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10.01.08

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Phaedra

Photograph by Felipe Buitrago
ANSWER MAN: Stanford economics professor Jonathan Berk is livid that a petition signed by himself and other top economists was used to defend the rejection of the bailout proposal in the House on Monday.

Crash Course

Stanford economist says the government must intervene in the Wall Street collapse—but taxpayers shouldn't foot the bill

By Eric Johnson


AT 1:30pm Monday, Stanford economics professor Jonathan Berk walked out into the hall and announced that he was unavailable for a scheduled interview. He apologized and explained that he was in the midst of an emergency conference with colleagues from top universities around the nation, trying to formulate a petition to send to Capitol Hill.

Just two hours earlier, the House of Representatives had rejected the bailout proposal that had been hammered out over the weekend. In response, the Dow Jones average had already plummeted more than 600 points on its way to a record-setting minus-777 Monday close. During the deliberations, Republicans waved around a petition signed by this same esteemed group of economists as an argument for a "no" vote.

Berk was practically livid.

"The petition we wrote was in opposition to the initial administration proposal—not the one being voted on in the House," Berk said, standing outside his office at Stanford's Graduate School of Business. "Many of us were in favor of the proposal they turned down this morning."

Berk and his colleagues had fought over the petition for days and had finally come to a consensus position, sent to Congress last Wednesday, Sept. 24. The document was signed by 200 of the nation's top academic economists, including three Nobel Prize laureates. It specifically addresses the plan put forward earlier in the week by Treasury Secretary Hank Paulson and Fed chairman Ben Bernanke.

"We agree with the need for bold action to ensure that the financial system continues to function," it says, adding, "We see three fatal pitfalls in the currently proposed plan."

The economists called Paulson's plan unfair—a "subsidy to investors at taxpayers' expense." They deemed it fatally ambiguous: "Neither the mission of the new agency nor its oversight are clear." And, they concluded, it would "fundamentally weaken [private capital] markets in order to calm short-run disruptions."

The petition does not mention the House plan that was defeated Monday. And there is no way to read it as a manifesto against a government bailout.

The vast majority of American economists—Berk included—believe strongly that government action is needed. It's just that there were certain things about the Paulson plan that many of them didn't like. "Ludicrous," is what Berk says about the original idea.

"The final proposal was a lot better then the original proposal," Berk says. "A lot of economists were not particularly happy Monday."

Practitioners of the so-called Dismal Science are generally in agreement that the U.S. economy is in dire need of what they call "liquidity" (which the rest of us call cash). And the House bill would have injected a lot of liquidity into the economy—$700 billion worth.

A lot of economists believe that the Great Depression was caused when the Federal Reserve refused to pump capital into the suffocating economy. "Right now," Berk says, "we need the government to put money into the system.

"But not at taxpayer expense."


Desperate Measure

As this newspaper goes to press, it's impossible for even a leading economist to predict what will happen. Speaking on his car phone while driving home following a day of fruitless negotiations with his colleagues, Berk sounds frustrated, but says he remains hopeful.

While he is certain that a bailout is necessary, he is equally insistent that it needs to be modified to address the crucial fairness issue.

"The cost of the bailout should be borne by the people who are being bailed out," he says. "Not by taxpayers. One small change could solve that problem."

Only an academic would call this idea "small": Berk's plan—shared with some other forward-thinking economists, is to require the sellers of all "distressed assets" to indemnify the government against all losses. In theory, the government would be able to sell them for at least the purchase price. Crisis averted; taxpayers protected; no Wall Street fat-cats enriched at the public's expense.

Berk presented the idea for consideration in the emergency meeting Monday. "It did not pass," he says flatly. "We couldn't even agree on language explaining that our petition applied to the initial proposal."

On the basics, however, Berk insists that most economists are in agreement. "It's no longer a question of whether the government should intervene. The question is: When? Nobody serious believes the government has no role."


Beyond Regulation

When asked if Republican-driven deregulation is to blame for the current crisis, Berk is careful and specific. "The Bush administration has been very good at looking after the needs of the contributors to its campaigns," Berk says. "In that sense, they definitely deserve some of the blame."

While that sounds a lot like a liberal-economist's position, Berk does not go straight to the classic liberal solution. Regulation, he says, is not the answer.

"The problem with regulation," he says, "is that the people you want to regulate are incredibly bright, and they can get around any regulation."

The ultimate solution, he says, comes straight from Dismal Science 101.

"Incentives can solve the problem," he says. "That's what we teach in freshman economics. Incentives, incentives, incentives."

According to Berk, the investment-banking market took care of itself for a long time because the banks were all structured as partnerships, not corporations. In a partnership, the principal owners are personally responsible for their company's debts.

"If someone had a claim against any of these banks, and they ran out of money, any bank customer could go after each partner's personal wealth," he says.

Goldman Sachs was the last of the big investment banks to go corporate—it operated as a partnership until 2005. If that system were to return, it's likely that people and institutions would find it easier to once again trust the big banks. That would provide an incentive for them to once again act responsibly, Berk says, because it would fix the problem at the root of this crisis. The desperate shortage of liquidity is the direct result of the lack of trust, which has dried up credit.

Berk's proposal would also bring a degree of fairness back into the banking game by making the lords of finance, those who have gotten obscenely wealthy while creating this mess, responsible for their actions.


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