Better Than a Bailout

Four steps policy makers could take to help financial markets

Philippe Lacoude & Veronique de Rugy from the January 2009 issue

What should the federal government have done in lieu of the $700 billion bailout signed into law by President George W. Bush? Here are four common-sense steps that don't involve the partial nationalization of the finance industry:

1) Raise the capital ratio for government sponsored enterprises and other investment banks to at least the level imposed on commercial banks—a cash balance of generally 8 percent of the market value of each firm’s tradable assets weighed for the risk of each asset. In a free banking system, there is no need for artificial, one-size-fits-all Securities and Exchange Commission rules. In such a system the amount of capital on hand should be left up to the banks themselves rather than government regulators. Sadly, we are not in a free banking system. We have a central bank, a lender of last resort, and not only does it implicitly guarantee certain banks’ losses but it won’t let them go under when they make mistakes, which creates some poor lending practices.

In this context, raising the reserve level would force institutions to have enough capital to face sudden increases in their default rates during tight credit markets. The bailout law does nothing to address this question.

2) Extend the capital gains and dividend tax cut past 2010, when it is due to expire under current law. This would raise the rate of return of financial assets at little cost to the Treasury and give a strong incentive to taxpayers to stay in or go back into the market.

3) Lift all Roth IRA contribution and eligibility limits for the rest of 2008. Because Roth IRA contributions are not tax deductible, this measure has no immediate cost to the Treasury, but it would likely pump billions of dollars into a tight market.

Such simple measures would have allowed the market to continue reorganizing its financial sector at absolutely no cost to taxpayers. That being said, if the president and Congress were dead set on directly injecting liquidity into the banking system, they still could have done so in a way that would have exposed taxpayers to far less uncertainty:

4) If Congress is absolutely committed to spending the bailout’s $700 billion, then it should send checks worth $3,600 to the 191 million U.S. taxpayers instead. Such checks would then have to be deposited into some type of retirement account or be subject to the Internal Revenue Service’s premature IRA distribution rules. The most risk-averse people would invest this windfall into relatively safe money market funds, thereby preventing the credit crunch predicted by the pundits. Some would buy instruments such as mutual funds, which would sustain the market. Savvier investors, or at least those with a high risk threshold, would profit from the low prices on Wall Street to purchase stock in distressed banks.

Such a measure would have proven popular with an electorate that does not trust the very politicians and technocrats who for years ignored the warning signs of a looming housing crisis. And it would have done so without socializing a big chunk of Wall Street, a risky and unprecedented intervention into markets whose full effects won’t be clear for many years to come.

Philippe Lacoude is the president of the consulting firm Algokian. Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

Comments

Lester Boe|12.31.08 @ 3:12PM|#

They could have given every American a $2,333.33 check.

|12.31.08 @ 3:13PM|#

Better yet, abolish taxes on dividends. There was a time when the way we judged a corporation's performance was on the amount it was paying in dividends. By double-taxation, the government has disconnected corporations from their primary duty, which is to pay a profit to their owners.

-jcr

|12.31.08 @ 3:24PM|#

Agree or disagree with the suggestions in the article, there is little doubt that there were other, better, and saner options to the government than what it has done, is doing, and will do.

As a consumer, I'm more "panicked" by the government's actions than I ever was by the failures in the marketplace. And I'm not even wearing my libertarian tricorne hat when I say that.

Reinmoose|12.31.08 @ 3:25PM|#

Such a measure would have proven popular with an electorate that does not trust the very politicians and technocrats who for years ignored the warning signs of a looming housing crisis

Tut tut tut... repeat after me:
"Nobody could have seen this coming"

Nick|12.31.08 @ 3:49PM|#

Fantastic article. Unfortunately, these ideas should have been pushed by Republican/Democrat opponents to the bailout and wasn't, leaving them all looking like obstructionists without solutions who don't care if markets collapse. I feel like opponents to the bailout should have been pushing better alternatives instead of simply opposing any form of bailout/rescue effort. 20/20 hindsight is wonderful, but frankly it's kind of too late now. Strangely, you'd thing these sorts of things would have been the first thing in the minds of the Bush administration as opposed to buying the equity of corporations...I guess I'm overestimating (for once) the mental capacity of the Bush administration people.

