One of the many outrageous elements of the bailout is that as far as I can tell, all those Wall Street guys who paid themselves millions of dollars in bonuses for pushing this garbage paper back and forth are going to be able to keep all that money and their houses in the Hamptons. I have no problem with people making money, but only if they are going to have to eat the downside risk too. And I'm including the 30 year old millionaires in this too, not just the kingpins (many who sucked their money out before the bubble burst). Its been remarked by many others, but what is going on looks like the kind of thing you'd see in Russia or some other crony capitalist country.
I understand that this is about preventing a liquidity crisis like that one that helped to cause and deepend the Great Depression, when bank failures resulted in drying up the very investment capital needed to reverse the economic slide. If there is a logic to this, I assume it is something like that. But it'd be nice if they'd find some way to make the bankers eat some of this loss.
One question I've been trying to figure out is what exactly the government is going to do with this paper. As I understand it, this has all come to a head because of the changes in accounting rules over the past few years which forces a more frequent updating of the valuation of assets. So in the past, the investment banks would have just held this paper on their balance sheets for an extended period of time until some of it got back into the money or was offset by other assets. Now, however, as I understand it, the day of reckoning occurs with greater immediacy, creating the crisis.
Functionally then, as I understand it, the government is going to essentially perform this function of holding the paper until some of it gets back into the money or rotates off the balance sheet.
Here's what I'm wondering though that I haven't been able to figure out (pointers appreciated for cogent discussions of this). Is there anything in the bailout proposal to prevent the following scenario. Investment bank sells its mortgages to the government. Government holds the mortgages until the emergency abates. Original sellers form a syndicate to buy back the paper that has value at a cheap price and then turns a profit off that. In other words, is there anything in the bailout that stops the bankers from making money both coming and going here--by getting the government to buy all the garbage now and then buying-back anything with upside value later? Who other than these same guys are going to be in a position to buy this stuff later?
I'm genuinely asking here--I haven't seen any discussion about this. It would be pretty gross if there is some way that they can make more money off this on the back end, but now that we know the way these guys operate my guess is that they are already figuring out how to turn this to their eventual advantage. If not this loophole, are there other obvious loopholes?
There is an old saying about the need to "save capitalism from the capitalists" and the close relationships between these big money operations like Wall Street and Fannie Mae on one hand, and the government on the other, is really quite revolting. It is infuriating that the when things are going good they jet around in their private planes but when things turn south they can get the government to bail them out on our nickle. Seriously, how about trying to find some way of making them throw a few million or billion into the pot for saving their hides?
Gary Becker's Doubts About the Wisdom of the Bailout:
I have resisted commenting in detail about the wisdom of the federal government's massive bailout of various financial institutions because most of the issues involved are far outside my area of expertise. For this reason, I have resisted using my perch at the VC to criticize what I consider to be a horrendous error by the administration that we will all pay for dearly over the coming years; in my view, the federal government should have allowed AIG, Bear Stearns, and other firms to fail, without any bailout whatsoever. I suspect (though of course I cannot prove) that any short-term damage from their failure would be more than outweighed by the longterm benefits of signalling that firms cannot rely on government handouts to compensate them for their mistakes. They will then have strong incentives to avoid overly risky investments and speculative bubbles in the future. Like co-blogger David Bernstein, I also fear the public choice effects of giving the executive a blank check to spend billions of dollars bailing out whatever firms they consider to be deserving of such largesse. There is an obvious risk of favoritism here, along with an even more severe risk that major firms will become dependent on government handouts over time.
Be that as it may, it turns out that Nobel Prize-winning economist Gary Becker has some of the same concerns as I do; and he surely has relevant expertise that I just as obviously lack. Although Becker has "reluctantly concluded that substantial [government] intervention was justified to avoid a major short-term collapse of the financial system," he criticizes the federal government bailout effort as follows:
Still, we have to consider potential risks of these governmental actions. Taxpayers may be stuck with hundreds of billions, and perhaps more than a trillion, dollars of losses from the various insurance and other government commitments....
Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.
The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.
Various other mistakes were made in government actions in financial markets during the past several weeks...
As they say, read the whole thing.
