My op-ed on toxic assets and the bailout appears in Mint today. You can read it here. The full text is also reproduced below.

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The financial crisis is largely a result of toxic assets held by banks. However, bailouts, originally designed to buy these toxic assets, are now trying to eliminate the liquidity crisis —but that’s only a symptom. The real problem is solvency.

Now in English.

Imagine that the string of monthly loan instalments one has to pay for a mortgage—the security for the loan—is akin to a string of pearls.

Banks dismantle entire necklaces, the pearls mixed up, repackaged into beautifully designed earrings or bracelets and sold to other banks. Let’s call them securitized mortgages. These new designs ensure high prices for pearl jewellery, often more than the value of the original pearl necklaces.

But some people offer fake pearl necklaces as a loan’s security. When the necklaces are dismantled, the fake pearls are mixed up with the real pearls and distributed across new pearl jewellery. Initially, no one knows that only part of their jewellery is real, but soon there are complaints regarding fake and missing pearls. Consequently, all the new pearl jewellery becomes suspect. Let’s call these toxic assets. Soon there is panic.

Since no one trusts the mixed- up pearls any more, the “fake pearl scandal” leads banks to stop lending money for home loans. Further, since banks raised cash by selling pearls, the banks have no money to pay people because the pearls have plummeted in value and banks are facing losses. This is our liquidity crisis.

In response, the government announces it will buy the fake pearls and will give banks money in return to continue their usual business. This is a bailout, or a substantial injection of capital.

Under the Term Asset-Backed Securities Loan Facility (Talf), the US government’s idea was to buy toxic assets from the banks with some private investors and sit on these suspect jewels for as long as it took for them to recover some value.

This is where the glitch began. The crisis was caused because banks could not assess the value of the pearl jewellery. The government faces the same problem: It has no idea how much it should pay for these toxic assets. Since the banks and the government don’t agree on prices, the government directly infuses capital into banks.

But more importantly, what makes these assets toxic? It is the prices at which pearls are currently trading—they are low enough to leave gaping holes in banks’ balance sheets.

This price reflects many things: if the pearl is fake, the level of risk and uncertainty in the pearl market, or other information.

So, are these “toxic asset prices” a good thing? Nobel Prize-winning economist F.A. Hayek would certainly think so. According to Hayek, the “most significant fact about this (price) system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action… Therefore, in abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned.”The price of the pearls is more than just what is on the sticker. Prices give away millions of small bundles of information to millions of individuals. If these prices are manipulated, or fixed by the government, they will distort the knowledge given by the prices.

Currently, banks want the fake pearls to be expensive: They want these assets to be priced higher in the bailout so that others believe them to be valuable and they receive more money. The government, even more wishful in its thinking, believes that buying fake pearls for enormous sums of money will give the banks the money required to trade in pearls again.

On the one hand, the government wants to take the toxic assets off bank balance sheets in exchange for money to be used to keep the bank afloat. But on the other hand, it tells the banks to trade with other banks with questionable solvency caused by the very same toxic assets. More importantly, banks have no ability to distinguish good assets from toxic ones, which merely means that the presence of liquidity does not solve the banks’ problem regarding lack of solvency, which can only be solved by the market.

What would happen if the government did not intervene? In this case the toxic assets would be valued in the market, leading to insolvency of many banks. On the one hand, the nature and cause of the insolvency will be exposed and the banks that are not facing the greatest threat will come to the forefront. This kind of information can only be gained in the market once the toxic assets and the banks’ balance sheets are correctly valued. The bailout, on the other hand, overvalues these assets in the hope that if they believe it is highly valued long enough, it will come true.

Therefore, the bailout money is a complete waste. It doesn’t get the toxic assets off the balance sheets. It involves the government directly running the banks. It does not tell banks anything about the nature, risk or uncertainty of the assets they hold. Nor does it solve the problem of solvency caused by the very same toxic assets. It only takes money from taxpayers and uses it for directly running banks, which then have a greater incentive to declare more assets toxic to get more taxpayer money.

This appeared in today’s edition of Mint in their Views Section.

Milton Friedman said, “….He may be a fool to drive that motorcycle without a helmet, but part of freedom…is the freedom to be a fool.”

