The Great Bailout Brouhaha

Free market economists weigh in on Paulson's plan


As Congress and President Bush set to "hammering out the details" of a proposed $700 billion bailout for investment banks, reason asked free-market-friendly economists three pressing questions: How bad is the current market situation?; how bad are the current proposed bailout plans?; and what's the one thing we should be doing that we're not?

Their answers are below. Reactions should be sent to letters@reason.com

Bryan Caplan

1. How bad is the current market situation?
To be honest, I'm not too sure. While we're blaming banks and investors for their "herd behavior," we should remember that politicians and the media often run with the herd, too. When the dust settles, I suspect we'll realize that conditions weren't as bad as people assumed—or at least they weren't until we tried to fix them.

2. How bad are the current proposed bailout plans?
Again, to be honest, I'm not too sure. The plans are creating a bad precedent—perhaps the worst precedent since the New Deal. But it's worth remembering that a "$700 billion bailout" doesn't literally mean that the government gives $700 billion to investors. Instead, it means that the government can buy $700 billion worth of assets; the transfer to investors is only the difference between $700 billion and the fair market value of the assets.

I should add, though, that I don't think the people spearheading the bailout have a clear idea about what they're doing either. They remind me of the old saying: "Something must be done. This is something. Therefore this must be done." I'm a former student of Chairman Ben Bernanke and his behavior during this mess has been a big disappointment.

3. What's the one thing we should be doing that we're not?
Waiting a couple of years. Unemployment is only 6.1 percent; by standard measures, we're still not in a recession. Even if you have no libertarian sympathies, shouldn't you at least give familiar, low-impact responses (especially standard monetary policy) before you throw caution to the wind?

Bryan Caplan is an associate professor of economics at George Mason University and the author of The Myth of the Rational Voter.

(Responses continue below video box)

Click above to watch economist Arnold Kling, founder of Homefair.com, Econlog blogger, and former Freddie Mac employee, talk about the bailout plan.

Robert E. Wright

1. How bad is the current market situation?
The current situation is potentially dire. The comparison with 1932-33 is sobering: An unpopular Republican president is in office, the financial system is a mess, and an important election looms, yet many fear what the articulate Democratic candidate might do if elected. We won't have to wait until March to find out this time around. But given how fast the world moves these days, late January will seem an eternity away. The payments system broke down last time (March 1933), necessitating a bank "holiday," a moving speech ("the only thing we have to fear is fear itself"), and creation of the FDIC (Federal Deposit Insurance Corporation). Breakdown of the payments system today would stagger the economy. During the Depression we didn't have to worry about hackers and terrorists but they must be salivating now. They will probably wait until after the election, but they will almost certainly try to kick us while we are down, just like they did during the last two recessions (1990 invasion of Kuwait and 9/11).

2. How bad are the current proposed bailout plans?
The current bailout plans are so bad it's impossible to tell just how bad they are with any precision. The devil, as they say, is hiding in details that are either undisclosed or will be concocted on the fly. For example, it is clear that some sort of tax will have to be placed on financial institutions that grow TBTF (too big to fail). If the tax is too high, financial services firms will stay small and the United States may lose, or be unable to regain, its competitive advantage in some important financial areas. If the tax is too low, financial services firms will merge and conglomerate at a rapid pace just to avoid "Lehmanasia" (euthanasia if they are not big enough to represent a systemic risk) during the next crisis. If the tax is just right, only those companies that need to be huge to compete internationally should be willing to pay it. The probability that regulators will get this and similar issues right appears small indeed given their track record.

3. What's the one thing we should be doing that we're not?
There are many things that policymakers are not doing that they should be. One is thinking long and hard about how to improve regulation. Clearly, both regulators and financiers need to know more about economics and financial history: Paying mortgage originators their full commission upfront was an affront to both theory (incentives matter big time) and history (the failure of six previous mortgage securitization schemes in the U.S. between the Civil War and World War II for the same reason). Equally clearly, compensation structures within financial services firms need to put much more weight on long-term or deferred compensation. Yearly bonuses may be appropriate for some (e.g. traders) but are clearly not appropriate for others (e.g. executives). Only then will managers eschew short term profits for long term gains, as they used to do when they were partners in private concerns.

Robert E. Wright is clinical associate professor of economics at New York University's Stern School of Business and the author of One Nation Under Debt.