A Simple Argument Against the Bailout:
Economist Steven Landsburg, writing for the Atlantic, presents what seems to me a simple, but powerful argument against the bailout. I don't know enough about finance economics to be sure whether it's right. But I thought that it's at least worth passing along to our readers. Even if it doesn't succeed in proving that no bailout at all was necessary, it at least casts doubt on the need for a plan as massive as the $700 billion monstrosity that the administration is trying to ram through Congress:
What's clear is that a bunch of financial institutions have made mistakes and lost money. What's unclear is why anyone (other than the owners and managers) should care. People make mistakes and lose money all the time. Restaurants fail, grocery stores fail, gas stations fail. People pick the wrong stocks, they buy the wrong cars, and they marry the wrong spouses without turning to the Treasury for bailouts.
So what's special about banks? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt.
Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.
That's one reason I feel squeamish about the official pronouncements we've been getting. They tell us bank failures will make it hard to borrow but never that bank failures will make it hard to lend. But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically. This makes me suspect that the official pronouncers have not entirely thought this thing through.
In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent. Second, as any user of match.com can tell you, the technology for finding partners has improved since then. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad?
Ultimately the key question is this: why shouldn't these banks be treated like any other business whose management has displayed bad judgment and lost a great deal of money as a result? Capitalism works because we insist that businesses bear the cost of their own losses, a process that gives them strong incentives to make good decisions and transfers their wealth to others with better judgment if they persist in screwing up anyway (as the big banks have done in this case). Perhaps really big banks are somehow special and deserve bailouts that we would deny to other businesses. But there is a heavy burden of proof on those who claim that this alleged specialness really exists and that it justifies hundreds of billions of dollars in public expenditures, unchecked executive power, and unprecedented control of the economy by the federal government. Like Landsburg, I am skeptical that the burden has been met.
The One Percent Doctrine and the Financial Meltdown.
Ilya, citing a column by Steven Landsburg, asks why a bailout is necessary. In Landsburg’s words, “Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.” That’s the question and the problem with answering the question is that no one knows the answer. History suggests, however, that the probability they won’t “find each other” is not zero; let’s call it one percent. If there is a one percent chance that the current financial meltdown causes a catastrophic outcome—not just people out of work and the reduction in the standard of living, but predictable bursts of xenophobia, beggar-thy-neighbor policies, global political instability, and all the rest—how much should the government do to prevent that from happening and at what cost? Does this question sound familiar? What about the government’s answer?
Do Low-Probability Catastrophic Risks Justify the Bailout?
Co-blogger Eric Posner writes:
Ilya, citing a column by Steven Landsburg, asks why a bailout is necessary. In Landsburg’s words, “Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.” That’s the question and the problem with answering the question is that no one knows the answer. History suggests, however, that the probability they won’t “find each other” is not zero; let’s call it one percent. If there is a one percent chance that the current financial meltdown causes a catastrophic outcome—not just people out of work and the reduction in the standard of living, but predictable bursts of xenophobia, beggar-thy-neighbor policies, global political instability, and all the rest—how much should the government do to prevent that from happening and at what cost?
Let's assume there is a small chance that, absent a bailout, there will be a "catastrophic outcome" of the sort Eric describes. That possibility is not by itself sufficient to justify the bailout. One also has to consider the risks of the bailout itself. Some of these are highly likely to happen, such as hundreds of billions of dollars of expenses borne by taxpayers, the creation of moral hazard for industries who will expect to be bailed out in the future, and the economic inefficiency caused by government control of a large part of the economy. In addition, there is a small but probably nonzero risk that the bailout itself might lead to a "catastrophic outcome" thatt goes beyond the onerous costs described above.
For example, despite the two year sunset provision in the draft legislation, that legislation might end up getting extended, leading to permanent government control of the finance industry, and an eventual monopolization of finance by government; a future administration could claim that the government cannot manage its massive portfolio of finance firms efficiently unless it has a monopoly of lending, and future, economically illiterate public opinion, might buy the claim. That in turn might lead to a severe permanent decline in our standard of living, as we spiral into quasi-socialism. By transferring enormous resources from successful businesses to failing ones, the bailout could also damage the economy enough to cause a deep recession, which in turn could lead to "predictable bursts of xenophobia, beggar-thy-neighbor policies, global political instability, and all the rest."
