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Living on a prayer: It will take more than faith in Federal Reserve Chairman Ben Bernanke for the U.S. Congress to come up with a workable bailout plan.

Foreign Policy: As you might have heard, the United States is in the midst of a pretty nasty financial crisis. There’s a somewhat technical debate among economists as to whether we’re seeing an insolvency crisis or a liquidity crisis, and some would argue the real problem is a transparency crisis. What’s your take?

Raghuram Rajan: This might be a semantic issue. The real problem is, regardless of which theory you espouse, the financial system has too little capital and as a result is running into funding difficulties. And the response to that will be to shrink assets and therefore lending, which means we will see a credit crunch that can have a widespread effect in the U.S. economy—car loans, corporate loans, student loans, credit cards. The works.

That’s the fear, and regardless of whether it be because a portion of financial institutions’ balance sheets (I’m going to say banks because it’s easier) are illiquid, it means that those things can no longer be financed from the credit markets. They have to finance those assets with long-term capital, which leaves less long-term capital to finance their other assets. So, if you think it’s a liquidity problem, it immediately does imply a capital problem. And if you think it’s a capital problem—that is, they’ve had huge losses on their balance sheets from these illiquid assets—the conclusion is pretty much the same.

If you think it’s a complexity problem, you could argue that these bank balance sheets are full of stuff that nobody understands. But once you’re done separating out the portions that people don’t understand, you still have to find a way to pay for that stuff. The bank would be happy to separate that stuff out and put it somewhere else, but those are assets. It can’t sell them for nothing, and if it does have to sell them at a loss, it has to find a way to replenish the capital loss that has occurred as a result. So again, you come back to the fact that it’s a capital issue.

FP: A lot of people are saying that the only way the Bush administration’s $700 billion bailout proposal can work is if the Treasury Department or whatever entity it sets up overpays for these assets. Do you think that’s right?

RR: In a sense, that’s almost tautological. If in fact players were willing to take the market price that prevails today, they’d have sold those assets. It wouldn’t be a problem. But in some cases there is no market, implying that at the price that sellers want to get, there is no buyer. For many of these assets, the prices that prevail out there are very low but some of them are carrying them on their books at a much higher price. If institutions sold all their so-called toxic waste at those low prices, they’d have to mark their capital down to the price at which they sell. And many are unwilling to do that because they simply don’t have enough capital.

So, in order to get people to actually release those assets off their balance sheets, the Treasury has to pay more than the market value. Now, that’s not to say the market price represents the long-term present value of the asset, what Bernanke calls the “held to maturity value.” But that’s a notional value that nobody is willing to pay at this point, and even as the government, you’d be making up what that value is. You don’t know, because these are horrendously complicated securities.

FP: As you’re watching the discussion about the bailout plan, do you think people are asking the right questions?

RR: I’m seeing more and more of the questions floating out into the public arena. What I worried about was a plan that was accepted quickly and pushed through Congress on the basis that the alternative was some kind of Armageddon in the space of a few days. I think three actions by the regulators have bought us a little bit of time. First, guaranteeing the money-market funds. The second was taking some of the pressure off Goldman Sachs and Morgan Stanley by allowing them to become bank holding companies. And third, announcing the fact that the government was serious about fixing the system.

FP: And what do you think about the government’s bailout plan itself?

RR: It’s better to address the capital problem directly than to do it indirectly by overpaying for assets. You really are doing two things with this purchase: You’re trying to create a market for these assets, because the market for them is dead, and you’re trying to establish prices in that market that private players can latch on to. For that, you need to do things at the market price, not some hypothetical price that the government is willing to pay. The moment you do it at that hypothetical price, you haven’t helped the other private players, who have no intention of doing the things the government is doing. They don’t want to overpay, right? So, the whole notion of price discovery is at odds with this backdoor recapitalization.