Economists Question Basis of Paulson's Plan

By Neil Irwin and Cecilia Kang
Washington Post Staff Writers
Friday, September 26, 2008; Page A01

The Bush administration’s pitch for a sweeping bailout of the financial system has centered on two simple premises: that the economy could suffer a crippling downturn if action is not taken very quickly and that this action should consist of the government buying troubled mortgage securities from banks and other institutions.

But many of the nation’s top economists disagree with one or both of those ideas, even as many top political leaders have swung behind them.

Wall Street economists have mostly endorsed Treasury Secretary Henry M. Paulson Jr.’s plan, or a variation thereof.

But almost 200 academic economists — who aren’t paid by the institutions that could directly benefit from the plan but who also may not have recent practical experience in the markets — have signed a petition organized by a University of Chicago professor objecting to the plan on the grounds that it could create perverse incentives, that it is too vague and that its long-run effects are unclear. Sen. Richard C. Shelby (Ala.), ranking Republican on the Budget Committee, brandished that letter yesterday afternoon as he explained his opposition to the bailout outside a bipartisan summit at the White House. The petition did not advocate any specific plan, including that offered yesterday by House Republicans.

Economists tend to agree that the nation’s economy is at serious risk as the flow of credit threatens to freeze. Just yesterday, the interest rate at which banks lend to each other rose steeply, as it has every day this week, suggesting that lenders are hoarding cash. History shows that when this happens, a broad economic crisis can follow, for instance, the Great Depression and Japan’s decade-long recession in the 1990s.

“If nothing is done, the potential for these markets to seize up in a big way is definitely there,” said Frederic S. Mishkin, an economist at Columbia University who was a Federal Reserve governor until last month. “When you look at the history of these crises, when things spin out of control, the cost to fix it later goes up exponentially.”

But many others with a deep theoretical knowledge of finance and experience in government are skeptical of the structure of Paulson’s plan — and the speed with which it has been crafted.

The critics can be roughly divided into two camps. One group thinks money should be directly infused into banks, which should allow it to trickle down through the financial system to borrowers. A second group thinks the government should buy individual mortgages, thus helping ordinary Americans more directly, with the benefits trickling up to the banks.

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