The blogospheric economists (e.g. Krugman, e.g. Atrios) have put out a lot of econobabble about why the Paulson plan can’t work. Having actually done financial statements, I can tell you why theoretically it might work.

Suppose a company holds assets that normally deliver a 10% rate of return. Under those conditions, they are valued at $100. Operating expenses are $10 and liabilities are $90. The firm is solvent and will remain so indefinitely since, in principle, it could sell off its assets, pay off its liabilities, and have cash in the kitty.

Now, suppose that 10% of the assets are impaired. For example, they represent a mine that has flooded and will take some time to pump out. When it is pumped out, its value will be fully restored. If it will be pumped out this afternoon, it’s worth full market price. But if it won’t be pumped out for 20 years, its value is only 64 cents–essentially zero– because these investors are expecting a rate of return of 10% (*).

Now, if the company had to sell its assets, it could only raise $90, an amount equal to its liabilities. Furthermore, with operating expenses of $10 and revenues of $9, it will be insolvent within one year. Any sane shareholder would dump his stock (making it impossible for the company to raise capital).

If the Federal government steps in and buys the impaired mine for $10, and the company buys an equivalent but unimpaired mine for $10, then the company is restored to solvency. The value to the federal government is actually much greater than 64 cents, since the Federal government is only looking for a return equal to T-bills, say 3%. Over an infinite period of time, the mine is worth $33, and losing 20 years of production only costs them $15, so the net value of the impaired mine is $18.

And that’s why the government can, theoretically, make money on what is a losing proposition to business. Whether the Paulson plan is good or not is yet to be determined–it really depends on how large a fraction of the assets are impaired to Level 2 and Level 3–but economists should ask their business school brethren before running on at the mouth.

As I commented to Krugman, the reason to be uneasy is not that this can’t work. It can. The reason to be uneasy is that the Administration is a bunch of steel-welded, road-tested, lying, incompetent weasels.

_________________________

Over an infinite period of time, an asset delivering $1 per year at a rate of interest of 10% is valued at 1/.1 = $10. But the value of the first twenty payments is $1 + $1/1.1 + … $1/1.1^20 = $9.36. So, if 20 payments are withheld, the asset is only worth 64 cents.