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The Economic Consensus v. Politics
The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization. Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself. Krugman would prefer a recapitalization in the form of nationalization. In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.) In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.
The consensus policy of economists would put most of the burden of adjustment on politically powerful holders of equity and bonds.
There is also a consensus among economists that the bailout bill is not the right policy. None of the above economists, for example, is enthusiastic about the bailout. My bet is that all of us think that the bailout has a substantial likelihood of failing. The support that exists is born out of hope and fear not judgment and experience. Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.
Addendum: Lynne Kiesling draws the Olsonian conclusion.
Posted by Alex Tabarrok on October 3, 2008 at 07:10 AM in Economics | Permalink
Comments
The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.
I guess this makes me the Richard Lindzen of economics. (Well, suppose I were a tenured professor at MIT. Then, if Alex's statement above is true, I would be the Richard Lindzen of economics.)
Alex, isn't it odd that your solution does not (apparently) have anything to do with what caused the financial crisis in the first place? In other words, if someone asks you, "What the #)*$# happened to get us in this spot?!" your answer would not simply be, "Oh, what happened was that everything was going well, and then all of a sudden the banks had no capital."
So it would seem to me that a solution that doesn't undo whatever it is that got us into this mess, at best will postpone the pain.
Posted by: Bob Murphy at Oct 3, 2008 8:41:25 AM
"The overdue collapse of the business of repackaging dubious mortgages, etc. hasn’t produced the economic recession that it might have. (People biting their nails over a possible collapse of some of our banks are just spoiling their appetite for mince pies. The governments of China and of the major oil producers – as well as many vulture funds - would be enchanted at a chance of buying up a few major Western banks. They have plenty of money available.)"
That is what I said late last November. The odd thing is that so little of the recapitalisation from these sources has happened. Too many bank mangements have refused to take the medicine. Is there now sufficient political, financial, popular (and international) exasperation to force them to swallow?
Posted by: David Heigham at Oct 3, 2008 8:44:41 AM
Before reading this blog further, spend some time to FAX or e-mail YOUR U.S. REPRESENTATIVE, ESPECIALLY IF THEY PREVIOUSLY VOTED NO.
Posted by: zbicyclist at Oct 3, 2008 9:16:09 AM
Bob Murphy:
I really should let Alex answer this but I guess the idea would be to implement a "conditional" recapitalization a la J.P.Morgan during the banker's panic of 1907.
Basically, all interested banks would have to open their 'real' balance sheets. Those insolvent would simply have to be put down, and the rest, after a write down of the most toxic/illiquid stuff in their books, would be recapitalized.
Why would this approach not be addressing the root of the problem?
Posted by: Jose at Oct 3, 2008 9:36:33 AM
I can think of another good scenario, that surely won't happpen.
The bill passes, barely, and the president does a turn-around and doesn't sign or vetos it. The president says something to the effect: "Congess has shown that they can work together and we will guarentee interbank lending. The current plan will take time to implement, I call upon congress to use this time to create a simplified plan better suited to the american people, without earmarks. And, to address the problem of default risk, the root cause of this problem, caused the lack of growth in energy supply. While we can not increase supplies to address this particular crisis, we can help ensure it won't happen again in the future. This cannot be done by America alone, but as America must lead the way, as it has been most reticent in developing production capacity..."
Posted by: aaron at Oct 3, 2008 9:39:15 AM
We do need to do something, but I have to agree with the above mentioned economists, this bailout bill is a disaster waiting to happen. I am a fan of auctioning off some off these banks to the highest bidders, if that is China then so be it, it might actually be more pollitically stable if China owned some US banks.
This bailout is simply put, government throwing money at something and hoping it goes away. This is the same scenerio as the economic stimulas package, we told them it wouldn't work but they wouldn't listen.
If this thing passes then we give almost ultimate power to a very select few. The president will have 100+ billion dollars to spend at his discretion, the oversight of this plan could be highly corrupted since it is very centralized.
Posted by: Torris187 at Oct 3, 2008 9:40:12 AM
Alex, can you please collectively get the attention of Greg Mankiw and get this in front of people who might have some sway.
Posted by: meter at Oct 3, 2008 9:43:20 AM
how hopelessly naive meter,
Peter and Alex have already done their part in earning the NYT money. They say the "paulson plan is better than nothing"!
This is what was required of them, all of the theatrics of holding the nose and putting forth semi-sensible alternatives is just a way for them to continue to lie to themselves and pretend that they didn't just help spread propaganda to create a financial czar for this country.
This is similar to a nazi prison camp guard who says he never enjoyed his job and he did try to tell his bosses about more humane ways to eliminate the undesirables from society.
Posted by: Gabe at Oct 3, 2008 10:04:36 AM
Wouldn't it make more sense to inject any new capital into the banks which have proved themselves to be prudent and well-managed, rather than the weak ones? If Joe's Auto Sales has been getting inventory financing from Last National Bank of Nowhere, why is it essential to preserve LNBN rather than putting more capital into the (better-managed) First National Bank of Nowhere and transferring Joe's business to that institution?