I don't consider these scenarios to be likely. But if we are going to justify the bailout by weighing low-probability catastrophic risks, we have to consider both sides of the equation. We can't defend the bailout by claiming that it might stop a low-probability catastrophic event without considering the possibility that it might itself become the cause of such a catastrophe.
There are low-probability catastrophic risks on both sides. When you consider the fact that the bailout also has severe non-catastrophic costs that have a very high probability of occurring, the case for it still hasn't been made.
A Bailout in Every Pot:
One predictable consequence of a massive bailout for investment banks is strong political pressure to provide similar handouts for others. The New York Times reports that big financial firms are starting to lobby for an even wider bailout than the already hefty $700 billion plan proposed by the Bush Administration:
Even as policy makers worked on details of a $700 billion bailout of the financial industry, Wall Street began looking for ways to profit from it.
Financial firms were lobbying to have all manner of troubled investments covered, not just those related to mortgages. At the same time, investment firms were jockeying to oversee all the assets that Treasury plans to take off the books of financial institutions, a role that could earn them hundreds of millions of dollars a year in fees. Nobody wants to be left out of Treasury’s proposal to buy up bad assets of financial institutions.
“The definition of Financial Institution should be as broad as possible,” the Financial Services Roundtable, which represents big financial services companies, wrote in an e-mail message to members on Sunday. The group said a wide variety of institutions as varied as mortgage lenders and insurance companies should be able to take advantage of the bailout, and that these companies should be able to sell off any investments linked to mortgages.
Congressional Democrats are arguing that the feds should bail out homeowners with mortgages they can't pay. Meanwhile, as George Will reports, the troubled auto industry also wants to get in on the act. No doubt, other industries will also try to get in line for their own handouts.
I realize, of course, that there are various arguments distinguishing the bank bailout from these other proposed bailouts. But as a matter of practical politics, it may be difficult or impossible for the federal government to resist the pressure. The general public is "rationally ignorant" about politics and economics and doesn't understand the subtle economic arguments that supposedly prove that the bank bailout is a good idea while other bailouts aren't. Many voters will think that if we are going to bail out a bunch of greedy Wall Street bankers, the "little guys" should get some goodies as well. The combination of ignorant public opinion and interest group lobbying will almost certainly ensure that this bailout goes far beyond its initially envisioned scope.
Senior Conspirator Eugene Volokh's classic article on "The Mechanisms of the Slippery Slope" is relevant here. We have a combination of what Eugene calls an "attitude-altering slippery slope" (a bailout for one industry makes public opinion more receptive to others as bailouts come to seem "normal"), an "equality slippery slope" (if banks get a bailout, many voters will think that "it's only fair" if industry X gets one too), and a "political power slippery slope" (as more interest groups become dependent on government largesse, the relative power of the pro-bailout groups will increase and that of their opponents will be reduced, thereby paving the way for further handouts).
These slippery slope dangers should be kept in mind as we weigh the potential risks of the bailout. They aren't the only relevant factor, but they do deserve greater consideration than they seem to have received so far.
UPDATE: As co-blogger David Bernstein points out, the homebuilding industry is now among those clamoring for a bailout of their own.
Bailout Quote of the Day;
Congressional Republicans have posted a far from impressive record in upholding free market principles in recent years. One of the few exceptions is Indiana Representative Mike Pence, who has the best short comment on the bailout I have seen all day:
"I must tell you, there are those in the public debate who have said that we must act now. The last time I heard that, I was on a used-car lot," said Rep. Mike Pence, R-Indiana. "The truth is, every time somebody tells you that you've got to do the deal right now, it usually means they're going to get the better part of the deal."
And, yes, I realize that the day is only 35 minutes old, so I'm incorporating all of yesterday by reference.
Economists Protest the Bailout Plan:
Numerous prominent economists on both the right and the left have signed this petition against the bailout plan proposed by the Administration (list of signatories available at the link above):
As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:
1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.
2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.
3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.
