Degrees of Freedom

I am reluctant to weigh in on proposed solutions to the financial crisis, because Ben Bernanke and Henry Paulson are a lot smarter than I and have a lot more information than I. Based on publicly available information, I thought Fannie and Freddie would be OK (and in the end, I think there is still a chance that the conservatorship will actually benefit taxpayers), but it is now clear that public information was not sufficient for making a judgment.

But while Bernanke/Paulson have more information than the rest of us, they have no foundation for calibrating a model to inform them how to move forward. We are completely outside the support of the data. As Charles Manksi describes it so simply and eloquently, because we are in a world of Xs we haven’t seen before, we cannot possibly know how to relate those Xs to Ys. And so at the end of the day even our smartest policy makers must rely heavily on judgment. I am not reasurred when I remember that Isaac Newton lost a bunch of money in the South Sea Bubble .

I do think I support the RTC type plan that Paulson is proposing. My worry with it, however, is political more than financial. If we get the wrong sort of people (say those who went to grade school with the Vice-president, or those who were until recently running the interior department) running it in the future, it could produce cronyism and kleptocracy unlike anything we could have before imagined.