By the way, how about adding "Repeal Sarbanes/Oxley"? Surely taking that yoke off the back of companies financial and not would help the economy a great deal. I'm all for protection against corporate fraud, but that legislation is absolutely ridiculous and overboard.

|12.31.08 @ 3:58PM|#

Yes, where were alternative ideas when the World's Greatest Deliberative Body (ha!) and the other side of the Capitol Building were meeting to discuss the bailout? Why not tell the president to wait a month or two until they sorted it all out? What is the purpose of Congress if they can't even deal with this sort of issue? Or, in the alternative, explain why they shouldn't attempt to?

Limited government, checks and balances, and our very liberty are increasingly at stake when Congress does nothing to protect our rights or to limit presidential action. Mark my words, this is the beginning of the end if we don't stop allowing this sort of crap from occurring.

mark|12.31.08 @ 3:58PM|#

Raise the capital ratio for government sponsored enterprises and other investment banks to at least the level imposed on commercial banks

This would have worked in 2004, maybe 2005. Not an alternative to the bailout recovery package.

Extend the capital gains and dividend tax cut past 2010

What a weak idea. This would probably make markets go down in fear. jcr's idea of eliminating dividend taxes is better.

Lift all Roth IRA contribution and eligibility limits for the rest of 2008

This would be a huge giveaway to the rich, who could move all assets into a Roth and live tax free for the rest of their lives. It might buoy markets, I'll admit.

send checks worth $3,600 to the 191 million U.S. taxpayers instead

Not a bad idea. I'm not sure millions of people running around with $2500 to burn (after taxes) is a great way to foster financial responsibility.

|12.31.08 @ 4:06PM|#

mark,

I'm not sure where you were going with your last point, but, if I'm understanding you correctly, then we should take all of the money from consumers. 'Cause they aren't responsible and stuff. But the government, of course, is.

|12.31.08 @ 4:11PM|#

"By the way, how about adding "Repeal Sarbanes/Oxley"? Surely taking that yoke off the back of companies financial and not would help the economy a great deal. I'm all for protection against corporate fraud, but that legislation is absolutely ridiculous and overboard."

Absolutely. Ironically, SOX-type regulation often serves to shield fraudulent business practices with the defense of "But we were playing by all the rules!"

A much better system would be one where defrauders were held personally liable for all the defrauded parties' losses.

mark|12.31.08 @ 4:17PM|#

When Paulson requested the $700 billion, the idea was to stabilize credit markets by buying CDO's and other bad assets. His thinking was that with one targeted intervention, markets would go back to normal. Once this seemed like wishful thinking he started writing checks to anyone who showed up at the door. At that point Congress should have dramatically altered the bailout legislation.

What large-scale interventions could have stabilized markets without giving $700 billion to one individual? The Republican-offered insurance plan and repealing mark-to-market were good ideas. John McCain's plan to buy and reconfigure mortgages was a step in the right direction, I think. Since the underlying problem of the crisis was the housing market, why not intervene there? Congress could have passed a bill, for instance, promising to pay 80 cents on the dollar for all adjustable rate mortgages made in the 2000's, and then selling them back to banks. At least this would limit the intervention to a specific area (though the effects would reach all areas of the economy). It would be grossly unfair to some homeowners, but it would give banks a floor to stand on, and the ability to accurately price their stinky derivatives.

mark|12.31.08 @ 4:20PM|#

then we should take all of the money from consumers.

I never said that. I was just worried about all those checks going out at once. Cocaine prices would go through the roof!