For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.
UPDATE: I have fixed the broken link to the petition.
Sliding Down the Slippery Slope Towards More Bailouts:
Recently, I warned that if Congress passes the Bush Administration's massive bailout plan for investment banks, we are likely to get more bailouts for other industries. It turns out that at least one industry - the Big Three Detroit auto manufacturers - have already gotten a bigger bailout than they would have otherwise. And that's just a result of the mere consideration of the administration plan (combined with the earlier Fannie Mae/Freddie Mac bailout); things will be far worse if the plan passes:
With Congress preoccupied with the massive, $700 billion bailout plan for the financial industry, General Motors, Ford, and Chrysler have finally secured Part One of their own federal rescue plan. A bill set to be passed by Congress and signed by President Bush as early as this weekend—separate from the controversial Wall Street bailout plan—includes $25 billion in loans for the beleaguered Detroit automakers and several of their suppliers. "It seemed like a lot when we first started pushing this," says Democratic Sen. Debbie Stabenow of Michigan, one of the bill's sponsors. "Suddenly, it seems so small...."
It might seem like a stealth rescue, but the plan has been in the works for at least 18 months. Approval for the loans was first included in last year's Energy Independence Act. Earlier this year, the automakers sought a first installment of loans totaling about $6 billion. But the nationwide credit crunch severely crimped their ability to borrow, and besides, next to bailouts like $200 billion for Fannie Mae and Freddie Mac, a mere $6 billion started to seem unduly modest. So Detroit raised the ante to $25 billion, the most allowed under current law.
Notice that the auto makers decided to up the ante from $6 billion to $25 billion in part because the Fannie/Freddie bailout made the former amount seem "unduly modest" by comparison. Similarly, Michigan's Senator Stabenow notes that the auto bailout "suddenly . . . seems so small" next to the Bush Administration's gargantuan bank bailout proposal. This illustrates two facets of the slippery slope problem I mentioned in my earlier post: First, the enactment (or even possible enactment) of one big bailout would lead other industries to step up their efforts to lobby for their own handouts. Second, the Bush proposal creates an "attitude-altering" slippery slope under which bailouts (especially those that are smaller in magnitude than the administration plan) come to seem "normal" to public opinion and are therefore less likely to encounter strong resistance.
Finally, it's worth emphasizing that, as the above-linked article points out, the current auto industry bailout is much larger and has fewer strings attached than the federal government's notorious 1980 bailout of Chrysler. At the time, the Chrysler bailout was highly controversial and took months of debate in Congress before passing. Today's much bigger auto industry bailout has drawn far less opposition - in part because we have slid so far down the slippery slope since them. Even worse, the current bailout is just the beginning for the Big Three. Next year, the article says, "[t]he automakers plan to ask the government for another $25 billion in loans . . . It's just spare change, after all." Compared to the proposed bank bailout, of course, it really is "just spare change." That's precisely the problem.
If we want to get out of this hole, a good first step is to stop digging. Sadly, the Bush administration and many in Congress want to do the exact opposite.
Cautionary Lessons from the Great Depression;
Joe Biden may have gotten a few factual details wrong when he urged President Bush to act like Franklin D. Roosevelt did when he sought to counter the Great Depression. But the basic sentiment that we should now follow FDR's example and take swift, decisive action in the current crisis is one that is widely shared.
In considering this view, it's worth recognizing that many of the massive, decisive government interventions that FDR and the New Deal Congress enacted actually made the situation worse. As I discuss in in this article, the administration and various interest groups used the crisis of the Great Depression to enact sweeping legislation that benefited themselves at the expense of the general public, sometimes in ways that made the crisis worse than before. In these efforts, they were abetted by voters' sense of desperation and widespread ignorance of economics and public policy. This made it easy to portray measures that benefited narrow interest groups at the expense of the general public as "emergency measures" needed to address the crisis.
