The Democrats have made good progress in getting the Bush administration to move from the $700 billion blank check proposal that we saw last weekend. The initial draft agreement provides for some real oversight, restrictions on executive compensation, and an equity stake for the government in exchange for taxpayer dollars. It is also includes language committing the government to seek workouts on mortgages that will allow people to stay in their homes.

This is all great progress, however there is still much that is missing.

The limits on executive compensation are vague. It is not clear whose pay will be restricted and by how much. It is reasonable to ask that these terms be spelled out. When Henry Paulson became chief executive officer at Goldman Sachs, his contract didn't promise him "adequate compensation," it provided for a specific package of millions or tens of millions of dollars. This deal should include the same sort of specific provision on pay restrictions that business people negotiate when they make a deal.

The same applies to the rules on acquiring equity. Senator Dodd had a very reasonable formula in the proposal that he put forward on Monday. His plan called for the government to get $1.25 in equity for every dollar that we lose on assets purchased from financial institutions. This would be applied to the value of the equity at the time the assets were purchased so that if the stock price subsequently rose, the taxpayers would get the benefit of this increase.

We can quibble over the number, but not the principle. Warren Buffet didn't give $5 billion to Goldman Sachs for an unspecified amount of equity. He had a contract that gave him a specific stake in the company. That is the way people do business. Why wouldn't we expect that the government would have the same sorts of contracts when it provides capital to banks?

The bankruptcy provision that the Bush administration insists is a deal breaker should in fact be rather innocuous. It just changes one provision of the bankruptcy code back to what its pre-1991 wording. Under the proposed change, bankruptcy judges would be allowed to reset the terms of a mortgage contract just as they can reset the terms of a car loan, business loan, or any other debt.

It is bizarre that President Bush is telling Congress that he would rather allow the financial system to collapse than have the banks lose a few dollars due to this change. Remember, the vast majority of foreclosures do not involve bankruptcy (the share would increase with a change in the law). And even in the cases involving bankruptcy, judges are not going to just give away the house. We are talking about limited reductions in mortgage payments which in many cases may still give the banks more money than they would get from carrying through a foreclosure. And, over this President Bush is willing to wreck the financial system?

The bill also offers nothing by way of stimulus. This is important not only because the bill will not directly provide a boost to the economy, but the opponents of stimulus are sure to use the money spent bailing out the banks as an argument against another stimulus package.

In other words, putting stimulus in this bill is not just a question of treating the bill as a Christmas tree. If we spend $700 billion or even $350 billion to bail out the banks, it is much less likely that we will then be able to get the support for the stimulus needed to boost the economy out of recession.

This leaves the question of whether the Democrats can responsibly walk away from the bailout. This involves a tough call. The financial system was really shaken by the events of last week when Lehman Brothers went under and AIG was about to follow suit. However, Ben Bernanke and Henry Paulson were able to duct tape things together with the cooperation of the other major central banks.

The financial markets remain extremely unsettled and more bad news is a virtual certainty, but Bernanke and Paulson have lots of duct tape at their disposal. The sort of financial breakdown that we all fear remains a possibility, but my bet is that they will be able to deal with whatever crises develop.

Of course it would be better to have a more settled financial market, but this should not come at any cost. Furthermore, there is no guarantee that this package will fix the problem. As many economists have noted, the more obvious way to address the current situation is to directly inject capital into the banking system, something this proposal does not do.

There is one other point worth considering in assessing the responsibility of a walk-away strategy. Suppose the Paulson plan goes through. It is virtually certain that the economy will weaken further and the number of foreclosures and people without jobs will continue to rise.

This is the fallout from a collapsing housing bubble. Families that have seen most of their home equity disappear will feel the need to cut back their consumption and increase their savings. We have a huge cohort of baby boomers at the edge of retirement, most of whom who have accumulated almost no wealth during their working lifetime. When these families respond to their loss of home equity by cutting back their consumption it will deepen the recession.

In this context it might prove very important to have the resources needed to provide a substantial stimulus. In principle, even a $700 billion bailout package would not be so large as to preclude a further stimulus next year. However, there is no doubt that this bailout will make further stimulus much more difficult to sell politically.
In this sense it is hard to view supporting a bad bailout package as the responsible course of action. While the bailout may lesson a presumably small risk of financial breakdown, it could have the effect of making the recession much longer and more painful than necessary. This would not be responsible.