In the Washington Post yesterday (Wednesday) we published an op ed with more details on our position regarding some of these issues:
http://www.washingtonpost.com/wp-dyn/content/article/2008/10/14/AR2008101402560.html

Basically, our view is that under the current circumstances, it would be advisable to use all of the $700bn to provide new capital to bank and nonbank financial institutions. Not all needs to be or should be committed today, but likely it will be needed soon.

Given market developments of yesterday (and early today, Thursday, in Asia and Europe), I feel even more strongly that the TARP auctions for distressed assets are at best irrelevant. There are not so many bullets left; don't throw any away.

More analysis is available on our crisis website http://BaselineScenario.com, where we update our views (and will tell you in real time if we change our minds!)

One more point on mortgage bailouts: They are largely regressive, since it is disproportionately high-income and net worth, white, male, traditional families, over 30 years old, etc., who would benefit. Bob, Jeff, and other people on this blog are aware of this fact, but it seems to be skipped over.

So I agree with Sebastian Mallaby (among others) that the best thing to do is a stimulus package, be it tax cuts, grants to state/local government, infrastructure spending. That can directly benefit the soon to be unemployed low-income people of color and single female head of households who disproportionately suffer in any recession, and have a higher overall multiplier for GDP growth than mortgage bailouts.

I do support the equity infusions.

Feldstein's plan sounds like a good idea to me. But I do agree that the government can't bring about a recovery by artificially preventing house prices from finding their natural fundamentals-determined equilibrium. (Feldstein's plan is intended to prevent housing prices from OVERSHOOTING their fundamentals equililbrium on the downside.)

Ultimately, there will be no sustained economic recovery until housing prices bottom out and resume at least some (modest) upward trajectory. This is because the health of housing affects consumers' wealth, which in turn influences their spending.

There are many plans out there for braking the fall in house prices. My view is that some of them are too generous -- in that they would be provide aid for everyone, regardless of circumstances. When we get around to further homeowner relief -- and I predict the next Administration will (whoever wins) -- I believe that relief ought to be targeted on those most in need, whether the aid is provided through rewriting of the bankruptcy laws, federal prodding of mortgage lenders/services, or through any further fiscal relief.

I believe Feldstein (and Stiglitz and others calling for action on housing prices) are wrong. People claimed the same thing in Japan in the 1990s and in Oklahoma and California in the mid-1980s, and in both instances that was mistaken. Without the financial fragility multiplying it, the asset price stops declining and the negative impact while real is neither huge nor persistent. Think about the huge collapse in asset prices in the IT bubble, and the economy shrugged it off. It will be worse with the mortgage market, but not that much worse, as already seen in the limited economic drag from two full years of declining residential construction and housing prices. Only when it eroded bank capital did it turn into something truly serious.

Nothing in the Treasury actions so far addresses the trigger of the financial crisis – declining home values. According to the latest Case-Schiller Index, home prices in major metropolitan areas are down 18 percent from their peak, and Mark Zandi was quoted in the Wall Street Journal predicting another 10 percent to 15 percent drop into mid-2009. So far, Treasury has signaled that it will spend an initial $100 billion to buy mortgage-backed securities. Will that be sufficient to create a stable price for these many different securities? Simon Johnson and Doug Elmendorf think the government should abandon this effort, but Bob Litan says this is still a viable complement to the bank equity infusions announced Monday.

Martin Feldstein says that the government will need to make much more of a commitment to purchasing mortgages directly – he proposes buying 20 percent of home mortgages to help stabilize prices. Is this a good plan and what else should be done? Can the Treasury rescue succeed without a turnaround in home prices?

The latest financial rescue program from the Treasury is much stronger and will be much more potent than the initial plan to buy troubled assets. The crucial task now is to put government money to work as quickly as possible. Just as the announcements of recent plans, including the original TARP and the Federal Reserve's commercial paper facility, failed to provide a sustained boost to confidence or lending, so the latest announcement may fail to provide a sustained boost unless the words are backed up quickly by dollars. When hundreds of billions of dollars of new equity is invested at banks, hundreds of billions of dollars of new bank debt receives a federal guarantee, and the Fed takes on hundreds of billions of dollars of CP, then lending markets may start to recover.