Nigel Watt|12.31.08 @ 4:23PM|#

Mark, according to most statist economists, spending the money on cocaine would be great for the economy.

|12.31.08 @ 4:30PM|#

Legalizing drugs and prostitution might massively stimulate the economy, and it would free up a lot of money (now allocated to law enforcement) for government to spend.

Nigel Watt|12.31.08 @ 4:44PM|#

They would spend it on equally useless things, ProL.

|12.31.08 @ 4:47PM|#

Nigel,

I'm sure. It's just a selling point to the governments running around screaming how they'll have to free all the kids and prisoners and destroy our roads because they have no money.

|12.31.08 @ 5:02PM|#

We dumb libertarians just don't understand.

This was a crisis. In a crisis, it's better to rush into counter-productive, even outright destructive, half-baked "solutions" that will wreak havoc for years than to think things through and try to come up with a real fix (or not do anything, if there's nothing you can do to help).

At least if you're in office.

bill|12.31.08 @ 5:04PM|#

Don't you mean the 8.5 trillion dollar bailout? Since that is what has been handed out so far.

|12.31.08 @ 5:11PM|#

I've suggested this before, but the obvious solution is to declare, on July 20, 2009, that we own the Moon. Then we send bills to people for looking at it and for imposing their gravity upon it.

damn it all|12.31.08 @ 6:34PM|#

I would use it to fix my small truck, pay bills, buy food and keep the lights on.

What does it matter what people do with THEIR "3600$"? Its our money.

Maybe I'd be able to get new shoes.

CC|12.31.08 @ 6:47PM|#

"Legalizing drugs and prostitution might massively stimulate the economy"

Maybe. But it certainly would stimulate both my brain and johnson.

|12.31.08 @ 6:49PM|#

Changing the mark-to-market rules also would have been a good idea. It makes those un-marketable assets worth something on the books if for nothing than accounting purposes.

One thing that still perplexes me about all this is why no one is concertedly figuring out exactly what all these "toxic assets" really are, on an individual basis. Lots of these securities are still profitable to own in the long term, etc. But no one seems anxious to actually do the boring paperwork of unwinding these things to re-calculate what each security is worth.

Its the biggest reason I think we are still "flying blind" as a society in regard to the drag these securities have on the markets. It also is going to be a huge windfall for more savvy business-types who actually do the footwork on wading through these things and picking them up for a song where they find real value. At no time has Ben Graham's Mr. Market been so depressed and anxious to sell you something without Mr. Market having a clue what it may or may not be worth.

Travis|12.31.08 @ 7:46PM|#

"I was just worried about all those checks going out at once. Cocaine prices would go through the roof!"

A cocaine bubble would do wonders for our economy & for our South American friends.

Kolohe|12.31.08 @ 7:50PM|#

I like number 4, despite the social engineering side of it. (And on that front, it's not too much more onerous than the existing tax advantaged status given to various classes of investments) .

Number 2 may be a good idea but has little to do with the current situation.

Like others have said, #3 has the downside of being the biggest loophole in the history of the IRS. And more importantly, it confuses symptom with cause. The down market is a symptom of downward economic trends, and the underlying the underlying credit crunch, but not the cause. True, based on the business model of the modern banking corporation, there are feedback loops where the reduction in equity in the capital markets adversely affects the business. But regardless, raising C's et al stock price is not going fix the root cause of their problem - the balance sheets full of toxic waste.

And #4 seems to me worse than closing the barn door after the horse has left. It's like closing the barn door while it is still on fire and letting the building burn down. As mentioned above, raising capital requirements would have been a good idea three or four or more years ago, and would have mitigated a lot of the current mess. But now, the last thing should be to demand a increase in capital holdings. In fact, that's may be happening now with the first distribution of TARP funds - institutions are holding onto them to firm up the balance sheets and not lending.

Kolohe|12.31.08 @ 7:53PM|#

The last para should start "And #1 seem to me worse..."

