Luigi Zingales: Why Paulson Is Wrong

Last week, my colleagues Doug Diamond and Anil Kashyap guest-blogged on the financial crisis.

The response to their piece was amazing. At one point, their blog post was the second-most-emailed article of the day for the entire New York Times, even though it wasn’t even in the printed version of the paper — just on our blog.

I can’t remember ever seeing a blog post make the most-emailed list.

After that kind of reaction, how could I pass up the opportunity to publicize the ideas of Luigi Zingales, another one of my colleagues, whose provocative piece is entitled “Why Paulson Is Wrong.”

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Comments are moderated and generally will be posted if they are on-topic and not abusive.



  1. Imad Qureshi says:

    This is so much better than the last one. This is socialized capitalism and its not right.

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  2. Mike B says:

    One could also say that the taxpayers who have taken advantage of this easy credit deserve to pay back what they borrowed and learn to save more and not live beyond their means. It takes two to complete a transaction, one to lend and one to borrow. Nobody forced people to buy McMansions in Exurban areas, 12 mpg SUV’s and granite counter tops with built-in plasma TVs.

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  3. George Khoury says:

    What a great piece – a direct challenge to the people (just about everyone in the media) who say the bailout is distasteful but “necessary.”

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  4. Tristan says:

    This is a clear, to the point, description of the problems with the proposed bailout. It also offers a good alternative.

    I’m going to email this out to as many people as I can think of, and will be sure to include my senator on that list.

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  5. Craig says:

    HTML is more accessible than PDF’s. This inaccessibility will be one of the reasons this isn’t as popular.

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  6. Dave says:

    This is amazing…To have not at least looked at this possibility and brought it to public debate just underscores the arrogance of the current administration holds against the very people who elected it. $700+ billion of our tax dollars to benifit a few corporations as corporate welfare is not right.

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  7. David Heigham says:

    Zingales has a sketch plan of what should be done. Paulson has merely said a lot of taxpayers credit will be needed to do something not properly described.

    Score 1 to Zingales, 0 to Paulson.

    Zingales is proposing measures that have worked in the past. Paulson is proposing unproven ideas.

    Score 1 more to Zingales, 0 to Paulson.

    Zingales does not question Paulson’s premise that drastic measures had to be taken in a hurry. However, I do not think I was alone in thinking that the market had probably touched bottom on Thursday the 18th. Short traders had just burnt their fingers on the terms of the AIG and HBOS takeovers. Morgan Stanley had signalled they would pay the market price for extra capital from China, and a couple of British banks had quietly raised a couple of $ billion from normal investors.

    Score 0 to Zingales, 0 to Paulson

    Paulson has said nothing about the fundamental need to increase the eqity capital base of the financial institutions to compensate for their losses and to allow the lower levels of leverage that are likely to be the norm for some years to come. Zingales has that in the core of his propsals.

    Score 1 more to Zingales, 0 to Paulson.

    Overall, it would be a great relief if Zingales would take on a big job in Washington for a while. Just to give Hank Paulson time to de-stress and re-focus, of course.

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  8. 4Justice says:

    I don’t know guys but this democracy thing is getting a bit too costly.

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  9. alex says:

    contact your senators and congressman/women in Washington.

    Tell them what you think of the Paulson “plan.” If you like the Zingales plan, tell them to read it.

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  10. kevin says:

    The last paragraph is great. “Do we want to live in a system where profits are private, but losses are socialized?”

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  11. umbrelladoc says:

    I’m jusr a simple city doctor, so I’m going to ask a stupid question. The subprime market is estimated at 2 trillion. The default rate is about 15%. That’s about 300 billion dollars. What would happen if the government bailed out the the ordinary folks with the mortgages? Wouldn’t that improve the value of the mortgage backed securities and solve the credit crisis in the other direction. Trickle up if you will? It seems to be a whole lot cheaper, and the government would wind up with real estate instead of dubious paper. And working folks who got suckered into these subprime loans would benefit instead of these corporate fat cats. Hey, I expect to be completely wrong on this one, but I’m just asking…..

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  12. jonathan says:

    You can’t cram down debt as you did in the 1930’s when the world was so radically different and smaller.

    You don’t have the time to unwind these complicated transactions.

    If we put this mess into an ersatz Chapter 11, there would be risks, as in the foreign debt holders of the US saying, “You are screwing up our financial systems so we won’t buy your Treasury debt.”

