The Case for Doing Nothing

The only plausible argument for bailing out banks crumbles on close examination.

Jeffrey A. Miron from the August/September 2009 issue

(Page 2 of 2)

The empirical problem with the claim that bank failures destroy intermediation capital is that there isn’t strong evidence to support it. Some evidence does show a correlation between bank failures and declines in output. But since declines in output should lead to bank failures, we don’t know which is causing which. Thus, there isn’t much quantitative data showing that bank failures lead to a large excess loss, over and above what you would expect when a negative shock hits the economy.

Because housing prices have declined, some people and institutions are worse off. Maybe it’s the first bank in the chain that takes most of the hit. Or maybe the first bank passes some of the hit along because of its counter-party claims to some other bank. But that hit has to be taken. And in the U.S., it was a big hit indeed—plausibly several trillion dollars in housing wealth. The size of that loss doesn’t demonstrate a spillover effect; it just shows that somebody has to experience the loss that the economy has already taken.

Twisted Incentives

The problem isn’t only that the bailout wasn’t necessary in the first place. The bailout may have made the credit situation worse. When banks hear that the Treasury Department is dangling hundreds of billions of dollars out there to purchase their toxic assets, what are they going to do? Sell their assets for 20 cents on the dollar, or hold onto them in the hope that the government will eventually buy them for 80 cents on the dollar?

The moment Treasury Secretary Henry Paulson got in front of the cameras last fall and announced that we were on the brink of catastrophe, Wall Street was bound to freeze, because bankers wanted to figure out how much money was available and how they could get some. Let’s not realize any losses we don’t have to realize, they figured, because Treasury’s going to bail us out. 

Of course, the bankruptcy approach is itself messy, and there are some legal issues concerning whether existing procedures apply to bank holding companies or just banks. But what the administration should do now is stop giving banks money and start being open to the bankruptcy approach when existing law allows it. Further, the administration could push Congress harder to expand and clarify the FDIC’s receivership authority. As long as regulators keep giving banks money, nothing is going to clean the mess in the financial sector.

The latest government program, the Public-Private Investment Program, is just another handout to the banks. It sets up a system where a small amount of private money is combined with a small amount of government money and a big loan guaranteed by the government to buy the toxic assets from the bank.

So what are the incentives to private-sector actors? Well, they’re putting hardly any money in. If it turns out that the toxic assets they bought aren’t worth anything, they haven’t lost much. If the assets are worth a lot, they make some money. Either way, the Treasury Department is guaranteeing everything. Reasonable estimates indicate that these toxic assets are not worth very much, so this is just another way of transferring resources to the banks by buying their toxic assets at inflated prices.

That’s not the only area where the Obama administration has twisted incentives. President Obama’s mortgage plan uses $275 billion in tax funds to help homeowners refinance and lower rates, to subsidize payments from borrowers to lenders, to get lenders to modify loans, and so on. It gives another $200 billion to the government-created home mortgage companies Fannie Mae and Freddie Mac. This is exactly the wrong approach.

The aim is to reduce foreclosures, so the delinquent or nearly delinquent borrowers can stay in their homes. That sounds like a laudable goal, but it ignores a fundamental reality: This money is coming from somebody else. So what the plan is doing is penalizing relatively responsible homeowners or renters—everybody who pays taxes—and rewarding those people who should have known, or at least should have had some inkling, that the loans they were being offered were too good to be true. This program creates exactly the wrong incentives for people deciding whether to borrow and whether to be homeowners.

More generally, it continues the policy of promoting homeownership. We got in this situation because the government wanted to promote homeownership. Until we create a situation where people make decisions based on their own resources and have to think about bearing the consequences of the decisions they make, the root cause of the financial crisis will only get worse.

Shrinking the Pie

Add in Obama’s $787 billion stimulus and his $3.6 trillion budget, and a picture emerges of an administration totally unapologetic about its designs to expand the size and scope of government. There is no question that the people advocating this spending want much more government intervention with respect to unions, energy, health care, infrastructure, and other areas. The crisis has given them the opportunity to ram through a bunch of things they’ve been pursuing for a long time.

As a matter of accounting, they are almost certainly understating the budgetary implications of their programs. Their assumptions about economic growth are optimistic relative to those of private forecasters. Furthermore, many of the items in the stimulus package that were supposed to be temporary are not going to be temporary. Thus, my guess is that deficits will be much bigger than the administration predicts.

The stunning thing about Obama’s spending proposals is that there’s almost nothing you could defend from the perspective of efficiency. It’s all about redistribution--not redistribution to the poor but redistribution to Democratic interest groups: to unions, to the green lobby, to the health care industry, and so on. At some point these everescalating government interventions will affect the size of the economic pie. If we start looking more like France, with more than 20 percent of GDP controlled by the federal government, output growth and economic freedom will all suffer.

