What to Make of the Financial Meltdown

What are we to make of the recent financial crises and the proposed solution to it?

I work with economics of a sort all the time, but what I deal with is the economics of price, supply and demand for product -- not high financial markets, interest rates and money supply. If, like me, you're trying to understand what's really going on (and you've caught on by not that very little said by political candidates at the moment is likely to be at all illuminating) the following are pretty good posts:

The Freakonomics blog at the NY Times provides a guess post on the meltdown. (H/T: Razib)

Megan McArdle also has some very illuminating posts on the topic:
How close was the financial system to melting down?
Why we need a bailout, even if not this bailout.
Even the easy answers aren't easy.

From what I can make out, one of the key things to keep in mind is that the crisis is not simply a matter of "bailing out" institutions which hold securitized mortgages. The issue is that although very few mortgages are actually defaulting, the knowledge that a number of them have or will has cratered the market for such securities. The institutions that hold these securities thus have assets which currently have no or little saleable value, even though if they continue to hold these assets they will pay off fairly well. However, accounting rules require that financial institutions value their investment assets at their current market value. This is causing massive losses in asset value for financial institutions, which then find themselves looking like increasingly bad credit risks as they seek short term loans to finance their normal cashflow. And yet they're already so heavily leveraged that if their debt ceases to roll over it can wipe them out -- taking down in the process the heavily interconnected web of other companies, institutions and individuals with capital invested in money market accounts.

The idea behind the $700B fund that Treasury Secretary Paulson wants is for the US government to buy many of these distressed securities allowing the companies that hold them to recover some measure of stability. The Treasury fund would then eventually sell the securities off again as it became clear which ones were good and the market for them recovered. By making sure that there remains a market for these securities, it keeps the whole edifice from coming down. (On why that's a good idea, go read Megan McArdle's posts.)

So it sounds to me like something like this bailout is probably necessary, and to the extent that it is, I would tend to follow Secretary Paulson's reasoning that the legislation setting it up should be short and clear.

Many on the left (Senator Obama among them) want to take the opportunity to put in some good "stick it to the rich" criteria, like only letting the fund buy assets from companies that fit congressionally mandated standards of not having "excessive executive pay", and also want to see "help the little guy" features that would help individual homeowners avoid being foreclosed on.

Many on the right are concerned about providing so much money and power to a treasury secretary -- who may well be replaced by an Obama appointee in four months depending on how the electoral winds blow.

And many in congress, on both sides, would much rather be able to oversee things themselves rather than leaving the decision-making to an appointee.

It's a messy situation which one wishes one were not in in the first place. I don't claim to have any insight into what the right answer is -- though my instict is that perhaps this is one of those situations in which putting the power in the hands of a few people (who aren't elected) might be safer than putting it in the hands of many (who are).

In the Roman Republic, they had a legal provision for installing a tyrant in times of national emergancy, who weilded absolute power for one year, after which power reverted to the Senate. That's always struck me as a very interesting provision, and one which is appropriate in certain kinds of grave emergency. Perhaps this is something of the financial equivalent.