Jeffrey A. Miron

1. How bad is the current market situation?
The current situation is serious, but not so much because the economic conditions are especially bad. The situation is serious because policymakers seem poised to undertake an enormous intervention that will have huge adverse effects and may well exacerbate the very kind of problem the intervention is meant to fix.

2. How bad are the current proposed bailout plans?
See #1. The bailout is a terrible idea. It transfers a huge amount of wealth to people who do not deserve it. It will generate enormous incentives for creative bookkeeping as the investment houses and banks try to rid themselves of any assets they do not want. The bailout fails to eliminate the crucial policies that contributed to and caused the current situation, such as the Community Reinvestment Act, the creation of Fannie Mae and Freddie Mac, and so on. Last but hardly least, the bailout sets a terrible precedent: If you take huge risks and become too big to fail, the government will bail you out.

3. What's the one thing we should be doing that we're not?
The only things we should be doing are eliminating the underlying policy causes of the current situation; see #2.

Jeffrey A. Miron is senior lecturer and director of undergraduate studies in the Department of Economics at Harvard University.

Chris Dillow

1. How bad is the current market situation?

No one knows! Our problem is one of Knightian uncertainty; we just don't know (and banks themselves don't know) what those illiquid mortgage derivatives are worth. If I were looking for comfort, I'd point out that the non-financial, non-housing economy has held up OK during the first 13 months of the crisis, so perhaps the linkages between the financial and "real" economy aren't as strong as feared. And there's some evidence that housing transactions are, at least, falling less quickly.

My problem is that, even before Lehman Brothers collapsed, the U.S. was likely to have a mild recession over the winter. The danger is that this'll increase risk aversion.

2. How bad are the current proposed bailout plans?
They're sub-optimal rather than terrible. It would be better if banks could be recapitalized either through debt-equity swaps as Luigi Zingales has suggested, or through a government order to stop paying dividends and hold rights issues, or through partial nationalization. I'm not so worried that the plan will cost taxpayers heavily—it might not—as by the social injustice of it. The welfare state seems more generous for bankers than for the poor.

3. What's the one thing we should be doing that we're not?
Apart from keeping our heads? Remember the distinction between capitalism and free markets. This crisis raises many questions about the merits of capitalism—and in particular the massive gap between ownership and control that afflicts quoted companies—but does not undermine the case for free markets.

Chris Dillow is economics writer at the Investors Chronicle. He blogs at Stumbling and Mumbling.

Frederic Sautet

1. How bad is the current market situation?
Very bad. It could be one of the worst business cycles since World War II or more. There is a mountain of malinvestments. This is coupled with over-leveraged investment banks and other financial institutions that have been using new financial instruments carelessly for a decade because of the perverse incentives in the system.

2. How bad are the current proposed bailout plans?
This is socialization of the banking industry, plain and simple.

3. What's the one thing we should be doing that we're not?

Getting out of the mess is not going to be easy. Once the perverse incentives are in the system, it's hard to go back. Bailing out is very bad and in the long run is worse than bankruptcy. It is not a coincidence that Paulson is the former CEO of Goldman Sachs and is now bailing out his friends. The problem is that bankers should be punished for their careless, stupid investments (JP Morgan, for instance, has $8.1 trillion in credit derivatives on its books), but since it was largely driven by the government's loose monetary policy and regulation, bankers are not the only ones responsible. Clearly letting the banks fail in the short run would have bad consequences for many households in the U.S. (and elsewhere). The problem is that the government does not have the incentives to intervene just for a short time. Once the banks are nationalized, it may take a while before the government leaves the place. Ultimately, this situation calls for radical policy solutions: The return to the gold standard and the abolition of central banks. reason should run a special issue on this theme.

Fredric Sautet is a senior research fellow at the Mercatus Center at George Mason University.

Mark Thornton

1. How bad is the current market situation?
I believe that the current state of the economy is worse than at any time during my life. Debt and future obligations of the federal government are daunting and the personal finance of the average American is extremely weak. The capital and financial imbalances in the economy are extreme. Ultimately this is due to the fiat dollar, fractional reserve banking, and the central bank (i.e., the Federal Reserve).

2. How bad are the current proposed bailout plans?
The actions taken over the last year and the pending bailout of Wall Street have not and will not help. They have made and will make the economic situation much worse. This is the exact same approach that took us into the Great Depression. There is no reason to expect the correct solution from the same people who created the crisis in the first place and who until very recently thought the economy was strong and that there was little or no chance of recession.

