Column The new Washington Consensus

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: managing the portfolio of these loans. Thus the Fed would be a “buyer of last resort” of the tainted loans, essentially swapping the “toxic” debt with treasuries, shoring up public confidence in the system and reducing counterparty risk to unfreeze lending.

While this dialysis of the financial system provides a way out of an ever-widening malaise by flushing out the offending cells themselves, there are many things that can still go wrong. First, it is not clear if the disease has already caused organ failure. In other words, would the institutions be sufficiently capitalised even after the “toxic” debt has been taken out? Many have argued that the real problem is that of under-capitalisation of financial institutions, something that this package would not directly address. Next, a lot depends on the price at which Fed purchase of the tainted debt happens. If it is at the current distress-sale levels, that may not be much of a help to most players—many systemically large ones included. On the other hand, if there is a significant premium, it will have uncomfortable implications about the fairness of use of public funds. On the flip side, again depending upon the price paid and the future recovery of this sector, the agency created to manage this debt swap can potentially turn a nice profit for US taxpayers in a few years. Finally, the Congress may well have issues about the complete freedom from supervision sought by the Treasury, particularly given the uncertainties about the next regime.

Any government bailout of the private sector is fraught with what is known as “moral hazard”. In essence, it sets wrong incentives. Private players can now be reckless in their risk taking, enjoy the upside and expect to be bailed out if the bets go wrong. Given the systemic nature of the current crisis however, this is not the paramount concern now. Also, letting Lehman fail sent out a signal, that even in a crisis, no player is large enough to have a guaranteed rescue at public expense.