So I wonder, Are we free to be foolish?

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The original purpose of laws was to prevent humans from infringing on another individual’s rights and liberty while exercising their own. So, any infringement on another person’s life, liberty and property in the broad sense became punishable by law so that men can coexist. The examples are obvious; theft, assault, murder, rape, fraud etc. These laws are absolutely essential for a free society.

The second set of laws, far more controversial, is those criminalizing acts which have no victims. Human acts which offend society in general or tarnish the moral fabric that a community seeks to preserve are also punishable. These laws detail what are also known as victimless crimes as there is no specific infringement on another individual’s life, liberty or property. These laws outlaw prostitution, suicide, drugs etc. In an ideal world, these laws shouldn’t exist and an individual’s rights must be supreme, but then that is in an ideal world.

While there is clear reason and purpose for the first set of laws to preserve order and uphold individual rights, and one could find religious or moral justification for the second set, there is a third set of laws which exist just to satisfy the whim of a nanny state, or in our case a mai-baap state, to protect an individual from himself.

The paternalistic state believes that people are fundamentally stupid and must be protected from behaving rashly, even if such behaviour affects no one else. The most obvious example of this is the helmet law, or the requirement to wear seat belts, which seems innocuous. But what happens when the paternalism is taken to a new level? By outlawing street food because it is presumed to be unhygienic? Or, in an outrageous example, the nanny state excluding the individual from litigation to protect one from one’s lawyers?

So, the real question is: Do we really need the state to protect us from ourselves or our foolishness? Or are we capable of evaluating the little risks we take to make our lives more pleasurable?

The helmet law or the requirement to wear a seat belt is an excellent example. But it doesn’t stop there. The Indian government likes to believes in the English notion of parens patriae , where the Crown is the protector of his subjects as a parent.

For instance, the West Bengal government attempted to outlaw hand-pulled rickshaws, to preserve the dignity of the rickshaw-puller and to give the presumption of a less disparate society. The rickshaw-pullers obviously oppose the law as they are happy pulling rickshaws and value their source of livelihood. But do they know better? Can they be trusted with preserving their own dignity? Was it not the actual father of the nation who said that all work is worship?

It’s not just rickshaw-pullers. Virtually all labour laws in India attempting to protect labour from the exploitative capitalist actually assume that every individual labourer is incapable of entering into a contract, being aware of the risks and rewards, and making a living. It takes away the right of two adults to enter into a mutually agreeable contract. Similarly, the government outlawed bar girls from dancing in bars to preserve the dignity of these women. What they did has put many thousands of women out of work and taken away their only source of livelihood. Did the bar girls weigh their loss of dignity against their livelihood? Or perhaps they felt no indignity in dancing to entertain at bars in the first place!

The Supreme Court, as always, has taken paternalism to a new level when it banned cooking on the streets by street vendors because street food, by default, is always unhygienic and citizens are too stupid to choose what to eat. We are all aware of the potential risk of falling sick eating pani puris on the street and yet we value the pleasure of a good, and slightly unhygienic, pani puri over the expected risks. But can we really be trusted with such an important decision?

Most of these instances may seem trivial to those who are not part of informal labour force, or who don’t enjoy that occasional pani puri. But sometimes paternalism in India takes on Orwellian forms.

The Indian government took it to a whole new level during the Bhopal gas tragedy case more than 20 years ago. It passed the Bhopal Gas Tragedy Act, 1985, which allowed only the state to sue Union Carbide.

The victims and citizens of Bhopal were not allowed to sue the company who took away the lives and health of their families and the prosperity of their city because the state felt that “ambulance chasers” would take away most of their compensation in legal fees. While the ambulance chasers might have taken away most of it, the government did an even more efficient job by taking away the entire compensation of most victims.

While each instance seems trivial, especially since it affects particular classes of people, there is a larger question at hand. Do we have the right to take risks that only affect us? Do we have the freedom to live our lives as we choose after weighing the risks, even if we are being foolish according to the government? And if part of freedom is the freedom to be a fool, are we free?

Shruti Rajagopalan is a lawyer and a writer.