Perhaps the most egregious example was the National Industrial Recovery Act, the centerpiece of FDR's 1933 "First New Deal" (discussed at pp. 649-55 of my article). The NRA (not to be confused with the National Rifle Association) established a system of cartels to raise prices and wages throughout nearly the entire nonagricultural economy. This benefited certain big business interests and unions, which were able to suppress their competitors. But it also had the predictable result of greatly reducing economic output and increasing unemployment, especially among the poor and unskilled who were already suffering greatly. Economists estimate that it reduced GDP by as much as 6 to 1l percent (pg. 650). Co-blogger David Bernstein points out in his book Only One Place of Redress that the NRA particularly harmed low-wage black workers and that it was supported by some white labor unions in part because they hoped it would stifle black competition. The NRA - the biggest and most ballyhooed of FDR's early New Deal policies - made the Depression significantly worse than it would have been otherwise.
The NRA was the biggest and most damaging of the New Deal's harmful interest group power grabs. But it was far from the only one. For example, all law students study the Supreme Court's decision in Wickard v. Filburn, which upheld the Agricultural Adjustment Act requirement that farmers limit their production in order to raise prices. Like the NRA, the AAA was a cartel scheme intended to raise prices in order to benefit big producers (AAA production quotas and subsidies were based on the amount of farmland each farmer owned, thus benefiting bigger producers who owned more land) at the expense of consumers and smaller competitors. The predictable and intended effect of the AAA was to raise food prices - this in the midst of a Depression when many people were already suffering from malnutrition and could not easily tighten their belts further.
The NRA, AAA and other similar measures were made possible by the crisis atmosphere of the time, combined with widespread political ignorance (discussed in my article) which made it difficult for voters to tell the difference between genuinely needed emergency measures and interest group rent-seeking masquerading as such. As a result, many policies were enacted that made the Depression longer,deeper, and more painful than it would have been otherwise. Today, even many historians sympathetic to FDR and his policies concede that they failed to end the Depression (unemployment remained in double digits until World War II) and that some of them worsened the lot of the poor and unemployed more than they helped. Econometric studies show that much of the increased government spending generated by the New Deal was transferred to politically powerful interest groups who could help FDR and his allies win reelection rather than to the poor and needy.
I don't claim that every aspect of the New Deal was harmful. Some parts of it were either beneficial or at least defensible given the information available at the time. Still, a great deal of extremely damaging legislation was enacted because powerful interest groups were able to exploit the combination of a crisis atmosphere and public ignorance.
Today's situation isn't exactly equivalent to that of the 1930s. The bank crisis is much less severe than that of the Depression and the bailout proposed by the Bush Administration is probably not as damaging as the NRA was. But we still could end up repeating some of the policy fiascoes of the Depression era, even if on a lesser scale. The history of the 1930s suggests that we should be skeptical when political leaders claim that we must act immediately to address an economic emergency - especially if they want to do so in ways that transfer enormous amounts of wealth from the general public to influential interest groups. Widespread political ignorance is still with us; indeed Americans' average level of political knowledge has risen very little, if at all, over the last fifty years. And political pressure to "do something" to alleviate the perceived emergency can easily be exploited by interest groups at the expense of the rest of us. Already, a variety of interest groups are trying to take advantage of the crisis atmosphere by obtaining bailouts of their own - just as happened during the Depression. We should do all we can to avoid going down that road again.
UPDATE: I have corrected a couple of typos, including one where I accidentally typed "NRA" when I meant "AAA."
UPDATE #2: I suppose it's only fair to point out that Joe Biden's remarks, linked in the first sentence of the post, only urged Bush to go on TV and explain the crisis (as Biden said FDR had done in 1929). However, this remark has to be considered in the broader context in which Biden and many others have been calling for swift government intervention similar to what was done in the 1930s. Biden has even expressed anger at John McCain for supposedly preventing the administration's massive bailout from going through fast enough. This last comment should not be read as an endorsement of McCain's own conduct, since he also strikes me as overly eager for a massive bailout.
Why the Stock Market Drop Doesn't Prove that Congress was Wrong to Reject the Bailout:
The stock market's record 778 point drop today will no doubt lead many people to conclude that the House of Representatives was wrong to vote down the bailout plan backed by both the Bush Administration and the Democratic leadership. Indeed, Senate Majority Leader Harry Reid has already made that argument. Here's why I think such claims are wrong.
