Henry Paulson is Wrong

The decisions that Congress must make now will affect not only the US economy's short-term prospects, but will shape the type of capitalism that we will have for the next 50 years. For anyone who believes in free markets, the most serious risk of the current situation is that the interest of a few financiers will undermine the capitalist system’s fundamental workings.

CHICAGO – When a profitable company is hit by a very large liability, the solution is not to have the government buy its assets at inflated prices.  The solution, instead, is protection under bankruptcy law, which in the United States means Chapter 11.

Under Chapter 11, companies with a solid underlying business generally swap debt for equity.  Old equity holders are wiped out and old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt-holders can agree to reduce the face value of debt, in exchange for some warrants. So why not use this well-established approach to solve the financial sector’s current problems?

The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the current crisis has reached a point where time is of the essence. But we are in extraordinary times, and the government has taken and is prepared to take unprecedented measures. As if rescuing the big insurer AIG and prohibiting all short selling of financial stocks was not enough, now US Treasury Secretary Henry Paulson proposes buying up (with taxpayers’ money) the distressed assets of the financial sector. But at what price?

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