Will the Geithner Plan Work? Four Leading Economists Speak Out

(Credit: Evan Vucci/Associated Press) Demonstrators standing behind Treasury Secretary Timothy Geithner before the start of a hearing of the House Financial Services Committee on Tuesday.

In Room for Debate, editors at the NY Times invited economists Paul Krugman, Op-Ed columnist, Princeton University; Simon Johnson, M.I.T.; Brad DeLong, U.C. Berkeley; and Mark Thoma, University of Oregon to respond to this question:

“…But is this plan {Geithner’s bank rescue plan} sufficient to restore the banking system to health?”

As far as I could tell, neither of the above named economists gave Geithner’s plan a wholehearted thumbs up, especially not Paul Krugman who writes:

Well, the stock market loved the Geithner plan, which proves … nothing. Stock investors have no special knowledge here; they’re groping like everyone else. For what it’s worth, credit markets didn’t react much at all.

But let’s back up and focus on the fundamentals.

In essence, the Geithner plan is the same as the Paulson plan from six months ago: buy up the toxic assets, and hope that this unfreezes the markets. Don’t be fooled by the apparent role of private enterprise: more than 90 percent of the funds will come from taxpayers. And the way the funds are structured provides a strong incentive for investors to overpay for assets (see my explanation on my blog).

So can this work?

Since the beginning of the crisis, there have been two views of what’s going on.

View #1 is that we’re looking at an unnecessary panic. The housing bust, so the story goes, has spooked the public, and made people nervous about banks. In response, banks have pulled back, which has led to ridiculously low prices for assets, which makes banks look even weaker, forcing them to pull back even more. On this view what the market really needs is a slap in the face to calm it down. And if we can get the market in troubled assets going, people will see that things aren’t really that bad, and — as Larry Summers said on yesterday’s Newshour – the vicious circles will turn into virtuous circles.

View #2 is that the banks really, truly messed up: they bet heavily on unrealistic beliefs about housing and consumer debt, and lost those bets. Confidence is low because people have become realistic.

The Geithner plan can only work if view #1 is right. If view #2 is right – if the banks are really in deep trouble that goes beyond lack of confidence — subsidizing investor purchases of toxic assets, many of which aren’t even held by the most troubled banks, has no real chance of turning things around.

As you can guess, I believe in view #2. We had vast excesses during the bubble years, and I don’t think we can fix the damage with the power of positive thinking plus a bit of financial engineering.

But that’s where the issue lies.

To read the responses of the other three economists, go here.