What is good for stockholders isn't necessarily good for the economy as a whole. Normally, I'm not much moved by populist rhetoric about how the interests of "Main Street" are at odds with those of "Wall Street." This, however, is one of the rare cases where such cliches have a measure of truth. If Congress were planning to pass a bill providing, say, a $100 per share subsidy to stockholders at the expense of taxpayers, no doubt stock values would rise in anticipation and then fall precipitously if the plan were unexpectedly voted down. That is essentially what happened here. Many stockholders owned shares in firms that expected to be bailed out. In addition to the financial firms that would have been the immediate beneficiaries of the bailout, shareholders in many other industries could foresee a "slippery slope" under which their firms could expect an increased chance of a bailout for themselves. At least for the moment, this slippery slope has been forestalled. Naturally, shareholders are disappointed, and their stocks are falling in value. But the outcome is good for the larger economy because we will not have a massive orgy of wealth transfers from successful industries to failing ones, nor will we create a serious moral hazard by signalling that firms that make overly risky investments that fail can expect to be bailed out in the future.
Past history shows that stock market drops, even big ones, don't necessarily cause longterm damage to the economy. Today's drop in stock values, while the largest in absolute terms, is not even in the top 10 relative to total shareholder value. The 1987 stock market crash was much more severe - a 22.6% loss in share value on the Dow Jones in one day - three times today's 7% drop. Yet the economy recovered swiftly, in part because policymakers were wise enough to let failing firms go bankrupt and free up their resources for use by more efficient industries.
Even in the Great Depression, most economic historians agree the harm caused by the stock market crash of 1929 was not by itself enough to cause a severe economic downturn. Rather, the Depression got as deep and prolonged as it did because of a wide range of failed government policies, including a massive currency deflation, the Smoot-Hawley Tariff of 1930, and gargantuan boondoggles such as the National Recovery Act.
I'm not a macroeconomist. So I can't be certain that no government action is required by the present crisis. Perhaps a modest and narrowly-targeted intervention would be desirable. I do, however, have some expertise in political economy and public choice problems, and the just-defeated bailout has all the classic indicators of a massive interest group power grab in the guise of an "emergency measure." I also draw some reassurance from evidence showing that numerous prominent economists across the political spectrum also believe that the bailout is ill-advised and likely to cause more harm than good to the economy in the long run. What makes the present situation different from many past crises is that the power grab has - so far - failed.
UPDATE: University of Chicago economist Casey Mulligan provides a helpful summary of the reasons why the performance of Wall Street generally and finance firms in particular isn't a good predictor of the condition of the economy as a whole.
Let’s see, if markets around the world are capitalized at about $50 trillion and they declined, say, 5 percent on average as a result of Congress’s vote, then about $2.5 trillion of wealth vanished (okay, maybe a bit lower, according to Jim's account of Asian markets; the rest of the world looks less good). For the United States alone, the loss is about $800 billion. Even by Congress’s standards, this is impressive. Further thoughts –
1. Perhaps, the market’s response to the failure of the bill came as a surprise to some. Now that it’s clear what’s at stake, the world should be willing to pay up to $2.5 trillion to get Congress to change its mind. Surely this is enough? Intrade says no; I’d bet against it but I prefer to keep my money under my mattress, thank you. Anyway, the Chicagoan in me says that the market decline already reflects the probability that a subsequent bill will also fail or will come too late.
2. Ilya and Casey say that the bailout was just a transfer of wealth from taxpayers to shareholders. Maybe. But most taxpayers are shareholders, and the return seems pretty good. Even if we confine ourselves to the U.S. stock market, a return of $800 billion on an investment of $700 billion (actually, a lot less, given that money is used to purchase assets that will eventually be sold again even if at a loss) is not bad. If we count the world’s $2.5 trillion, the return is quite excellent. (I realize this is not a controlled experiment, but we have to use whatever information is available. As Ilya hints, he can salvage his theory by arguing that the failure of the bill tells shareholders that subsequent bailout bills, spending even more money, are less likely than before.)