3. What's the one thing we should be doing that we're not?
The most important reform is to recognize the legal monetary status of gold and silver as intended in the Constitution so they can serve as an alternative money that is untaxed and unhindered by government interference. This would send a strong message throughout the world economy and begin to establish political pressure against monetary inflation and fiscal irresponsibility by government.

Dr. Mark Thornton is a senior fellow at the Ludwig von Mises Institute in Auburn, Alabama, and  the book review editor of the Quarterly Journal of Austrian Economics. His books include The Economics of Prohibition and Tariffs, Blockades, and Inflation: The Economics of the Civil War (with Robert B. Ekelund, Jr.). He is the editor of The Quotable Mises and The Bastiat Collection.

Yves Smith

1. How bad is the current market situation?
This credit crisis has already led to the biggest 12-month fall in household wealth in U.S. history, including during the Great Depression. It has not yet had a commensurate impact on economic growth because our foreign creditors provided what economist Brad Setser called "the quiet bailout," lending to us to the tune of roughly $1,000 per man, woman, and child. But it would be a mistake to expect this largesse to continue, at least at such favorable interest rates.

As Harvard University's Kenneth Rogoff and the University of Maryland's Carmen Reinhart found in their analysis of financial crises, every country that experienced a housing/bank crisis of the magnitude of the one we are in has suffered a marked fall in GDP. As they noted in their paper "Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison":

At this juncture, the book is still open on the how the current dislocations in the United States will play out. The precedent found in the aftermath of other episodes suggests that the strains can be quite severe, depending especially on the initial degree of trauma to the financial system (and to some extent, the policy response). The average drop in (real per capita) output growth is over 2 percent, and it typically takes two years to return to trend. For the five most catastrophic cases (which include episodes in Finland, Japan, Norway, Spain and Sweden), the drop in annual output growth from peak to trough is over 5 percent, and growth remained well below pre-crisis trend even after three years.

Note that their study shows the U.S. to be on a trajectory considerably worse than the average of the five worst cases, suggesting our fall in growth will be at least as severe. And no public official in the U.S. is willing to tell the public that no matter how this crisis plays out, we will suffer a fall in our standard of living.

2. How bad are the current proposed bailout plans?
Frankly, they are dreadful. First, let's focus on the aspect that should get the proposal dinged (or renegotiated) regardless of any possible merit, namely, that it gives the Treasury imperial power with respect to a simply huge amount of funds. $700 billion is comparable to the hard cost of the Iraq war, bigger than the annual Pentagon budget. And mind you, $700 billion is not the maximum that the Treasury may spend, it's the ceiling on the outstandings at any one time. It's a balance sheet number, not an expenditure limit.

But here is the truly offensive section of an overreaching piece of legislation: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

This puts the Treasury's actions beyond the rule of law. This is a financial coup d'etat, with the only limitation the $700 billion balance sheet figure.

Second, the eagerness to pass this measure and Sen. Christopher Dodd's (D-Conn.) improved variant is based on the faulty premise that this package will actually salvage the financial system. It won't. Trying to prop up asset prices at above market levels is destined to fail, and worse, only digs us deeper in the debt hole in the process, making the ultimate resolution of our economic mess even more costly and painful. We are not alone in this view. Virtually no economist is in favor of the program (save Alan Blinder). The University of Chicago even published an open letter with a long list of signatories against it. And commentary on econoblogs has been as close to unanimity as one sees in these parts against it.

All it will do is provide a short-lived burst of confidence. Then, as market participants think through its operation and ramifications, the anxiety and stressed conditions will return. How long will the false euphoria last? Two weeks to six weeks, I'd hazard. And worse, the existence of this program will block any other course of action being taken. It is so large and resource-intensive an approach that it precludes other remedies.

3. What's the one thing we should be doing that we're not?
There are no plans, zero, zip, nada, for better regulation and oversight of banks. Given that the credibility of the U.S. financial system is in tatters, and we continue to depend on foreign capital to fund our government deficit, which will only grow as a result of interventions already underway and whatever new program is passed, we need to take a cold hard look at how to improve financial industry regulation, particularly regarding murky over-the-counter markets. 

Curiously, the U.S. seems to lack the appetite for reform despite the havoc that deregulation and lax oversight hath wrought. But whether we are keen for it or not, it behooves us to move quickly to try to clean up our industry, if nothing else, to try to restore faith in our markets and institutions overseas.