Posted by: david foster at Oct 3, 2008 10:08:31 AM
This bailout is a disgrace.
Recapitalize the insolvent banks, let their equity holders get nothing and their bondholders take a haircut.
The entire intention of the bailout is to give money to the equity holders so they don't get wiped out.
Disgraceful.
Posted by: Matthew at Oct 3, 2008 10:26:56 AM
I was ambiguous above. Urge your congressman to vote "no".
1. It might not pass. After two failures, perhaps there will be more thinking.
2. If it does pass, perhaps there will be more attention paid because the unpopularity will be clearer.
If we ever revise the constitution, there should be a big "restart" button added -- if 70% of voters hit that, the entire Congress would be replaced, with incumbents not able to run for the same office.
Posted by: ZBicyclist at Oct 3, 2008 10:50:00 AM
Actually, the point of the "bailout" is to replace illiquid assets with liquid assets. People get hung up on value when liquidity is the issue.
Posted by: Norman Pfyster at Oct 3, 2008 11:01:02 AM
More foreign ownership of financial institutions;
and expect government handling every generation.
In the past, America has given harsh advice to countries in financial crises.
To avoid hypocrisy, America should take their own past advice.
Taking that advice, it would become more like Mexico
with foreign companies owning 80% of its financial companies,
similar to David Heigham's comment above.
Shouldn't we expect financial companies to fail every generation?
Unlike other companies, financial companies face
interest rates rising above their previous loan rates, as in the Savings and Loan collapse.
Financial companies also face loans for assets rising in price,
but never knowing when those assets are over priced,
like the problem we now have.
These two problems characterize the financial industry.
So, we should expect government to face many failed financial institutions every generation.
Its universality is reflected over the years in many nations.
For a couple years, those institutions can't handle the flux in either interest rates or else asset values.
Does our economy function better by not institutionalizing
the necessity to handle many failed financial institutions every
generation, thus avoiding moral hazard?
Or should we institutionalize something like
putting many banks on government books for a couple years until interest rates fall,
or for several years until asset prices meet previous expectations?
Posted by: jamesonburt at Oct 3, 2008 11:01:24 AM
Our balance of trade problem means that foreigners have lots and lots of dollars that they want us to redeem. Since we can't sell stuff for those dollars, we borrow them -- we promise them they'll have more dollars in the future if they don't insist on something tangible now.
One of the main functions of our financial system is to take the money we borrow from foreigners and somehow distribute it into the US economy so that we can buy more imports with it and repeat the cycle.
But I believe that cycle is broken now. Why would anybody in their right mind lend money to the US economy, if they have any better choice? There's reason to expect more depreciation. Not counting the rise in 2008, In the last 5 years the dollar lost about 1/3 of its value against the euro, and 1/3 of its value against the hungarian forint. We haven't done so badly against the korean won, the syrian pound, or other currencies that are somewhat pegged to the dollar.
Unless we can get them to loan the money to us, we can expect a whole lot of devaluation. Our imports including oil get much more expensive while our exports go cheap. US standard of living drops sharply. And they won't want mortages, they'll want something safer.
Would foreign lenders accept T-bills at 5%? 6%? 7%? We can get them to take T-bills if the interst rate is right. But then we have to get the money out of the government and back to the consumers who buy the imports. How do we do that? Ah. We give it to the banks who used to distribute that money and let them do it again.
That way we can do business-as-usual for a little while longer. But foreigners aren't going to want so many of our dollars for very long, not without something to buy with them. We have to make fundamental changes. This only buys us a little time.
We might buy a little more time by cutting down our redwood forests. Does somebody want a board that's 100 feet long and 10 feet wide? We can provide it, for a little while. After the big redwoods are cut down and sold it will take us a thousand years or more to replace them, but we can do it once and get another short time of business-as-usual before we have to make changes.
Also our sigint is considered the best in the world. We could sell country A's decrypted messages to country B. If they trust us.
Anything else? China might pay us pretty well for taiwan, and saudi arabia might pay for israel, provided we could deliver.
But at some point we have to quit the stopgap measures and make some changes. We'd stop more than half the trade deficit if we didn't have to import oil. We could do that either with alternate energy or by doing without. Unless we develop alternate energy we will do without.
Posted by: J Thomas at Oct 3, 2008 11:08:26 AM
stop subsidizing fractional reserve(dishonest)banking. It is fraudulent to tell people you are holding their savings for them and they can demand them at ANY time and then to stick the money in illiquid loans. Fraud should be against the law. There are NO benefits to this activity. The new loans associated with the multiplier effect do NOT create additional wealth, they simply devalue the worth(currency) that people have earend by honest means.
Posted by: Gabe at Oct 3, 2008 11:13:03 AM
This is similar to a nazi prison camp guard who says he never enjoyed his job and he did try to tell his bosses about more humane ways to eliminate the undesirables from society.
Uh, no, it is not "similar." This is the kind of lame brained "analogy" that gets trotted out by folks eager to make something they object to morally equivalent to the Holocaust.
