Reaction to Caballero’s ‘call option’ policy to fix the banks

Posted by Mark Thoma on 22 February 2009

I'll first point to James Kwak's comments on Caballero's Lead Commentary. James liked Ricardo Caballero's recent credit insurance much better than this one. His objections to the most recent plan, in summary, are:

  1. The plan allows banks to double their capitalization overnight, but given the low starting value and the high goal, even a doubling of values is nowhere near enough to save banks that are in trouble.
  2. Since the plan guarantees the future price of shares, there is an incentive for firms to take on more risk than is prudent - after all, the downside is covered.
  3. The wealth effect is relatively small, so the simulative effect for the economy would be limited.
  4. The claim is that the plan will be free (because it will restore the economy and hence asset values to normal). But if assets really do double or more in value, all plans, the Paulson plan, the Buiter/Romer good bank plan, government takeovers, most any plan you can think of, would also be free.

 

To this list, I would like to add one more.

  1. A big problem right now is lack of faith in the ability of policymakers to solve the problems plaguing financial markets. Given a choice between a plan that has been tried before in some form and worked, perhaps not perfectly but a plan that did lead to clear improvement at a defensible cost, and a plan that has never been tried before but might work wonders, I would prefer the plan that has a history of producing positive results.

 

There are times to experiment and to try to improve upon the past, but right now is not one of those times. The many shifts in direction that policy has taken so far, and the perception that policymakers aren't sure what the problem is or what to do about it have undermined faith that policymakers can solve the problem. Perhaps I’m wrong and this is, in fact, our best shot, but if the policy doesn't work this time around, the resulting collapse of faith in policymakers and the pessimism that collapse in faith would bring would make it much, much harder for the financial system to recover. The bank bailout policy must produce positive effects, the need for quick action to combat steadily deteriorating conditions combined with the need to avoid creating further pessimism concerning the likelihood of recovery means we probably won’t get another shot at this, so right now is not the time to test new policy frontiers.

 

Mark Thoma
Professor of Economics, University of Oregon.