Can Mankiw be right?

I don’t often agree with Greg Mankiw, but in this case I do agree with two of his points, if not with his reasoning.

First, I think he may be right to say that the ‘key passage’ in Pres. Bush speech yesterday was:

as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back

It’s not key for the reason that Mankiw implicitly suggests: that it’s a correct assessment of the problem affecting the financial system. The suggestion in the passage is that the problem is all these sub-prime mortgages made to people who won’t be able to pay, and that they’re a small fraction of the mortgages in the securities the Paulson Plan will have US tax-payers take ownership of. However, the problem isn’t sub-prime mortgages, it’s the bursting housing bubble itself: falling house prices. That affects a much greater share of mortgages than just the sub-prime mess, because falling house prices makes it less likely that even people who can pay their mortgages will continue to do so, when the house is worth less than what they owe.

Second, I think he’s sort of right to say that:

one has to be at least a bit skeptical about the idea that government policymakers gambling with other people’s money are better at judging the value of complex financial instruments than are private investors gambling with their own.

Since these same policy-makers (Paulson, especially) have been consistently wrong about the economy, I wouldn’t trust them to bet $50 on the Super-Bowl for me let alone a trillion or so on the financial markets. In addition, Paulson, former head of Goldman Sachs, is just the type of genius that got the financial system to this mess in the first place. The markets certainly seemed to like the idea of Paulson’s bail-out. Let me suggest that the markets think that Paulson’s loyalties are with the markets, not with the tax-payers who employ him.


  • Tom, the two things you semi-agree with Mankiw about look to me to be contradictions of themselves. In the first, he says that the markets have irrationally underpriced these financial instruments. In the second, he says that the government’s people are less likely than private investors to correctly judge the value of these financial instruments. Is Greg Mankiw the only person, private or governmental, capable of accurately judging the value of complex financial instruments?

  • He may well think so. Of course, his two ideas aren’t necessarily contradictory. He may just be saying that Paulson & Co. might be EVEN WORSE than the already irrational private investors. I’d simply call it a tie and go home.

  • But by his logic, if the government takes equity in the bailed firms, then it is acting like an investor, rather than a lifeguard. That would–by Mankiw’s logic–magically make the government’s assessment of financial values more rational. Problem solved!