Academia debates whether Paulson bailout is the right course of action

More than 160 economists last week signed an open letter to the leaders of the U.S. House of Representatives and Senate expressing concern over the $700 billion financial-sector bailout plan.

Emanating from the lauded University of Chicago economics department, the letter criticizes the plan’s fairness, ambiguity and long-term effects. (Besides 44 Chicago school signatories, there were 14 from the University of Pennsylvania.)

The Chicago school pans Treasury Secretary Henry Paulson’s initiative as a “subsidy to investors at taxpayers’ expense.” The economists agree that “bold action” is needed to keep the financial system functioning, but this bailout isn’t it.

“We ask Congress not to rush,” it states.

I expressed some of the same worries last week about the pell-mell push this massive, ill-defined effort was getting.

And in response to my column, Villanova School of Business finance professor David Nawrocki told me that I and 166 economists are wrong.

“We need this rescue plan,” Nawrocki wrote me in an e-mail. “It is a bigger-scale problem than Resolution Trust … but it is basically the same issue.”

Nawrocki, like others, points to the success of the $125 billion Resolution Trust Corp. that cleaned up the mess left by the failure of dozens of savings and loans in the late ’80s and early ’90s. The federal entity took on the assets of those institutions, sold them off in a 48-month period, and disappeared.

To me, the big difference is that the Paulson plan would have the federal government buying bad assets from financial institutions that still have a pulse - good or bad - and sitting on them until it can auction them off. While we don’t have details of how the mechanism would work, it stands to reason that some “bad” banks would be able to whistle past the graveyard after littering it with their junk.

Is that a good idea? Shorn of the liabilities of their bad decisions, will those bankers suddenly make ethical and sound lending choices, once again lubricating the gears of the American economy?

Wouldn’t it be better to let the Washington Mutuals of the world fail?

Not to Nawrocki. He doesn’t see why any banks need to collapse. “I understand the natural evolution of value creation and value destruction, but I like the idea that a lot of people at the lower levels of these institutions still have a job at the end of the day,” he said.

Counter to the free market/no regulation crowd, Nawrocki said governmental intervention is needed to jump-start a market for assets that no one wants to touch right now. Only some federal entity willing to step up and buy mortgage-backed securities and other derivatives can begin to restore confidence, he said.

“Markets are powerful when they can do price discovery,” Nawrocki said. The trouble with a lot of the derivatives dreamed up on Wall Street is that they lack transparent secondary markets and that’s why no one knows what these “toxic” assets are worth.

He’s been telling his students since January that Congress was going to have to pass some kind of rescue plan. His estimate then was $400 million to $500 million.

Despite the poor sales job by Paulson and others on this rescue plan, the country can’t afford to wait, according to Nawrocki.

“We need the Paulson plan to start us out of this mess and then Congress has to revamp the whole market regulation process,” he said.

“We are not bailing anyone out. We are fighting for the survival of our credit market system,” he said. “Credit is needed in order to maintain a level of GDP - if the credit goes, the GDP goes. Very simple.”