Yves Smith has written the blog Naked Capitalism since 2006. She has spent more than 25 years in the financial services industry and currently heads Aurora Advisors, a New York-based management consulting firm specializing in corporate finance advisory and financial services.

Robert Higgs

1. How bad is the current market situation?
How bad the current situation is depends on where you find yourself in the market system. So far, the troubles are highly localized in certain financial markets and, to a lesser degree, in the housing and related industries. Financial institutions that made foolish bets—all of them more or less contingent on perpetually rising real-estate prices—are in deep trouble, but the overall financial scene does not look bad. Lending continues at high levels; credit is not "frozen," as the media keep insisting. Outside the financial sector, conditions generally look OK for the moment.

2. How bad are the current proposed bailout plans?
The proposals already accepted or likely to be accepted add up, not to a house of horrors, but to a Five Star Hotel of Horrors. The bite taken out of the taxpayers—$700 billion to start with—is a huge injury with virtually nothing of value in return. The implications for future conduct are horrendous. To the old "too big to fail" rule, the government is adding "too well connected to fail." Moral hazard will be promoted tremendously, not to mention that the government is resorting to outright socialism by taking ownership positions in rescued firms, as well as pursuing the usual economic-fascist policies of subsidies and bailouts.

3. What's the one thing we should be doing that we're not?
Who's we, white man? The government would do almost all of us ordinary people a favor if it merely refrained from what it's been doing for the past few weeks, and simply let badly managed firms go bankrupt. Capitalism is supposed to be a profit-and-loss system. Too bad the so-called capitalists and their lackeys in the government don't believe in capitalism.

Robert Higgs is a senior fellow in political economy at the Independent Institute and editor of The Independent Review: A Journal of Political Economy. He blogs on the bailout and other topics at The Beacon.

Mike Munger

1. How bad is the current market situation?
We stand on a knife's edge. If confidence erodes further, people will run for the exits. And there aren't many exits. This is not a deflation, or a liquidity shortage. This is a problem of insufficient equity to cover liabilities. Our government is treating this like a bank run, when the problem is that banks are holding worthless assets.

A bank run can be stopped by an infusion of credit and cash. But in an equity crisis, throwing in cash is just pouring money down a rat hole. Worse, we are taking money from the taxpayers who earned it and giving it financial agents who squandered it.

2. How bad are the current proposed bailout plans?
Very bad. And I am confident they will soon be much worse on the way to getting passed. There are two main problems. The first is that we don't know what we are doing. The effects of the bailout are as likely to be catastrophic as beneficial.

The second is that current deficits are future taxes. We aren't saving any money; we are just pushing our problems into the future. If we aren't careful, we might precipitate a run on the dollar, with people dumping dollar-denominated assets in favor of Euros. That kind of run, given the amount of debt held in foreign hands, would make the current crisis look like a cake walk. 

3. What's the one thing we should be doing that we're not?
Let the price mechanism work. High gas prices, for example. We are trying to bring down gas prices. But high gas prices limit demand, elicit new supply, and make alternative energy more profitable. Same with low prices on mortgages and other financial instruments. Buying up worthless assets is like trying to drink the ocean to stop a flood. You can't do it. Let financial firms, like AIG, take the hit, and build fire lines to contain the contagion. Guarantee the assets of the folks AIG owes, and consign AIG to the flaming hell it so richly deserves.

Otherwise, we will have class war. If my mortgage is more than I can pay, why shouldn't the government bail me out? If AIG gets the grease, so should I.

Mike Munger is the chair of the Political Science Department and a professor of economics at Duke University. He is also North American editor of the journal Public Choice.

Alex Tabarrok

1. How bad is the current market situation?
Very short term credit markets are in bad shape although bank credit has so far managed to stay high albeit with declining growth rates.

2. How bad are the current proposed bailout plans?
The disaster is not so bad that more thought about what to do would not be beneficial.

3. What's the one thing we should be doing that we're not?
To avoid a credit crunch we should be encouraging savings. I propose a temporary but strong stimulus to savings which could be implemented by a) making the Roth IRA tax deductible for a year and eliminating the income limits and b) eliminating for a period of time any taxes on interest. Increased long-term savings will help to alleviate the credit crisis by providing funds and reducing the maturity mismatch which is creating liquidity problems. In addition, long term savings are good for economic growth.

Alex Tabarrok, Associate Professor of Economics at George Mason University writes regularly at MarginalRevolution.com.