Paul Krugman, unsurprisingly, offers some of the clearest thinking on deficiencies in the bailout. As he argues, the financial crisis is, fundamentally, a problem of undercapitalization. Firms have too little money to survive a credit contraction, a drop in the worth of their assets, and a panic in which investors demand their cash back. Think of it like this: Health Wonk Investments has $100 cash on hand, the ability to borrow $10,000, and $20,000 in assets. That gives it about $31,100 in cash available. Then there's an asset crisis. The assets are now worth only $10,000. Meanwhile, the credit markets are in turmoil. Now the firm can borrow only $500. And suddenly, its customers want $20,000 of their money back. With only $100 on hand, and only $15,000 accessible, the firm collapses. What the bailout does is buy the assets for more than the market currently thinks they're worth. So where Health Wonk Investments could only sell them for $10,000, the government will now give them $15,000. In return, the government will hope that these assets aren't junk, and they can sell them off for $20,000 later. But there's no reason, Krugman argues, for the government to focus on the assets. The basic problem is undercapitalization. So why not just...capitalize the players? Lend the Health Wonk Investment firm money directly, let them right their financial house, and force them to pay the loans back -- with interest -- over time. That way, the government is fairly certain to at least break even. If you lend the firms enough money to stay solvent now, they will pay the cash back later. They have no incentive to be liquidated, or see their executives end up in debtor's prison. Conversely, if you buy up the assets now, there's no promise that they can be sold at a profit later. No one knows how undervalued they are, and so there's no guarantee that the Treasury is buying them at some price point between their current value (too low) and their eventual value. It could be that their eventual value is lower than what the Treasury pays, in which case, the taxpayer just lost a lot of money. In other words, rather than simply ensuring Wall Street against collapse, the government is trying to ensure them against loss -- against having, over time, to pay back the price of the bailout. But the government could, if so inclined, stop collapse without incurring as much risk of loss. It's just that Paulson and the Bush White House would rather inflict pain on the taxpayer than on Wall Street.
