Paulson’s “Ideological Blinders”

The Associated Press ran a piece yesterday that addressed Treasury Secretary Paulson and Bush administration’s dramatic reversal regarding bank recapitalization.  October 13, Secretary Paulson’s Treasury Department announced their intentions to begin purchasing equity in undercapitalized banks.  The AP reports that “The Bank of New York Mellon Corp. said it would sell $3 billion in preferred shares to the government, the first bank to do so.”

So the government will be purchasing preferred shares to inject capital in troubled banks.  Is this surprising?  Certainly not.  A consensus of economists of all political persuasion — ranging from Nobel Prize winner Paul Krugman to former Bush appointee N. Gregory Mankiw — has been saying for several weeks that the most immediate problem with the financial sector is that banks are undercapitalized.

While the world should be thankful that Secretary Paulson finally came to his senses, his performance over the last month certainly raises the question: what was he thinking?

Specifically, why did Secretary Paulson initially fail to identify capital injection as the required fix, even though this solution was obvious to most reputable economists — including Federal Reserve Chairman Bernanke?  Newsweek reports:

Bernanke all along wanted a direct capital injection into the banks—the financial equivalent of an adrenaline shot to a stopped heart—as the best way to open up the frozen credit markets.

Then why was Paulson’s initial proposal to Congress so far off the mark?  For a moment, let’s put aside the proposal’s ludicrous assertion that treasury decisions should be “non-reviewable.”  What was the basic function of the Paulson’s plan?  For the Treasury Department to “purchase mortgage-related assets” in the amount of $700 billion.

Secretary Paulson never adequately explained how, exactly, the government’s purchase of toxic mortgage backed securities was supposed to address the under capitalization problem.  The other glaring problem with the Paulson plan: there was virtually no chance taxpayers would ever recover much of the $700 billion.  In order for Treasury’s purchase of toxic mortgage backed securities to actually provide any assistance to banks, the government would have to overpay — i.e. pay more than the market price for the troubled assets.

The only way the government could ever recover some of its money would be if the toxic assets it purchased were actually undervalued by the market.  This premise would rely on the assumption that Treasury officials have a better understanding of market conditions than the general public.  After the Treasury Department spent the last several years denying the existence of a problem with credit markets, any plan that relies upon Treasury’s omniscience should raise all sorts of red flags.

Thankfully, despite Paulson’s resistance, Democratic leaders in Congress made sure the bailout bill included a provision which granted authority to partially nationalize banks.  Yet, Paulson clearly did not ask for — and did not want — authority for a capital injection.  The AP writes:

When asked during congressional hearings three weeks ago about providing new capital to banks, Paulson dismissed the idea, saying he preferred “market mechanisms” like his proposal to remove troubled mortgage-related assets from banks’ balance sheets.

Government injection of capital “is about failure,” he told members of the Senate Banking Committee. “This is about success.”

However, Paulson eventually reversed course.  Newsweek explains that “after the markets tanked yet again (and Britain injected its own banks with capital, starting the trend), Paulson finally endorsed [recapitalization] on Oct. 13.”

Treasury Secretary Paulson, former CEO of Goldman Sachs, is certainly intelligent.  Yet, it took Paulson three weeks longer than everyone to determine that the crisis called for a capital injection.  It seems evident that Paulson’s behavior is the result of his rigid antigovernment ideology.  Krugman, who advocated recapitalization from the very beginning, writes:

“It’s hard to avoid the sense that Mr. Paulson’s initial response was distorted by ideology. Remember, he works for an administration whose philosophy of government can be summed up as ‘private good, public bad.”

The AP reports:

The delay in [proceeding with recapitalization] “mostly seems to have been (due to) ideological blinders on Paulson’s part,” said Adam Posen, deputy director of the Peterson Institute for International Economics.

I suppose, given the track record of the Bush administration, we should be thankful that Paulson finally did the right thing and endorsed recapitalization.  However, Paulson’s initial refusal to accept recapitalization as the required solution — due to ideological prejudices — raises serious doubts about his competence.