3. Intrade says that Obama and the Democrats have benefited. That sounds right to me. The bill is identified with the Democrats, who crossed party lines to make a deal with the Republican administration. Nearly every knowledgeable person supported the bill – in the sense of believing that the bill was better than nothing, even if he or she believed that some variation would be even better than the actual bill. Republicans are seen as obstructionist, perhaps influenced by libertarian arguments they read on VC (just kidding).
No, the real reason for the no votes is that constituents of at-risk members of Congress don’t want to bail out Wall Street. Do these constituents have any insight into the risk that the current financial crisis will cause significant harm to the economy? I doubt it. Perhaps, these words should be carved into the entablature of the Capitol:
"We're all worried about losing our jobs," Rep. Paul Ryan, R-Wis., said, endorsing the bill and voting for it after leading a rebellion against an earlier version last week. "Most of us say, 'I want this thing to pass, but I want you to vote for it, not me,'" he said, speaking for colleagues who have tougher re-election fights than his own.
4. Can the administration be faulted for failing to make an adequate case for the urgency of the situation? Just how is it supposed to do that without being accused of exploiting people’s irrational fears in order to expand executive power?
5. If Congress is paralyzed, what can the executive do on its own? Where is that constitutional dictator when you need him?
Does the Stock Market Fall Prove that the Bailout Would have Been Worth it? - Round II:
Co-blogger Eric Posner argues that today's decline in the stock market proves that the bailout would have been worth the cost:
Ilya and Casey [Mulligan] say that the bailout was just a transfer of wealth from taxpayers to shareholders. Maybe. But most taxpayers are shareholders, and the return seems pretty good. Even if we confine ourselves to the U.S. stock market, a return of $800 billion on an investment of $700 billion (actually, a lot less, given that money is used to purchase assets that will eventually be sold again even if at a loss) is not bad. If we count the world’s $2.5 trillion, the return is quite excellent. (I realize this is not a controlled experiment, but we have to use whatever information is available. As Ilya hints, he can salvage his theory by arguing that the failure of the bill tells shareholders that subsequent bailout bills, spending even more money, are less likely than before.)
I continue to disagree, for several reasons.
First, as I noted in my original post, past stock market crashes show that the real economy isn't necessarily damaged as a result and can in fact rebound quickly if no harmful policies are adopted to prevent it. To use today's fall in stock values as an indicator of the costs and benefits of the bailout is similar to claiming that the similar 7% loss in stock value when markets first reopened after 9/11 was an accurate measure of the economic impact of that attack - while ignoring that the economy (and stocks) did well thereafter, soon recovering the loss. Sudden stock market shocks caused by uncertainty, disappointment (in this case, disappointment that stockholders won't get an expected bailout), and fear are not a good measure of longterm impact on an economy.
Second, as Eric suggests, I do indeed worry that the bailout would have caused other bailouts and government interventions that would put us on a path to significantly lower growth in the future. That really would damage the overall economy in a way that a sudden drop in stock prices doesn't.
Finally, much of the fall in stock prices may be due to the market devaluing assets (e.g. - bad mortgages) that had been overvalued previously. The bailout might have prevented or reduced such reconsideration because it would have artificially propped up the value of these overpriced assets by buying many of them up with taxpayer funds. More accurate pricing of assets is good for long-run economic growth and is likely to enhance our wealth, not reduce it. By pricing these bad assets more accurately, the market can facilitate the transfer of capital to other, better uses, making us richer in the long run.
UPDATE: I also respectfully disagree with Eric's claim that "Nearly every knowledgeable person supported the bill – in the sense of believing that the bill was better than nothing, even if he or she believed that some variation would be even better than the actual bill." A recent petition signed by over 190 prominent economists from across the political spectrum stated that the bailout plan "is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise." They also contend that "If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted." It sure looks to me like this large group of highly knowledgeable people don't believe that "the bill was better than nothing."
UPDATE #2: Co-blogger David Bernstein points out in an e-mail that the stock market often reacts favorably in the short term to any drastic action to control a perceived crisis. For instance, the Dow Jones saw a then-record one day increase when Richard Nixon imposed wage and price controls in August 1971. That euphoria faded as the true impact of this flawed policy became more clear over time. Today, few if any economists believe that Nixon's decision was a good one (many were highly critical at the time, too). Indeed, his policy is considered a grave error by most experts.