Rose|12.31.08 @ 11:37PM|#

Kolohe's right. We should have done #1 a few years ago, but I don't think it will help now. I imagine banks will be quite a bit more conservative with leverage now at any rate.

Sending checks to taxpayers? Sounds a bit iffy. Has direct stimulation of that kind worked since 1964? I didn't get the impression that the authors were serious about that as a policy; it just seemed in the vein of "anything is better than the bailout we have."

Eliminating or cutting dividend taxes sounds sensible; we do need to encourage investment.

nobody u no and a big fan of j|1.1.09 @ 1:46AM|#

if only we had urban planning on a national level, like cuba, then we would have avoided this mess.

now we need a cra of martial plann proportions.

|1.1.09 @ 9:39AM|#

Thats easy, they should have been told to DEAL WITH IT! But, with Dictator Bush at the helm, once again Main Street America gets the SHAFT!

Jess
http://www.privacy.de.tc

|1.1.09 @ 9:43AM|#

Or, in the alternative, explain why they shouldn't attempt to?

Because they have no Constitutional authority to do so?

|1.1.09 @ 9:54AM|#

R C Dean,

Naturally, that would be my first choice. However, in this instance, I'd be happy if they'd just say there's nothing useful that they could do.

Ken T.|1.1.09 @ 10:06AM|#

Great Article.

I've been tossing this stuff around since the auto makers came in for their hand outs from Uncle Sam. What makes a company too big to fail? In the case of autos it really is the fact that the barriers to entry in the market are just too large to be surmounted. I'd like to see the government addressing these issues to make sure that in the next downturn there is no such thing as a company that is considered too big to fail.

What would that have meant in banking? I'm not sure, but something is wrong with the system if we can't let failed companies go bankrupt.

Besides, I might be interested in buying a Tata Motors Nano.

|1.1.09 @ 3:00PM|#

Dictator Bush swallowed my penis whole.

Jiff
http://www.iblowcock.u2.me3

DJF|1.1.09 @ 3:36PM|#

The problem with the original plan and all the other plans is that it treats failure as something that should be avoided at all costs. However failure is a vital part of the market and without it the market does not work. So the only thing government should have done is beef up the bankruptcy system with more judges and workers to handle the bigger case load. These banks and other businesses could then file for Chapter 11 or Chapter 7 or what ever other chapter applies and either been reorganized or their remaining assets sold off.

We certainly don't have any shortage of bad bankers or bad businesses in general and I see no reason to subsides the bad banking or bad business industry. Does anyone really think that leveraging yourself 30 or 40 to one using short term borrowed money so you can lend out long term is a good long term business model? If so you can go buy some Goldman Sachs stock. Does anyone think that buying bonds or CDS's or whatever which are so non-transparent that even the people who create them are not quite sure what they are worth is a good business model then if so I am sure that someone today is very willing to sell you some of those. Does anyone think that building huge amounts of "luxury" priced RE in an economy where average income has not increase a good business plan then I bet that your local RE agent is very happy to arrange so you can buy some

Heinrick|1.1.09 @ 5:07PM|#

"Because they have no Constitutional authority to do so?"

I honestly don't think that matters to most Americans anymore.

Elf Ninos Mom |1.1.09 @ 5:38PM|#

Elf Ninos Mom ("Last Free Voice") Is Tamara Johnson from Huntington WV

badda bing badda bang badda boom

allahu akhbar

Mike Farmer|1.1.09 @ 5:54PM|#

Crony-statism is so unattractive.

They could have given the money to Professor Irwin Corey to distribute and it would've been better than what they've done.

|1.2.09 @ 11:02AM|#

The "bailout" money should have been used to bailout FDIC, if and when that became necessary. The Fed should support FDIC, lending to banks that FDIC recognizes as solvent, with FDIC paying back the Fed, if FDIC is wrong. Again, the Treasury, and the U.S. taxpayer then, should "bail out" FDIC.

