Crony Communist or Businessman?

Is Henry Paulson a crony communist or a businessman? The answer could be the difference between economic disaster and recovery.

Understanding Paulson’s role in stopping – or fueling – the credit crisis requires a review of two axioms from Economics 101: 1) A credit crisis occurs when banks stop lending and 2) The amount banks can lend is a multiple of the capital in their vaults. Therefore, ending a credit crisis means prompting new lending – and that means maximally increasing bank capital.

Enter Paulson, the former Goldman Sachs executive and current Treasury secretary. The bailout he fearmongered through Congress aims to waste almost a trillion taxpayer dollars buying banks’ bad mortgages – a scheme all but ensuring a disastrous outcome.

If Paulson pays banks exactly what their mortgages are worth, he will not increase banks’ capital (or their lending ability) – he will merely convert one asset (mortgages) into another (cash), making no impact on the credit crisis. If, to protect taxpayers, he buys mortgages at lower prices than banks list them, banks will have to write down their capital and consequently contract lending – and the credit crisis will worsen. If Paulson overpays for mortgages, he may marginally augment bank capital, but also incur massive taxpayer losses when he later resells the mortgages at their real price.

The silver lining is a little-noticed provision in the bailout bill allowing Paulson – if he chooses – to buy ownership stakes in banks. According to Robert Johnson, the Senate Banking Committee’s former chief economist, this would cost roughly $375 billion less than the mortgage-buying plan – and, better yet, more aggressively attack the credit crisis.

Mortgages may be underpriced today, but they retain some value on banks’ books. So rather than purchasing mortgages (a capital-neutral transaction), Paulson could buy bank stock, infusing banks with new capital on top of their mortgages. That would exponentially increase lending capacity, prevent taxpayers from buying toxic assets, give the public a share of future profits, and grant regulators ownership leverage to restructure bank management.

This is where Paulson’s personal proclivities come in.

A crony communist looking to socialize risk and privatize gain would consider these options and choose to buy mortgages – that is, choose to ignore the credit crisis, reward discredited executives and permit banks to keep any subsequent profits – all while inhibiting a potential government-mandated housecleaning of Wall Street. Indeed, the Financial Times’ Wolfgang Munchau says Paulson’s mortgage-buying program is driven by ​“a wish to benefit the investment banks he once chaired, and which stand to gain handsomely from such a package.”

A businessman, by contrast, would limit taxpayers’ exposure, give us a stake in future gains and demand management control. He would, in short, treat taxpayers like Warren Buffett treats his Berkshire Hathaway shareholders when buying banks with their money.

This is how Sweden successfully confronted its banking crisis in 1992, and how England is addressing its own meltdown today. In fact, world leaders are citing our crony communism as a cautionary tale. ​“This is not the American plan,” said British Prime Minister Gordon Brown in announcing his bank rescue. ​“We will have a stake in the banks – we are not simply giving money.”

The bailout bill’s failure to make this course of action mandatory should have killed the legislation in Congress. But banking CEOs and their lobbyists turned ​“should have” into ​“didn’t.” They love crony communism and hate government ownership stakes because, as financial analyst Luigi Zingales says, ​“Nobody likes to pay for their own mistakes – it is much better to have the taxpayers pay.”

Considering the opposition, then, it is a miracle any ownership stake language slipped into law. Whether Paulson now uses that language will signal how deep Washington corruption runs.