The fundamental problem underlying the financial crisis was government policy. Instead of undertaking enormous new policies, we should try to fix or eliminate bad policies and focus on efficiency rather than redistribution. Doing nothing new and simply working with pre-existing procedures would have been much better than anything we’ve done so far.

Jeffrey Miron ([e-mail]) is senior lecturer and director of undergraduate studies at the Harvard University Department of Economics and a senior fellow at the Cato Institute.

Comments

|7.9.09 @ 3:22PM|#

I'm quite surprised that a CATO fellow is on the Harvard faculty. I thought that school was completely overrun with pinko rat bastards of the Keynsian orthodoxy. I guess there might be some hope for that school yet.

-jcr

SpongePaul|7.9.09 @ 3:23PM|#

Doing nothing would have been the only const. and the only American thing to have done, not stepping in like communist russia and spending taxpayer money to prop up failed dinosaur PRIVATE companies.

|7.9.09 @ 3:40PM|#

heh...the "do-nothing" approach applied to DC...we'll call it the "Tao of Congress".

|7.9.09 @ 3:45PM|#

Tom Woods has some interesting things to say about doing nothing.

-jcr

|7.9.09 @ 4:05PM|#

Is there a greater name in the universe than Elmo Studd?

IceTrey|7.9.09 @ 4:37PM|#

Illuminati or incompetence?

Invisible Finger|7.9.09 @ 4:47PM|#

The Legislative and Executive branches have done shitloads of stuff that adds up to less than zero.

mark|7.9.09 @ 4:49PM|#

If only they had given the people what they wanted back in 1994 we wouldn't be in this mess.

</|7.9.09 @ 5:03PM|#

How stupid is this?

Everyone knows doing nothing was not an option.

|7.9.09 @ 5:03PM|#

I'm no economist, and what Jeffrey Miron says about doing nothing sounds appealing and all, but I was under the impression that doing nothing was already attempted. Wasn't Lehman Bros. allowed to fail and it sent such shocks through the worldwide financial industry that the government had to step in to stop further such shocks? Am I completely out to lunch on that one?

yitzhak arod|7.9.09 @ 5:37PM|#

Well, I suppose if we had to do something, we could always try the Chinese method: having a couple of irresponsible CEOs rounded up and publicly shot as a warning to anyone else who wants to try these shenanigans. Short of that, though, I don't see why we needed to do anything else then, and I see no reason to do anything else now either. If anything, we should be actively doing nothing: that is, trying to prevent other people from "doing something" about the crisis. Specific examples: tell GM's executives to go to hell if they come begging for money, and send in riot police to crack a few heads if UAW protests over plant closings get too rowdy. Recession is when your neighbor loses his job, Depression is when you lose yours, and Recovery is when every "activist" and "community organizer" loses his.

kilroy|7.9.09 @ 5:51PM|#

Recession is when your neighbor loses his job, Depression is when you lose yours, and Recovery is when every "activist" and "community organizer" loses his.

I'm going to steal that.

DJF|7.9.09 @ 6:29PM|#

Actually doing nothing is not what would have happened. Existing bankruptcy and other laws would have been applied and incompetent/crooked banks would have gone out of business and their remaining assets sold off to pay creditors. Failed business practices would have been exposed and repudiated.

Instead the incompetent/crooked banks were bailed out and even today the FED and Treasury are attempting to prop up failed practices that got the economy into the mess its in.

As to shock waves, that is what is suppose to happen when you lose trillions of dollars. It is the feedback that the free market is suppose to learn from. Instead the only thing the banks have learned is to make sure they control the politicians and media

|7.9.09 @ 7:05PM|#

Grr.. I munged the link above.

Here's Tom Woods on "Why you never heard of the great depression of 1920":

http://www.youtube.com/watch?v=czcUmnsprQI

-jcr

Bruce Majors|7.9.09 @ 8:40PM|#

You simply don't understand how Keynesian policy works.

Paul Krugman has a nice power point presentationon it he did for the other 6 dwarves:

http://www.chilloutzone.de/files/player.swf?b=10&l=197&u=ILLUMllSOOAvIF//P_LxP92A42lCHCeeWCejXnHAS/c

Some Guy|7.9.09 @ 11:56PM|#

If elected, I would burn down the headquarters of Fannie & Freddie, and sow the ground with salt. I would require seppuku by the CEO of a bank as an application fee for a bailout. All applications would be denied. Every piece of legislation that had anything to do with "promoting home ownership" or "preventing foreclosure" would be repealed. I would tack on so many more requirements for TARPed up banks that they'd pawn their office supplies to try to pay the money back.

johnny john john|7.10.09 @ 6:17AM|#

Stimulus money is not meant to to just help the economy. It is meant to help people; its a form of socialism to give disaster relief to people when an economic disaster strikes. It is not made to be efficient.

