Toxic Assets Plan: a Good Buy, or a Good Diversion?

Treasury Secretary Timothy Geithner has just unveiled his new plan for a public-private partnership to buy up “toxic assets”. The government will provide a small amount of upfront money and a price floor guarantee to encourage hedge funds and other investors to buy up troubled assets. While economists debate if Geithner's new plan will work, an equally important debate is whether Obama and Geithner even believe it will work. I call these two possible views of the administration the optimistic and pessimistic strategy.

It is impossible even for economists and industry leaders (let alone pundits) to properly judge the new Geithner plan. Geithner has vastly unequaled access to important data. He has been able to examine the banks' balance sheets, talk with potential buyers, and he knows what government policy changes are likely to be in the future. While his plan may seem misguided now, it may be a very good investment because Geithner knows there will be a new trillion dollar stimulus bill, big change in money supply, or a massive home owner tax cut.

Given what limited information the public has to judge this plan with, it is impossible to know how much stock the Obama administration puts in this plan working.

The administration may take the “optimistic strategy,” anticipating their plan will work. There will need to be some changes around the edges, and it will be months before the economy turns around, but for the most part, the plan is over. There will be no more need to focus so strongly on the banking sector, and Obama will be able to move on to his real agenda.

The “pessimistic strategy” is the idea that the administration expects this current plan to fail partly or fully. In that case, this is only a band aid plan. It serves two main functions. Obama may know that he will need to nationalize some of the big banks and does not have (or want to use) the political capital to do it now. After this plan fails, he will be able to go Congress and the American people claiming that he has literally tried everything else, and temporary receivership is the only option left.

The other purpose of a band aid plan would be to ease the passage of both his budget and health care reform. It may not be coincidence that the new toxic assist plan was unveiled right before the budget comes up for debate. Many fiscal conservatives are freaking out over the size of Obama's $3.6 trillion dollar budget, but $750 billion of that is money set aside for another potential bank bailout. If after unveiling this new plan the administration can claim it will not need all of the extra $750 billion, his budget drops from $3.6 trillion to $2.9 trillion. Overnight without cutting any programs, Obama's budget would become 20% smaller and would complete null and void the CBO deficit projections. The amount that is going to be set aside just for this year for another round of bank bail outs is roughly equal to the amount of new money need for health care reform over the next decade.