Don’t attack the shareholders

So says Ricardo Caballero, here is more:

First, a private sector solution to the current crisis requires fresh capital injections into financial institutions. However, in an environment of widespread uncertainty where the instinctive reaction is to run away from risk-taking, private capital is likely to remain on the side for much too long. Thus, the optimal policy response is to encourage and leverage private risk-taking, not to discourage it with a pending threat of exemplary punishment were a fragile situation turn worse, regardless of cause. Economic policy risk is compounding the private sector’s reluctance to capitalize financial institutions…

Second, during periods of high uncertainty and the potential for runs, large or coordinated shortsellers are more likely to succeed in triggering socially inefficient panic-selling. Rumor-mongering and persistent selling pressure eventually weaken wary investors and depositors. Unfortunately, by choosing to punish shareholders, Secretary Paulson has rewarded shortsellers and raised their ammunition to cause further financial instability.  Again, while shortselling plays a very useful role during normal times, it can turn into a source of instability during periods of high uncertainty.

Two points: first, if we are going to nationalize this argument implies we should do it quickly to avoid further hemorrhaging.  Yet the mortgage agencies are not quite proven to be unsalvageable failures (much as I opposed their initial creation that does not imply immediate obliteration as the proper current response).  Second, even if nationalization is the right response this time, it might not be the next time a financial institution gets into fiscal trouble.  Yet in that subsequent case nationalization will be that much harder to avoid, given the understandable fears of private capital if nationalization happens this time.  Every time you nationalize and wipe out shareholders, you create a dangerous precedent and scare away private capital for a long time.

You are probably reading lots of absolutist recommendations around the blogosphere but these are truly difficult issues and the correct policy responses are not obvious.