. If they spend a lot of money and the assets do not go up in value, the taxpayers will clean up the mess. So why not overpay?

This is the other half of the Krugman critique: the Geithner plan "is an open invitation to play heads I win, tails the taxpayers lose."

It is also the view that I feel like I understand least well. Presumably the private investors do have some incentive not to dramatically overpay for the assets: if they dramatically overpay, they won't make any money. And presumably they want to make money. (It's also not totally clear to me from the details that leaked over the weekend that the private investors have NO downside risk. Don't they have a little skin in the game?) The investors also have another incentive to avoid dramatic taxpayer losses: populist ire. The long shadow of AIG might make it less likely for certain investors to participate. But once the investors are in, that shadow makes them less likely to play fast and loose with the taxpayers' money.

At the very least, the fact that we are subsidizing investor losses through a taxpayer subsidy can't be considered totally crazy, because we do it all the time. It's not what the FDIC is designed to do, but it's what the FDIC does implicitly: it gives banks a subsidy to be reckless with other people's money by insuring deposits. We think this system is worth it because we want people to feel secure making deposits and we wants banks to feel secure making investments. At some point, the moral hazard becomes unbearable. But why is it clear to Krugman et al that we've reached this point?

Update: The plan is out; the Treasury Department fact sheet is here.