UPDATE #3: Jonah Gelbach at Prawfsblawg responds to this post, but mischaracterizes my argument. He claims that my position is based on the argument that "the stock market lost more in the crash of 1987" and "A recent petition signed by over 120 prominent economists from across the political spectrum" [expressing opposition to the bailout plan]. These points are not, of course, my main argument, which is that today's stock market crash does not prove that the bailout was a good idea because stock market conditions - especially short term swings - often don't reflect the underlying condition of the real economy. In this and the previous post, I give several reasons why that is true. The stock market crash of 1987 is just one historical example backing up the main point. Gelbach says nothing that disproves my more general arguments.
My citation of the the economists' petition merely serves the narrow purpose of rebutting Eric Posner's claim that "Nearly every knowledgeable person supported the bill – in the sense of believing that the bill was better than nothing." Gelbach does make a worthwhile point in noting that the economists' petition has been revised to state that "This letter was sent to Congress on Wed Sept 24 2008 regarding the Treasury plan as outlined on that date. It does not reflect all signatories views on subsequent plans or modifications of the bill." Fair enough. But the amended plan does not change any of the features that the original petition objected to: that the bailout "is a subsidy to investors at taxpayers’ expense" and that it "weakens" private capital markets through massive government intervention. The petition also objected to the original plan's seemingly excessive "ambiguity." But as Eric Posner points out, the amended plan actually gives the Secretary of the Treasury even broader discretion than the original one, thereby increasing ambiguity still further.
Thus, it is a reasonable bet that most if not all of the signatories oppose the amended bailout plan as well, or at least that enough of them do to undercut Eric's claim that "nearly every knowledgeable person" supports it as "better than nothing." Gelbach deserves credit for correcting the error about the petition. But the rest of his post isn't responsive to the real arguments that I raised in mine.
UPDATE #4: Gelbach has modified his post to emphasize that his point is that "serious people in the blogosphere are focusing on the wrong topic (the stock market)," which he believes is "remarkably wrongheaded." If a focus on the "stock market" is indeed "remarkably wrongheaded," it seems to me that any resulting blame attaches primarily to those raised the stock market decline as a defense of the bailout - not to those who sought to rebut that claim.
The Bailout and the Market:
Co-conspirators Ilya Somin and Eric Posner are having an interesting debate (see chained posts) about what the market's near-collapse does, or doesn't, show about the perceived virtues of the bailout bill. It's an interesting epistemological question -- a question about how we know what we know about the world from the evidence presented.
On an ordinary day (and on pretty much every ordinary day) there's a headline in (pretty much) every newspaper that looks like: "Markets Close Lower on Intel Earnings Warning," or "Market Surges on Oil Price Drop," or "Inflation Fears Spur Stock Sell-Off," or the like. It's all pretty much total hooey -- the fact that we see it every day sometimes makes it look like it means something, but it doesn't. The stock market moves billions of shares every day -- over 4 billion yesterday -- as a result of millions of individual trades (over 17 million yesterday). Those are very big numbers. The market moves as a function of the aggregate of each of those decisions. The idea that a reporter, sitting at her desk making a few phone calls, can understand the "why" behind anything other than a vanishingly small proportion of those trades, is nuts.
Back to Ilya and Eric's argument. It seems to me that the following statements are indisputably correct:
1. If traders believed that the government was about to enact a bailout bill that amounted to a naked transfer of wealth from taxpayer to shareholders [Ilya's position, roughly], and had traded in anticipation of such a bill, the market would fall calamitously when the bill goes down to defeat.
2. If traders believed that the government was about to enact a bailout bill that would save the U.S. economy from descending rapidly into a credit crisis of vast proportions [Eric's position, roughly], and had traded in anticipation of such a bill, the market would fall calamitously when the bill goes down to defeat.
I don't see any way to distinguish between those two hypotheses without asking a (large) number of yesterday's traders what they had in their heads, and why they made the trades they made (and even that, of course, is deeply problematical, given the enormous difficulties of getting any reliable information from surveys of that kind).