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The Paulson Predicament


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Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have put Congress in a hell of position. They have forecast financial doom unless their $700-billion bailout plan passes, yet their explanation of to how it will work, judging by their answers during congressional hearings this week, is basically “trust us.”

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In any other circumstance, that posture would be unacceptable. But the prospect of an imminent financial meltdown looms. As Paulson and Bernake have repeatedly argued, the reason to stop this meltdown is not to save the irresponsible players who created this mess, but to save the rest of us from the consequences of their mess. So far, the “real” economy has weathered the financial turmoil amazingly well. But that won’t last if no one can get a loan. At the very least, we will likely face a sharp economic downturn on par with 1981-82 or 1974-75, and at worst a Japan-like disruption that will take years to work through. The cost of such an event would be far larger than that of the Paulson plan.

There are serious questions about how the Paulson plan would work, the most important being how it would set prices for the debts bought by Treasury. At times, Bernanke has seemed to suggest that the government would pay the “hold-to-maturity” prices for these debts rather than the “fire sale” prices. But how would it determine the former prices in a “fire sale” market? If, on the other hand, the government pays a steeply discounted price, it may drive down prices for these assets and thus further harm the standing of the banks. This is a tricky business and even many supporters of the plan are not 100-percent certain it will work. The best case is that, once the panic subsides and the credit markets begin working again, the government will not have to buy up as much of the debt as initially thought and the debt it does hold will recover value.

Conservatives have proposed various alternatives to the Paulson plan. These alternatives have fallen into two categories. Some of them consist of excellent long-term reforms that do not address the issue at hand. Take, for example, the proposal to drop the capital-gains tax rate to zero: We certainly believe that policy would promote the long-term growth potential of the United States, but it would do little to stem the current panic. It is an idea better suited to trying to pick up the pieces afterward than saving the credit markets now. The same with more drilling, or a repeal of Sarbanes-Oxley, or any otherwise sound policy proposal that does not directly and immediately address the crisis before us by injecting more capital into the system or rendering currently illiquid assets liquid again.

Other conservative proposals — we think particularly of the plan being promoted by Reps. Eric Cantor and Jeb Hensarling — are better geared to the problems of the moment, even if they are probably insufficient. Regardless, it seems to us unlikely that enough of a consensus will develop for an alternative to get it passed. If conservatives refuse to support the Paulson plan, whether because they cannot stomach it or prefer an alternative, it may become impossible to enact anything but a left-leaning deal that depends on votes from liberal Democrats. The result of their opposition would thus be to make the Paulson plan simultaneously more intrusive and less effective.

Rightly viewed, Paulson’s proposal is a distasteful emergency measure to right the credit markets and should be phased out as soon as possible. Liberals want to make it, instead, an endless warrant for financial socialism. Many congressmen are already trying to limit executive compensation of participating firms, with some Democrats saying that it would be the first step to limiting the pay of all executives. The Democrats also want the taxpayer to have more upside by owning shares in firms that sell their bad debts to the government. But the American taxpayer, between Fannie, Freddie, and AIG, already owns too much of the financial sector. More practically, the “warrants” to buy shares that are being discussed as a way of giving taxpayers a piece of these firms would have to be counted as liabilities on the books — weakening the firms’ capital position, when the entire point of the plan is to strengthen it.

Right now, conservatives have leverage in this debate. They should use it to stop liberals from hijacking the plan and, indeed, to improve it themselves. Their strategy should be to improve the plan rather than to try to kill it outright.

Republicans should push for every measure possible to lessen the need for the Paulson plan and to limit its scope. Proposals like reforming mark-to-market accounting rules that have worsened the crisis, suspending dividend payments by financial institutions, and allowing the Fed to pay interest on its reserves can help ease the crunch and increase capital in the system. Meanwhile, even if Paulson needs the $700 billion figure next to his “bazooka” and needs a great deal of discretion in operating the program, Congress should structure it so that it is reviewed every month and the possibility exists to pull the plug quickly if it isn’t working. If it is possible, Republicans should also try to include some of their long-term reform ideas in the package — as a supplement, rather than an alternative, to a solution to the current crisis.

We understand, and share, the instinctive repulsion many conservatives feel for the plan. But in a true crisis, the financial system needs a government backstop. Panics must be stopped because it is their very nature to damage the economy out of all proportion to reason. So something must be done, and it appears that the Paulson plan is going to have to be the template for that something.

Reasonable conservatives might well disagree with that judgment. We understand our compatriots who consider it too risky and too costly, not just to the U.S. government but to our principles. Would that the government’s insistence on promoting bad loans and Wall Street’s recklessness had never brought us to this pass.



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