Saving Capitalism from the Capitalists

I have a favorite economist.  I was going to say I have a new favorite economist, but I don’t think I ever had a favorite economist before.  Anyway, his name is Luigi Zingales from the University of Chicago.  He authored far and away the best piece I have read on General Motors, which proposes putting GM into a pre-packaged bankruptcy and using federal funds to finance a DIP loan, but requiring a bank make the ultimate lending decisions.  In doing so, Zinglaes proposes that the bank would be liable for further losses made after the initial DIP loan, and thus would not allow GM to continue squandering the governments funds if its assets continue to decline in value.  Zingales also proposes solving the problem posed by consumers not buying a car from an auto manufacturer in bankruptcy by requiring GM to purchase third-party insurance and making management and workers responsible for the quality of cars by linking VEBA payments and executive compensation to an index based on the cost of warranty claims.

Even more thought-provoking, Zingales wrote a piece opposing the original Paulson bailout plan, entitled “Why Paulson is wrong.”

Recognizing that our financial institutions can not afford the often long and drawn-out chapter 11 process, he advocates “cramming down” a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants.  In other words, Congress should pass a law allowing failing financial firms to initiate a quick bankruptcy (which would not trigger any defaults in loans) whereby partial debt forgiveness or a debt-for-equity swap is mandated.  The government could entice failing firms to enter this restructuring process by cutting off access to short-term debt windows.  This process would leave the taxpayers out of the picture, and avoid a long chapter 11 process.  Deposits would be exempt (so not to burden main street), as would credit default swaps (so as to avoid getting caught in the tangled webs that have burdened the Lehman Brothers bankruptcy).

But if this plan is so simple and at no cost to the taxpayer, why no expert has mentioned it?  I’ll let Zinglaes explain:

“The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition.

The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is
difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. 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? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.


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