    Another risk is that such a cram down / restructuring without an immediate government takeover would drive the financial industry to other countries – well, let’s face it, this catastrophe will likely have that effect over time and that will significantly damage the US and alter its position in the world long-term so why accelerate the move? If the Treasury steps in, then we have a chance to preserve our world position. If not, then imagine the financial world shifting overseas and think what that would do to America, to the cost of running this country and every business in it, to the value of American assets.

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  13. Jeff says:

    There are 2 problems with this analysis. First, the gov’t bail out of AIG was essentially a debt for equity (gov’t gets warrants with the right to buy 80% of equity if debt is not paid off). If the private sector comes to the rescue of AIG and pays off the gov’t loan, then the tax payer is not footing the bill.

    Second, the author fails to account for the fact that the creditors of AIG / Bear / Lehman are JPM / BofA / Citi etc. So his suggestion to force the mildly healthy financial institutions to take further write-downs on their debt is imprudent. More write-downs for the big / somewhat-healthy institutions would only cramp liquidity further.

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  14. d gvillain says:


    I think you have a good point (I’ve been saying the same thing myself) — we might have been better off if we had handled this on the front end. The only thing is that it’s probably too late now. Would have needed to happen a few years ago before the foreclosure crisis.


    Taxpayers taking advantage of easy credit?? You make it sound as if the opportunity to take out a mortgage were a charitable blessing offered by the financial sector. Subprime lending is not charity, it is business meant to garner profit. Even if these companies were making loans as a “favor”, they were private transactions and as such have little to do with taxpayers in general.

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  15. Alan says:

    Moving to Canada is looking good. ;-p

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  16. d gvillain says:

    @ 13

    “If the private sector comes to the rescue” — That is a really big “if”. With the onus no longer on them, I wouldn’t hold my breath waiting for the private investors to come and save the day.

    I like the second point, but I think it calls for hard assessments — not just speculation — to determine if creditors (many of whom, I think, are overseas and probably faring much better), can really withstand debt-write downs or not.

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  17. BT says:

    Great piece indeed. It is unfortunate that no one seems to be talking about any alternatives to the $700 billion dollar bailout, except for a catastrophic financial meltdown.

    There are three things I dislike about the current bailout plan.

    1) the precedent it is setting for other companies in the future. Every struggling big industry is going to make a case for why it “can’t fail” and seek government money. The automakers have already been doing it.

    2) the enormous cost to the future generations. This generation of taxpayers will reap the rewards of the promised stabilization of financial markets due to this bailout. Most of this generation will even get tax cuts in the coming administrations. But, the coming generations will have to pay for this bailout, $10+ trillion federal deficit and entitlements like social security, medicare and medicaid.

    3) the way the government is selling it to the people. When Chris Dodd tells the public that everyone was horrified after Paulson described the extent of the current financial crisis, I was having flashbacks of Cheney and Bush talking “mushroom clouds” just before the invasion of Iraq. If you scare people enough, they will oblige to anything, no matter how obscure and fuzzy the facts are. I hope congress does its homework this time and scrutinize the deal.

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  18. BT says:

    By the way, Paulson looks like a wholesome character, but he was a Goldman Sachs CEO and I suspect he has vested interest in helping the financial giants as much or more than the average American people. I hope Bernanke the Academic sets him straight. Most of the people in congress are probably not well versed in the workings of the financial markets to pose a serious challenge to Paulson’s proposals.

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  19. DJH says:

    For Craig (#5) and others who can’t easily view PDF files … there are some online PDF-to-HTML/text converters. (This particular document is all text, no graphics, so in this case either will do.) Search one out online.

    Here is one I found: It requires you first to download the PDF, then upload it for conversion. You will see it paginated just like the original PDF, but with formatting largely gone (only text alignment is preserved).

    There is also Zamzar, at which I’ve used, though not recently. It may function by inputting the PDF URL, bypassing the download-then-upload requirement, but at the moment I can’t tell, I can’t get to Zamzar behind my firewall at the moment.

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  20. jhattva says:

    i’m not 100% the gov will de facto pay too much for the assets, merely by virtue of being the gov. there’s a much bigger concern that 700B won’t be enough, with the focus of the current plan being mortgage related debt, and eve4n bigger concern that, if done too hastily, real transparency into relationships and dependencies among parties and actual payment histories of individual mortgages won’t come about. on this reasoning, i think there’s a big risk of paying too much.

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  21. nik / says:

    If, as Paulson suspects, the assets “RTC2″ will buy are not worthless, but just illiquid right now then the answer is to wait until the “frozen” markets thaws.