Posted by: at Oct 3, 2008 11:33:51 AM
It's even worse than most economists realize. If this bill passes, how is anyone who voted for it going to be able to resist more farm subsidies, national health insurance, more education spending, etc.? How do you respond to the charge that "Gee, you didn't mind bailing out your billionaire friends on Wall Street, but now you won't help (pick one: farmers, sick people, teachers, etc.)!"
And here is yet another reason the plan will fail. The stated goal is to get murky securitized mortgages off the books of domestic banks. But here are huge quantities of these securities overseas, and once the bill passes, they immediately become more valuable to domestic holders than to foreigners, which leads to their repatriation. We could easily end up with just as much junk on the books of domestic banks as we started with.
Finally, it bears repeating again and again there is no real evidence that banks troubles are hurting the larger economy. We hear plenty of anecdotes from people blaming their troubles on the credit markets, but the actual data contradict that. The Fed publishes reports on commercial paper issuance and bank assets and liabilities. The latest data show that nonfinancial CP outstanding was $199.1 billion on Oct 1, up from $162.7 billion at the end of last year. That's a 30 percent annual rate of growth. Furthermore, bank credit is also growing, from $9409.5 billion Aug 27'th to $9554.4 billion Sept 17'th. I'll be happy to wager anyone that the data to be published this afternoon will show continued growth. So what's the emergency?
Posted by: Jeff at Oct 3, 2008 11:34:58 AM
So, the problems have rippled on to money markets while Wells Fargo has bid for Wachovia. Has the wave moved on from what this bailout was designed for? If so, why not keep our powder dry? Sorry, no time for consistent metaphors.
Posted by: Andrew at Oct 3, 2008 11:36:45 AM
Wow the crazies shure do come out of the woodwork on this one. Nice post Alex I will now have something to say when people ask me what economists think of the bailout besides "I don't do Macro"
Posted by: goodnessOfFit at Oct 3, 2008 11:36:49 AM
Today, we learned that Wells Fargo is buying all of Wachovia, as opposed to Citigroup just buying its retail banking units. It looks like everyone, except for Citigroup, would make out better under this deal than than the Citigroup deal. It would require no FDIC backing or anything from any other government agency. I'm sorry if this a stupid question, but isn't the WaMu model and possibly the Wachovia model (depending on what company gets what) better because it allows the possibility of another firm deciding that it wants to buy all of or parts of a company? Wouldn't nationalization prevent that, or at least delay that from happening?
Posted by: Brian J at Oct 3, 2008 11:59:52 AM
Passions run high in the comments section regardless of the mastery those commenters have of the issues at hand. I lack passion on how certainly each plan, including inaction, is to ruin us. Reasonable (even brilliant) people can certainly approach the solution to this issue differently.
As I see it Paulson's plan is not inconsistent with recapitalizing the banks. With every widget that I buy I recapitalize widget makers. In other words, a business acquires capital through operations, through debt issuance, and through contributions from owners. Those who would recapitalize through taking ownership of the entities see that approach as importantly different from recapitalizing through taking ownership of distressed assets. I don't. And I leave it to the likes of Paulson to know where the greater value lies: in buying, restructuring, and selling at a profit a stake in these companies; or in buying, restructuring, and selling at a profit the distressed assets of these companies. A company is its assets.
Posted by: Matthew Petersen at Oct 3, 2008 12:32:41 PM
Agreed Brian J.
I just don't see why continuing along the path we have been on, including WAMU and Wachovia was such a bad thing.
The Fed and FDIC can handle failures to make sure we do not have a collapse of the financial system. Also the Fed can pump in liquidity to insure against deflation. Some banks need to fail and be gobbled up by other institutions. The financial sector and credit need to shrink.
The policy should be focused on seeing that this process does not lead to systematic risk. Not to insuring that banks don't fail or that lending rates stay low to borrowers.
Posted by: eccdogg at Oct 3, 2008 12:38:19 PM
Newt Gingrich argues persuasively for an immediate change in mark-to-market accounting practices. I don't see this idea discussed anywhere much and think it may be of distinct value.
Posted by: Sean at Oct 3, 2008 12:48:08 PM
Link to the Gingrich article:
http://www.forbes.com/opinions/2008/09/29/mark-to-market-oped-cx_ng_0929gingrich.html
Posted by: Sean at Oct 3, 2008 12:48:59 PM
Andrew and others.
The encouraging thing about Wells Fargo's bid for Wachovia is that they have bet the bank on raising $20 billion new capital. That means Wells Fargo management will pay the market price for that capital. This is a move that could break the log-jam.
Sean,
Abandonning mark-to-market accounting in the present situation would look like (and be) panic. It would be hiding from the unpleasant reality.
Mark-to-market needs amending to show the illiquid reserve that exists when market prices do not reflect amounts eventually likely to be realised , but that is a question to tackle in calmer times.
Posted by: David Heigham at Oct 3, 2008 1:35:34 PM
