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April 8, 2009 10:05 AM

Why the Geithner Plan is Good Medicine for the Banking System

By
Brad DeLong
(MoneyWatch)  One thing that has puzzled me has been why I find myself to be one of relatively few people who approves of the Geithner plan. I think that it not only has a good chance of improving the employment situation by boosting risky asset prices so that businesses have an easier time obtaining funding to make expansion profitable, but also that it stands a very good chance of making money for the government -- a lot of money.

As I see it, the appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets that other private investors will have to hold. And the sudden appearance of 5-10 different government-sponsored funds that make public bids for assets will convey information to the markets about what models other people are using to value assets in this environment. This sharing of information will reduce risk -- somewhat. When assets are seen as less risky, their prices rise. And when there are fewer assets to be held, their prices rise, too. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms.

As I see it, the problem with the Geithner plan is that it is too small: How is a $500 billion intervention supposed to change levels of asset prices in a $60 trillion world market? But there is a counterargument -- what Alan Blinder calls the mistaken-beliefs-of-the-Martians argument. It goes like this: If you were a Martian, and if you landed on earth and went to the Federal Reserve, and if you were told that the Federal Reserve planned to move short-term interest rates 0.25 percent and shake the structure of intertemporal prices out 30 years with a $2 billion purchase of Treasury bonds, you would not believe them: you would say that is much too small an intervention. Yet, in normal times, open-market operations work. And that gives us reason to think that the Geithner plan will work, too.

Follow Blog War over the federal stimulus package:

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