Another View - How to Recapitalize the Financial System

Greg Mankiw's suggestions on how to recapitalize the system are worth considering:

"There is broad agreement among economists that what the financial system needs right now is not only an injection of liquidity but also a recapitalization. The essence of the current financial crisis is that many firms bet that housing prices would not fall; the prices fell nonetheless; and now these firms have too little capital to perform the crucial function of financial intermediation..."

"Other economists have suggested that the government inject capital itself. That raises several questions. First, which firms? The government does not want to put taxpayer money into “zombie” firms that are in fact deeply insolvent but have not yet recognized it. Second, at what price should the government buy in? Third, isn’t this, kind of, like socialism? That is, do we really want the government to start playing a large, continuing role running Wall Street and allocating capital resources? I certainly don't..."

"Here is an idea that might deal with these problems: The government can stand ready to be a silent partner to future Warren Buffetts."

"It could work as follows. Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date."

"This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control."

The basic idea here is that such a move would make it easier for companies to swap debt for equity and the market, not the government would decide which companies were worth investing in. This may be the best suggestion I have seen to date.

My view, however, is that if you solve the liquidity problem the recapitalization problem is significantly diminished - because that money has to end up somewhere, and one of the places it will end up is in the purchase of equities.

The basic problem seems to be one of deflation. Stock prices are falling. Commodity prices are falling. House prices are falling, which is of particular concern since now many people's houses are worth less than their mortgages.

As an inflation hawk, it pains me to say it, but having a large scale increase in the money supply makes sense - so I cannot disagree with the co-ordinated 50 point cut in rates around the world. I think we can go further, though. Prof. Mankiw states:

"This is not the time for recriminations."

I cannot say that I agree. If it does not happen now, it may never happen. At the very least we should avoid solutions that end up directly benefiting those who caused the problem in the first place.

The more I think about it, the more I think Milton Friedman's idea of a helicopter drop - that is injecting liquidity by having the Federal Reserve give money directly to consumers in a lump-sum transfer makes sense in this situation. A lot of that money will wind up in banks, in the stock market, and back into housing - reversing the deflation we see in those sectors. Plus the move would directly benefit Main Street rather than directly benefiting the financial sector, which has to take at least part of the blame for all this in the first place.