As U.S. lawmakers debate the merits of Treasury Secretary Henry Paulson's $700 billion bank rescue plan, we asked a few experts to share their thoughts on the proposed bailout. Here are their responses.

ALEX J. POLLOCK 

Reflecting on widespread bank failures, a senior government official wrote: “The failures of the current year have been numerous, many having been characterized by gross mismanagement and some by criminality. In many cases, however, the unfavorable conditions were greatly aggravated by the collapse of unwise speculation in real estate.”

This was from the Comptroller of the Currency—in 1891. 

Yes, we have been here before: in financial panic and crisis stemming from overexpansion of debt based on real estate. Indeed, leveraged real estate speculation has a long and colorful history. 

In the wake of our most recent housing bubble and bust, we are seeing the inevitable government interventions in the financial system. The first bailout in the current series occurred not in the United States, but in Britain (which is experiencing its own severe housing bust): UK officials intervened to stop a run on mortgage lender Northern Rock. Then came the government-engineered rescues of Bear Stearns, Fannie Mae and Freddie Mac, and AIG. Now Treasury Secretary Henry Paulson has proposed creating a giant $700 billion government hedge fund (about the size of Fannie or Freddie) to buy nontrading mortgage-backed securities. 

Of course, the very existence of Fannie and Freddie was a remnant of past government interventions designed to stem housing finance crises. In other words, bailing out Fannie and Freddie was an intervention to save an intervention. 

How are we to think sensibly about this ongoing series of bailouts? Where is Adam Smith in all this? In my view, he is still the master spirit who guides long-term economic growth and (in his words) “the natural progress of opulence,” 90 percent of the time. But to paraphrase economist Charles Kindleberger, author of a classic history of bubbles and panics, “use Adam Smith on the trend and Keynes in crisis.” 

If we are all interventionists in crises, we must still seek to design the least bad bailout. All government bailouts should be temporary, and they should consider the taxpayers (whose money is being committed) as investors. 

One alternative to the Paulson plan would be to recreate a version of the Reconstruction Finance Corporation (RFC), which was originally set up by President Herbert Hoover and was expanded as part of the New Deal. As it evolved, it made equity investments in the form of preferred stock, primarily in banks, to offset lost capital. The goal was to have a modest positive return on the taxpayers’ investment and redemption of the preferred stock at par when growth resumed and the firms were refinanced in the private capital market. 

It seems to me that something along these lines might be a better bet than the Paulson plan. 

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

DESMOND LACHMAN 

Treasury Secretary Henry Paulson is certainly right in arguing that large-scale government intervention is needed to avert a major U.S. financial crisis that could have highly negative implications for Main Street. However, the $700 billion package that he is proposing is seriously flawed and fails to address the real sources of the present crisis.

At the heart of the crisis is the most severe housing bust since the Great Depression and the worst credit crisis since World War II. Underlying the credit crisis are the large losses from bad bank lending practices that go well beyond bad mortgage lending. These losses have seriously impaired the banks’ capital base and have induced a vicious process of bank deleveraging. In the period ahead, the banks’ losses will be compounded by the ongoing decline in home prices and by the deepening of the recession (yes, I believe we have already entered one).

At best, Paulson’s plan to buy $700 billion of the banks’ bad assets provides the banks with additional liquidity and eases their deleveraging process. However, it does nothing to arrest the rise in home foreclosures or the downward spiral in home prices, both of which are compounding the bank loss problem. Nor does the Paulson plan do anything to repair the banks’ depleted capital base, which is inducing them to make drastic lending cutbacks and to sell assets in a depressed market.

Congress should not let itself be steamrolled into approving a half-baked plan that has little chance of success and could potentially be very costly to taxpayers. Instead, U.S. lawmakers should be contemplating bold measures that simultaneously address the home foreclosure problem and do something to repair the banks’ capital position. A good start in that direction would be for Congress to force banks both to suspend dividends and to issue preferred shares to the government that would supplement the banks’ capital and dilute existing shareholders’ interests.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

PETER J. WALLISON 

I see the issue as one of pricing. Fair-value accounting, with its focus on marking assets to market prices, has created doubt about the value of portfolios of asset-backed securities, especially mortgage-backed securities. As long as there is doubt about the value of these assets, there will be doubt about the solvency and stability of the financial institutions that hold them. We could have addressed this problem a year or so ago with changes to the accounting system, but it’s too late for that now. A sensible pricing regime, run by the Treasury, could potentially establish correct and credible values for these assets and in that way assist the banks and stabilize the market. I don’t think the reverse auction idea would achieve this objective, but a discounted cash flow system would fix the problems inherent in the mark-to-market system that now prevails.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

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