Seven Questions: How to Clean up Toxic Waste

Chip Somodevilla/Getty Images Living on a prayer: It will take more than faith in Federal Reserve Chairman Ben Bernanke for the U.S. Congress to come up with a workable bailout plan.

Foreign Policy: As you might have heard, the United States is in the midst of a pretty nasty financial crisis. Theres a somewhat technical debate among economists as to whether were seeing an insolvency crisis or a liquidity crisis, and some would argue the real problem is a transparency crisis. Whats your take?

Raghuram Rajan: This might be a semantic issue. The real problem is, regardless of which theory you espouse, the financial system has too little capital and as a result is running into funding difficulties. And the response to that will be to shrink assets and therefore lending, which means we will see a credit crunch that can have a widespread effect in the U.S. economycar loans, corporate loans, student loans, credit cards. The works.

Thats the fear, and regardless of whether it be because a portion of financial institutions balance sheets (Im going to say banks because its easier) are illiquid, it means that those things can no longer be financed from the credit markets. They have to finance those assets with long-term capital, which leaves less long-term capital to finance their other assets. So, if you think its a liquidity problem, it immediately does imply a capital problem. And if you think its a capital problemthat is, theyve had huge losses on their balance sheets from these illiquid assetsthe conclusion is pretty much the same.

If you think its a complexity problem, you could argue that these bank balance sheets are full of stuff that nobody understands. But once youre done separating out the portions that people dont understand, you still have to find a way to pay for that stuff. The bank would be happy to separate that stuff out and put it somewhere else, but those are assets. It cant sell them for nothing, and if it does have to sell them at a loss, it has to find a way to replenish the capital loss that has occurred as a result. So again, you come back to the fact that its a capital issue.

FP: A lot of people are saying that the only way the Bush administrations $700 billion bailout proposal can work is if the Treasury Department or whatever entity it sets up overpays for these assets. Do you think thats right?

RR: In a sense, thats almost tautological. If in fact players were willing to take the market price that prevails today, theyd have sold those assets. It wouldnt be a problem. But in some cases there is no market, implying that at the price that sellers want to get, there is no buyer. For many of these assets, the prices that prevail out there are very low but some of them are carrying them on their books at a much higher price. If institutions sold all their so-called toxic waste at those low prices, theyd have to mark their capital down to the price at which they sell. And many are unwilling to do that because they simply dont have enough capital.

So, in order to get people to actually release those assets off their balance sheets, the Treasury has to pay more than the market value. Now, thats not to say the market price represents the long-term present value of the asset, what Bernanke calls the held to maturity value. But thats a notional value that nobody is willing to pay at this point, and even as the government, youd be making up what that value is. You dont know, because these are horrendously complicated securities.

FP: As youre watching the discussion about the bailout plan, do you think people are asking the right questions?

RR: Im seeing more and more of the questions floating out into the public arena. What I worried about was a plan that was accepted quickly and pushed through Congress on the basis that the alternative was some kind of Armageddon in the space of a few days. I think three actions by the regulators have bought us a little bit of time. First, guaranteeing the money-market funds. The second was taking some of the pressure off Goldman Sachs and Morgan Stanley by allowing them to become bank holding companies. And third, announcing the fact that the government was serious about fixing the system.

FP: And what do you think about the governments bailout plan itself?

RR: Its better to address the capital problem directly than to do it indirectly by overpaying for assets. You really are doing two things with this purchase: Youre trying to create a market for these assets, because the market for them is dead, and youre trying to establish prices in that market that private players can latch on to. For that, you need to do things at the market price, not some hypothetical price that the government is willing to pay. The moment you do it at that hypothetical price, you havent helped the other private players, who have no intention of doing the things the government is doing. They dont want to overpay, right? So, the whole notion of price discovery is at odds with this backdoor recapitalization.

FP: Youre known as an advocate of free-market economics, and your book, Saving Capitalism from the Capitalists, offers a pretty strong defense of financial markets. Federal Reserve Chairman Ben Bernanke likes to say that just as there are no atheists in foxholes, there are no ideologues in financial crises. Not that youre some sort of ideologue, but has this crisis caused you to reassess your views at all about the nature of financial markets?

RR: Well, no. In the book, we talk about manias and panics in financial markets, and were very careful to say two things. Were not fundamentalists who think that markets exist without any intervention. We understand theres a solid bedrock of government regulation that is needed to make a free market work. The mistake some people on the extreme right make is that they think thats not needed. It is needed, but we say also that when regulation fails and the market sort of creates its own crisis, that becomes the opportunity for those who are anti-market and anti-competition to come in with a host of proposals to essentially defeat the market and to shackle it in the future.

And thats really my fear about this particular crisis. The more government intervention there is to bail out the system without private-sector participation, the more the public opinion will be, This is a one-way street. They feast in good times, and theyre bailed out in bad times. And the results will be to the financial sectors own detriment because the public will want overregulation rather than underregulation.

FP: Is there anything in the current debate that smacks of overregulation in your mind?

RR: Trying to fix CEO salaries as a quid pro quo [for participating in the bailout]. Im all for thinking about the pattern of CEO pay and financial-sector participant pay, but theres a competitive labor market out there. If you say, You cant pay more than X, youre going to do two things. First, youre going to drive a lot of pay underground, and second, youre going to make it much harder to recruit the savvy executives you need to run these firms. Rather than micromanaging CEO pay, Congress should focus on what rules we need for better corporate governance or what the regulators need to do to effect a better compensation structure.

FP: But Im sure you can sense that people are angry and they want their pound of flesh, so to speak.

RR: Yes, but rather than focusing on penalties, we should make sure that the cost to the taxpayer is minimized and that there is burden-sharing. I dont see any private-sector willingness to get together and say, Were the problem, and were going to be part of the cost. The private sector should be willing to raise more capital on its own, and in a sense should be forced to do it before we put more public money at stake.

Where are the titans of the financial sector at this point? Why arent they coming together in a room at the New York Fed and saying, This is a severe crisis for the financial system and we are going to put up some of our own money to refloat the system. They should find ways to ensure that the public is not giving a windfall to the financial sector, because it will actually hurt them in the long run. The taxpayer is not in a forgiving mood.

Raghuram G. Rajan, the Eric J. Gleacher distinguished professor of finance at the University of Chicagos Graduate School of Business, served as chief economist at the International Monetary Fund between 2003 and 2006.