I do not think it is necessary for the Treasury to purchase troubled assets at this point, although it is sensible for the Treasury to preserve the option to do so. Before such sales began, I would like Treasury to enunciate more clearly its strategy for such purchases. Would it start with more homogeneous assets for which reverse auctions are most feasible, or with the most heterogeneous assets which might be least liquid but are also hardest for the government to price? How would its decisions about what assets to buy depend on the estimated capital adequacy of the institutions holding the largest concentration of particular assets? And so on.

A related question is whether the TARP should be used to buy whole mortgage loans or to collect pieces of certain mortgage loans so that the government, as lender, can apply more pressure for mortgage modifications. Additional modifications are not a substitute for other steps to stabilize the financial system, but they can provide substantial benefit to afflicted families at fairly low cost to taxpayers. For example, a new Federal Reserve working paper concludes that, "while servicers have substantially improved borrower outreach and increased loss mitigation efforts, some foreclosures still occur where both borrower and investor would benefit if such an outcome were avoided." The paper describes mechanisms for increasing mortgage modifications, including "further industry efforts to expand borrower outreach and establish servicing guidelines, educating investors, paying servicers fees for appropriate loan workouts, and improving measures of servicer performance."

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For not the first time in recent weeks, I am unable to sleep, agonizing over the question of whether we (meaning I and the economists whom I identify with) really had it all wrong. Now, I've checked, and I wasn't previously totally oblivious to reality. Please humor me by seeing the article linked at the end of this message.

Despite that self-indulgent lead-in, of course I am more concerned with what will happen to people in the US and around the world, and what to do about it, than with just intellectual correctness (or simply my being mistaken). My agonizing is more about whether I still felt we (I) had enough understanding of the situation to continue to offer reassurances and advice, and I guess we (I) do after all.

That being the case, let me say that I remain relatively optimistic, that the current panic will subside, and that the actual amount and duration of economic damage will be limited. As I put it in Saturday's Washington Post:

"We are all spooked out of our minds because of the last three weeks, but just as we've seen in Japan [during their lost decade], this doesn't have to be that tough...Sure, it's bad for vulnerable people, those on fixed incomes and someone who is about to retire. But if the average American goes through what the average Japanese did [in the 1990s], it does not have to be a huge setback."

As the truly great economist Olivier Blanchard, who cares about social justice and who just became Chief Economist of the IMF, said two days ago:

"We're not heading toward a depression," the French-born Blanchard said in an interview. "We've learned a few things in 80 years...This is not a crisis where we are completely lost...We are surprised by the facts, [but] we understand what the solutions are and how to use them. When governments are scared enough, they will use them correctly."

The reason I spent much of 1998-2003 writing about Japanese economic policy and dealing with the Japanese government was precisely to convince them to use those available solutions correctly rather than dawdling. And when they did use those policy tools starting in late 2002, the Japanese economy recovered, and doubled its growth rate for over five years straight, cutting unemployment in half.

Similarly, while you may see me quoted in various places complaining about the G7 communique, and the Paulson Treasury's lack of explicit commitment so far that they will recapitalize the US banking system, that is part of my attempt to get them to implement the needed policies. But I am confident that those policies will be undertaken before too much longer, and that they will work.

So keep the faith. The coming months will be not be painless, and what has happened definitely will harm the US' ability to provide needed economic leadership in the world (more on that later), but it will be okay in the end.

Here's Posen's warning from 2005.

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In principle, Treasury could both purchase mortgage securities from a bank at the same time it is buying stock in the institution. There needn't be conflict if the stock purchase plan is voluntary -- up to the bank -- and there is an agreed-upon formula for pricing the stock. In my Brookings article with Martin Baily, we cited an idea floated by William Poole, former President of the St. Louis Fed, that suggested fixing the purchase price as the price on the date before the $700 billion rescue plan was floated. If the price is fixed and can't be affected by the mortgage securities purchase, there won't be a conflict between the two initiatives. Further, we suggested that Treasury need not engage in massive mortgage securities purchases to help the market establish a price and thus to jump start private trading.

As a practical matter, Treasury may be able to rescue some banks more quickly than it can stabilize markets for mortgage securities. IN this connection, we argued strongly that Treasury husband its resources that were previously to be targeted solely for mortgage securities stabilization, so that it would have plenty of room to pursue bank recapitalization.

At this point, my view is that the government should try all options at its disposal. We need the financial equivalent of the Powell doctrine in military affairs: overwhelming force. As for the mortgage securities purchases in particular, once they get started they should provide better pricing.

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