Wednesday, September 30, 2009

Bailouts book

Last night the Social Science Research Council launched Bailouts: Public Money, Private Profits last night at the Museum of American Finance. Below is the text of my short remarks.

Bailouts: Public Money, Private Profit

This book fits into the Social Science Research Council’s Privatization of Risk series because it is about how government bailouts, particularly bailouts of the financial system, shift the risk of speculative finance onto individual taxpayers. Such a transfer might not be such a bad thing if those taxpayers also reaped the benefits of that increased risk burden. But clearly they don’t. They are below the security market line, which is to say in the Sucker Land of high risks and low returns. They are certainly not in Warren Buffett-ville, which lies above the said line, and is where returns are high and risks low. I’m so certain that taxpayers are taking it hard and dry because nobody but nobody argues that we were better off economically for having a crisis and a bailout. Rather, the choice offered taxpayers was bailouts or breadlines, gratification of greed or Great Depression, transfer of wealth from the many to the few or poverty for all. Taxpayers were told to lose half their nest eggs or all of them. Yipee!

And that was the best case scenario. In their contribution to this volume, political scientists Guerillmo Rosas and Nathan Jensen statistically analyzed the economic effects of bailout activity worldwide since 1970. The subject is a difficult one to be sure but, in the end, they concluded that they could not reject the hypothesis that bailouts do not speed economic recovery. In plainer terms, they found no econometric evidence that bailouts help economies to rebound any faster than they would in the absence of bailouts. In other words, taxpayers may have just taken on a bunch of risk for no return at all, not even in the amorphous form of a quicker return to robust economic growth.

Their study concludes with the year 2007. At this moment, the most recent wave of bailouts appear to have worked in the United States and most other places but of course the situation remains fragile and fraught. It’s quite possible that we are experiencing a temporary lull in a protracted period of crisis, similar to the 1830s, 1890s, and 1930s. In fact, the most recent bailouts may have simply set the stage for the next crisis, which could take the form of another leveraged asset bubble gone kaplewy, a fiscal slash exchange rate slash inflation crisis, or both. If a dollar collapse sounds far fetched to you, check out page 32 of the October 5 issue of Forbes magazine, which I was somehow able to buy at O’Hare last Friday. It shows that earlier this year investors were paying as much as $100 to insure against the default of $10,000 worth of U.S. Treasuries. Before the failure of Bear Stearns, the going rate was only $10.

This Museum formed in reaction to the stock market crash of 1987. For many years thereafter, Fed chairman Alan Greenspan was lauded for saving the day. Almost a quarter of a century later, however, his actions now appear to have initiated a pernicious cycle of crisis followed by federal rescue in the form of low interest rates, easy loans, and other government interventions, with each crisis looming larger than the last. Over the past several decades, central bankers have proven that they can stop financial panics by indiscriminately lowering interest rates and flooding markets with cash. What they have not shown the ability to do is to prevent such actions from increasing moral hazard, which in this context means risk-taking on the part of financial institutions. The book therefore suggests that central banks ought to consider resuscitating Hamilton’s nee Bagehot’s rule and lend only on good collateral and at a penalty rate. That rule has the virtue of protecting the interests of taxpayers and limiting moral hazard. Of course its implementation would be more difficult than lowering some overnight interest rate target.

It’s true that the U.S. government has tried in the past to approximate Hamilton’s Rule but nearly all major bailout efforts throughout its history have run afoul political boobytraps and bureaucratic infighting. In his contribution to the book, financial economist Joseph Mason details the problems encountered by the Federal Reserve and the Reconstruction Finance Corporation or RFC during the Depression. Under Hoover, the RFC’s lending policies were conservative to a fault. Major reforms implemented under Roosevelt improved it, but according to Mason the RFC did not stop fresh banking panics from exacerbating the debt deflation spiral at the center of the downturn. At best, the RFC allowed for the more orderly liquidation of failed banks. The whole story sounds quite TARP-ish if you ask me.

Such pessimism about the efficacy of bailouts led Benton Gup in his contribution to this volume to call for the government to work harder and smarter, much harder and smarter, to prevent financial panics in the first place. We know in general terms why panics occur but foreseeing the triggers of the next crisis is devilishly difficult. Gup does a masterful job of describing the causes of past panics and the dubious effects of bailouts large and small, financial and non-financial, but doesn’t provide concrete guidelines for preventing future fiascos, which would be a daunting task.

In my contribution to the volume, I argue that we will not be able to make much headway on preventing panics until we learn to see that a wide gamut of dysfunctional economic activities, including those that led to the most recent crisis, were not caused by governments. Or markets. Instead, they were hybrid failures, or market failures like asymmetric information, externalities, market power, and public goods, complexly combined and intertwined over decades with government failures like inappropriate and ineffective regulation and highly distortionary taxation.

The biggest market failure was of course the housing bubble and it was a whopper. The major government failures were the mortgage interest deduction combined with retirement savings tax breaks, various affordable housing initiatives, and Too Big To Fail policy. None in and of them themselves were economy breakers but combined and magnified by time they became quite potent toxins indeed. Finally, the government-sponsored enterprises colloquially known as Fannie and Freddie, the cartelized credit rating agencies, and our nebbish-like corporate governance system epitomize hybrid failures as they lie squarely at the nexus of the government and the economy, of Leviathan and the market’s innumerable tentacles.
I don’t have the time to go into all the details now but feel free to explore hybrid failures in the q&a period and in the book itself.