The GSEs should have been nationalized sooner, which means that the "bailout" would be of their holdings of bad assets. They shouldn't buy more mortage backed securites or collateralized debt obligations. I don't think imposing capital requirements makes sense. In the long run, they need to be wound-up and closed down. I think that this would be the wrong time to do it. Let them use government guaranteed debt to fund conforming mortgages until the crisis ends.

Undercapitalized, solvent banks, should have been able to use any new capital raised to meet regulatory requirements on new loans.

In effect, this reduces capital requirements on banks. The capital that they held against risk pre-crisis, has been partially used up by losses on the mortgage backed seecurities and mortgages. Requiring them to raise more capital against their existing asset portfolios doesn't make much sense.

Having the goverment purchase stock in the banks, increasing the bank's capital, so that the banks can meet the capital requirements that the government imposes, supposedly to protect the taxpaper from loss.. well, that is idiotic.

Insolvent banks should be closed by FDIC. Bondholders and uninsured depositors should receive equity positions in newly organized, well-capitalized banks.

The investment banks should have been allowed to fail. If they want to reorganize as commercial banks, that is fine.

FDIC should not have been allowed insured banks to bail out Special Investment Vehicles. Those holding the liabilities should have taken the losses.

Those holding balances in money market funds should have been allowed to take losses. The
only reason to have money market mutual funds is so that they can break the dollar.

Hold bank deposits if you want no risk of loss.

The regulatory policy here is for solvent banks and reorganized banks to expand to undertake all of the profitable intermediation that had been done by the shadow banking system (including investment banks) and the involvent commerical banks.

What I think the Fed and Treasury have been doing is trying to maintain the shadow banking system. That is, keep the market based upon securitized loans, asset backed commerical paper, and a vareity of deposit like investment vehicles going. Wrong approach.

The Fed should have kept total spending growing at previous trend. That is, at about 5% a year. Once the Federal Funds target hits zero, then watch the money multiplier and offset changes it it. If it looks like velocity is falling, increase the targets for the money supply.

The Fed should buy up T-bills, and if it runs out of those, it should stick to other short term, low risk assets, until it runs out of those. Hopefully, it would not need to go further. If the monetary base is hitting 4 or 5 trillion, and total spending in the economy is falling and won't rise. Then, it will be time to get creative.

The result of this policy would almost certainly be stagflation for a time. Inflation would be higher than 2% and the unemployment rate would rise. Resources, including labor, would need to be moved around. I have no idea really, how high the unemployment rate would need to go, but I am thinking not too high. As the malinvestments are worked out, the unemployment rate would fall and the inflation rate would come down.

The greater fools left holding the bag from the housing bubble would lose money. Hopefully there will be fewer myopic momentum traders in the future. The moral hazard from "too big to fail" would hopefully be reduced.

Oh, and the three bond rating agencies should all be sued, and they should lose those suits, and with all of their investors, both stockholders and creditors--wiped out.

I still support free banking. But, any fundemental reform should wait until after the crisis. When the memory of the stagflation is fresh, and the national debt and interest burden on the national debt is higher from the bailout of FDIC and the GSE's, then that should be the basis of a new system were this will be less likely to happen.

Jason Caucasian|1.2.09 @ 11:46AM|#

I totally agree! Irrelevant, computer-generated response!

Cunt
http://www.privaci.do.to

|1.3.09 @ 9:40AM|#

Where do you get these people? Certainly not from any credible list of libertarian economists. Like they couldn't figure out that even if the money was put into IRAs that it would still have to be printed and would still lead to massive inflation? Of course they didn't, because they Keynesians. Spare us this drivel.

Pete Muldoon|1.3.09 @ 4:47PM|#

In regards to the first suggestion, we should keep in mind that regulations that balance risk against cash require that we be able to measure risk. In the current crisis, all of our risk management systems failed.

I also believe that, while a perfectly free banking system may provide the greatest wealth in the long run, we have to remember that in the long run we are all dead. It's important to remember that maximizing wealth and maximizing happiness are not the same thing.