    By definition the Treasury will be unable to properly place a value on them. What are they going to do? Buy at par? Last traded value? Acquisition cost? Replacement cost? Equivalent asset value?

    If he’s right, the proper answer is to stop making firms mark these assets to a nonexistent market.

    If he’s right, the proper answer is for a savvy and intrepid(and perhaps newly unemployed?) entrepreneurial investor buy the junk up for a song, hold it for a year or two, and feed it back into the markets at proper prices. Why must it be the government who does this? Probably because they’re the only ones with no profit incentive.

    The real problem is not frozen markets or illiquid assets. Its LEVERAGE as I’ve been explaining in my blog:

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  22. PaulK says:

    There is too much assumption that all this risky debt is worthless. Part of the problem has been that the loan holders are often restrained from changing the terms to keep the people in their houses vs. foreclosing. Since foreclosing returns far fewer cents on the dollar and even less when lots of them at once (depresses all values, especially foreclosed areas), it makes sense to try to negotiate with the debtors (give them more runway, keep payments where they were for longer, allow a below mortgage sale with debt writeoff if above what a foreclosure would return, etc). The question is whether a RTC2 will do that properly (mixed results with the S&L mess). We can lose far less taxpayer dollars (regardless of the risked amount) if we are not so eager to foreclose every mortgage. This would have a value to much of the country as well, since it would stop the freefall of home values that will continue if nothing is done. I am not sure how a cram down of debt relief itself solves this, since you need to still separate the hopeless debt from the ones that can be salvaged.

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  23. Steven Schornack says:

    has anyone asked for Rep. Ron Paul’s opinion?

    He spent much of his campaign warning about the President’s Working Group on Financial Markets and the Federal Reserve who are now riding to the rescue of those markets. What does he think now?

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  24. Chris Whatley says:

    The whole idea of this bailout works for me if it comes with a sizable tax increase on the investor class and keeps taxes for the wage earners stable. Then the burden of cleaning up the explosion lies on those who reaped the benefits of the bubble in the first place.

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  25. Tristan says:

    24. I think you are totally on the money.

    In the article this is stated:

    “the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses”

    The problem is that with the current system alot of the people pushing the buttons and flicking the switches WON’T be hurt by a company failing. A CEO that has made huge profits in an inflated rising market and left a company (or even if he’s traded the company stocks away at the inflated price and stays with the company) STILL BENEFITS.

    What is letting a company fail going to do to stop that?

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  26. Tristan says:

    In additon to my above post I find this very interesting:

    Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?

    Seem like a left-winger could have made the same statement of problem.

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  27. hyokon says:

    Thank you for the great article.

    The economy may be a problem of a few or maybe 10 years, but the damaged principle will last much longer. It will remain forever in the history book.

    This could be a more serious issue than a war or the election. I want to believe that the US government understand the significance of this.

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  28. Adriano says:

    “Do we want to live in a system where profits are private, but losses are


    is equivalent to

    “Do you want to live in Italy, where (almost) every politician and the current government is proclaming that `Alitalia Can Not Go Banrkupt?`”

    Is not by chance that Professor Zingales is Italian. He knows what he is talking about :-)

    Adriano, Italy

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  29. Pakoda says:

    I dont know why the thought struck me now, but just reading this piece brought home to me the overwhelming impact of the internet. The internet hasn’t just connected people across cultures, its connected them across eras. The internet has allowed ordinary individuals from the third world to access thoughts of individuals from societies that are a century or so ahead of us. A mere ten years ago, there is no way I would have access to a piece such as this, and I am so much richer for it.

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  30. RZ says:

    I think this discussion (not specifically the Freakonomics blog but the overall financial crisis discussion) can use a little Nietzche for perspective: “What does not destroy you makes you stronger.” How about letting the economy go through its correction, even though we know that such a course will result in suffering, so that all involved will learn from it and (hopefully) not make the same mistakes in the future? I fear that if we don’t do this, we’ll all be having this same discussion again in 10-15 years.

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  31. Bobby G says:

    I also agree that I’m not sure the government will be paying overinflated prices for assets. A big part of the bailout goes towards purchasing up mortgaged homes in need of a stable price, i.e. establishing a price floor.

    I know that all us (former) economics students hear words like “price floor” and “price ceiling” and immediately think, “government interference! Social welfare losses!” but in this case it needs to happen. Banks need to know there is some price on their potential foreclosures (i.e. worst-case scenarios) so that they can at least begin to feel safer about loaning money. Banks do not have the liquid capabilities to sit on these houses until the prices go back up; not only are there laws and regulations that determine how long banks have to liquify seized assets, but especially these days they need that liquidity.