In short: Liberals, democrats, and people in control don't give a shit about the economy. It's about the end goal: Keeping their constituents and voters happy by giving them relief.

Maybe the economy would do fine without stimulus. But more people would suffer in the short term without it. That is why stimulus exists!

Yes the bailout may not have been necessary. Disaster relief for Katrina was not "necessary". I'm sure everyone there deserved what they got when they didn't have hurricane insurance or whatever. But the gov't greedily redistributed wealth there to those black guys in New Orleans, huh? What an injustice! They deserved to die in the hurricane for their stupid mistakes for staying! (If you can't tell I'm being sarcastic...)

A T|7.10.09 @ 6:53AM|#

You give it to that straw man, johny boy!

johnny john john|7.10.09 @ 7:26AM|#

A T: yah you got me I didn't really read the article I just skimmed it. My bad. But there still are plenty of libertarians opposed to the stimulus...

Some Guy|7.10.09 @ 7:49AM|#

Disaster relief for Katrina was not "necessary".

At least giving out trailers and ATM cards doesn't cause hurricanes. Past bailouts helped cause this mess, and the new ones are going to cause another meltdown in a decade or two that makes this look like good times.

johnny john john|7.10.09 @ 8:38AM|#

Some Guy: Maybe you're right, maybe you're not. We'll see when the future comes.

Then again, maybe giving out trailers and ATM cards do cause hurricanes. Have you heard of the butterfly effect? Well this wasn't a butterfly, this was billions of pounds of equipment moving in and out of Louisiana. Point is that it's hard to prove your assertion "Bailouts will cause another meltdown". It's hard to predict the future.

Some Guy|7.10.09 @ 9:50AM|#

If the government would cover say 50% of your gambling losses but let you keep all your winnings, would you find yourself at the casino more often? I certainly would. Now explain how that is different from what is happening now, or why that wouldn't cause lots of people to gamble.

johnny john john|7.10.09 @ 10:40AM|#

Some Guy: I guess that's a valid analogy. I feel the difference is that it is "common knowledge" that you can never win at gambling in the long run and that the house has advantage for pretty much every single game. For most people in the world, they will lose in the long run in gambling. The state would be foolish to cover gambling losses.

However, unlike gambling, the state has a vested interest in encouraging MORE business, not LESS. Thus providing a safety net to business when times are tough is not a poor policy choice. When more people start gambling in business because of stimulus money or the promise of a safety net, economic activity increases.

|7.10.09 @ 1:12PM|#

Financial crisis...caused by bankers pumping loans to pump their own bonuses. Apparent failure to understand that the business model of a bank is to loan money and GET PAID BACK.
Securitization of said "loans" rated by "bond raters" that is required by law(moodys, fitch, S & P)that rated these "securitized" bonds triple A, even though they were 750K loans to farm workers who made 14K.
What to do.
Give money to the crooked irreponsible idiots who ran the banks and brokerages that got us into this mess. Keep the same dunces at the FED. Don't prosecute anybody (at a bank or a brokerage - thank God for Madoff, who ripped off 1 penny for every million lost by AIG)
Banks: Sounds good to us!!!

|7.10.09 @ 2:56PM|#

I wonder why we keep sidestepping much larger problems in the mortgage crisis. Creative mortgages (ARMs, interest only, 50-year loans, etc) allowed the housing market to do an end-run around supply and demand. If no one can qualify for a 30 year (or less) fixed rate mortgage to buy your home, then the price you are asking is too high. The market would have long ago corrected itself. But everyone involved made money either in interest or in fees for services for approving people who had no business buying a home or worse people who had no intention of living in that home and saw it only as a way to make a quick buck. I love making a quick buck myself but it was lunacy to believe (and plenty of us did not) that these kinds of price increases were sustainable. At some point the bubble was bound to burst. Add to that the securities based on loans that were given for no other purpose but to supply those securities (another part of the story not mentioned nearly enough) and the crisis was an inevitability.

I was for the bailout. I regret that now because the same people are for the most part still in charge and haven't learned a thing. Do whatever you want. Take whatever risks you want and not only will the government bail you out when it goes bust, you'll still get your 30 million dollar bonus. People only learn from mistakes if there are consequences to those mistakes. Otherwise they will keep doing the same thing over and over again.

No more.

Jesus|7.11.09 @ 6:56PM|#

"For the government to intrude into homeownership was an off-budget, nontransparent, backdoor attempt at redistributing income. And when the policy became a way of transferring income to people who couldn't afford those homes, it was doomed to failure. "

That's preposterous conspiracy theory nonsense blathered by the Rush's of the wing nut claptrap world. The banks weren't forced to give people that couldn't afford them home loans. There is no such law. The deregulation lead to exactly you might expect and exactly what the big banks and their government servants wanted. Stealing. We were stolen from and the "bailout" and followup "stimulus" package are just more of the same theft from scum bags that would be fearing a guillotine if this were late 1700's.