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September 24, 2008

Dr. Strangelove, Paulson, and the Face-Slap Theory

Dr. Strangelove: Of course, the whole point of a Doomsday Machine is lost, if you *keep* it a *secret*! Why didn't you tell the world, EH?
Ambassador de Sadesky: It was to be announced at the Party Congress on Monday. As you know, the Premier loves surprises.

-- Dr. Strangelove (1964)

Paul Krugman articulates something I've been saying for a few days now, and that I tried to say here in an earlier post. My guess is that Paulson believes that we have a locked market in mortgage-related securities, and, rather than bailing out every company in sight, he hopes that he and Bernanke can slap the market's face and get it moving again. Were that to happen, so the theory goes, much of the paper currently trading at absurdly low prices would spike higher, neatly allowing the market to solve its own insolvency/illiquidity problem -- without necessarily using all the capital in the TARP plan.

If true, that would also help explain the Paulson-ian aversion to preferred shares. Why complicate things if you actually think that a small injection of capital can restart the market?

It's a dangerous and interesting theory. If it works, he'll be a hero, having bailed out the financial sector speedily and inexpensively. If it doesn't work, however, it will mean we have poured billions of dollars into useless face-slapping with nothing to show for it, other than a badly-bruised and increasingly comatose patient.

In answer, however, to Krugman's point about being more transparent about the idea if that's really the plan, the answer is you can't. Because the face-slap only has a chance if you're not expecting it to work that way. In a Strangelove-ian sense, it's an anti-doomsday device, in that the latter only worked if you told people. This stops working if everyone knows.

Thoughts?

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