    Increasing the national debt and permitting the government to buy up these distressed mortgages allows the government to step in, ease the tension in the real estate market as well as keep some of these holdings until prices go back *up* and potentially make a profit. This is one aspect of the proposal that many critics seem to overlook. Another example why I think our country as a whole, not just politicians but the public, needs to think more about –long term– politics… Seriously, people, we complain about the lack of long-term politics and then we criticize long-term policies that seem to have bad short-term costs. Sometimes we are so hypocritical. This bailout might not actually cost us $700b down the road if the economy recovers, which is exactly why increasing the national debt to pay for it is much better than taxing citizens directly.

    Yes there are overpriced assets on the market right now, but if you pay attention to those markets, you’ll see that these assets aren’t moving; they aren’t selling. Like the article (correctly) states, investors simply don’t know how to value those assets… the market is so unstable that people are afraid to buy up assets out of fear that in a week or even in a day they’ll realize they paid too much. A large part of the bailout will set that price floor and allow a more stable evaluation process to occur. Prices will adjust, being pushed down, and those assets will start moving. It’s even possible that we won’t need to use all of the money in the bailout if the private sector can react to the policies with enough confidence.

    I am not opposed to the Democrats’ idea about restricting executive pay of companies seeking help; I think this would highly reduce incentives to ask for government bailout money in the future. It’s certainly better than their normal ideas of stimulus checks and overtaxing the rich.

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  32. Jason Ruspini says:

    Recall two central failings of socialism: lack of incentives and inferiority of centralized decision-making. IF this bill must go through in a way that leaves the shareholders intact, we need real accountability and transparency at the government level — which were completely missing from the first draft. As many have by now pointed-out, lack of transparency is partly the source of the problem in the first place. We need to know what the trust is buying and selling, and preferably from whom. The Treasury then must actively elicit bids for the assets on its books, which must be marked and made public at least once per quarter. A public book should also attract more bids and discover better prices than a private one. Hold-to-maturity pricing subverts all of this.

    The Treasury must be subject to review by Congress in such a way that there is an incentive to not simply take in assets at inflated prices. If real TARP losses exceed certain levels, Treasury and other relevant officers should face penalties at the discretion of Congress, including removal from office.

    Basically, there needs to be a structure in place to decrease the chances of taxpayers overpaying for assets.

    Slathering new redistributions onto the bill does not address its problems.

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  33. Mark E. says:

    @2: “One could also say that the taxpayers who have taken advantage of this easy credit deserve to pay back what they borrowed and learn to save more and not live beyond their means … Nobody forced people to buy McMansions in Exurban areas, 12 mpg SUV’s and granite counter tops with built-in plasma TVs.”

    Sounds fantastic. Since I didn’t make any of these poor choices OR attempt to cash in on them as a creditor, maybe I can opt out of the upcoming tax burden and then be the first in line to invest in the property that floods the market during the fire sale afterwards? We’ll see what happens, but let’s just say I’d short-sell the stock of something so beautifully capitalistic occurring in the MYOPIC and OPPORTUNISTIC economy that these “free market” activists have created for us.

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  34. Brian says:

    “I hope we shall… crush in its birth the aristocracy of our moneyed corporations, which dare already to challenge our government to a trial of strength and bid defiance to the laws of our country.”

    –Thomas Jefferson to George Logan, 1816.

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  35. Larry Elliott says:

    $700B bailout = green light and blank cheque for Klepto-Capitalism.

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  36. Let Them Eat Cake says:

    People cheat. It is basic human nature. And the more cheaters get away with it, the more they cheat, the more others are tempted to cheat alongside them. In the absence of regulation in the capital markets, cheating becomes institutionalized, which we have seen with the hedge funds on Wall Street. Never before have they had greater access to real-time information with less transparency about what they do with it. Programmed trading induces volume, more fees, greater volatility and gives tremendous advantage to the largest pools of capital. Naked shorting, painting the tape and a panoply of market manipulations increase unchecked. The game is 100% fixed. On top of that they have been getting tax breaks to maximize the take. With their ill gotten gains they buy more politicians to stay out of their way while they continue to steal. Essentially they have been free to prey on the common investor as long as the profits are concentrated into the hands of the ruling elite. And now they sit in a pile of their own filth, a by-product of illegitimate lending and trading in convoluted CDOs, begging us to save them from their losses. Meanwhile they blame the lower classes for biting off more than they could chew. We the people, the ones they fleeced in the first place.

    This shall not stand.

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