Saturday, September 20, 2008

Deeper thought

Some details of the Bush administration's plan to save the world are being made public, and the numbers aren't too pretty. Essentially, the government wants to spend $700 billion buying up all the bad debt that is crippling private actors in the financial sector, like Bear Stearns, AIG, and Lehman Brothers. Theoretically, this should let the industry catch its breath a little bit, and get back to business, freed from the crushing burden of carrying all this junk and trying to do business in an illiquid market.

The government also imposed a temporary ban on short-selling; the practice of day traders selling large amounts of stock to drive prices down, and then buying it back at the lower price, which many believe contributed to the meltdown we saw last week.

The first question a lot of people have is likely this: With the US government already running massive deficits, how can it be justified in purchasing almost a trillion dollars worth of bad mortgages just to bail out investors and executives who made exceedingly poor decisions based on greed?

First off, let's be clear about one thing; the cost of this to the overall economy is already present. It was incurred when these loans were taken out in the first place; this is not new spending. With that said, the government did just take out an enormous amount of new debt, which is why they had to ask Congress for a new debt ceiling (from $10.6 trillion to $11.3 trillion). Dean Baker has a post up explaining this:

From an economic standpoint, the cost of the bailout was incurred when the
bad loans were made. That was when people built a home, borrowed for a vacation,
and spent in some other way that demanded real economic resources in the form of
newly produced goods and services.

When the government supports a bailout, it is not directly creating
demand for new goods and services. It is simply ensuring that money that we
thought was already there (e.g. funds in a money market account) does not
disappear through a financial collapse. No one is going to spend more because
their savings account did not disappear. (They obviously would have spent less
if their savings account actually did disappear.)

Paul Krugman also has a nice graph up showing where the money will come from:

Ultimately, it will move in a circle. The banks will sell their sludge at a marked-down price, and use the money to pay off their debts to their debtors, who are represented here by "Public". And these people will move their money into Treasuries, which the government will be issuing to pay for the bailout.

Next, yes, it does seem grossly unfair to bail out these firms with taxpayer money, but there are a couple things to consider. First, the possibility that this is in large part a liquidity crisis with the banks just irrationally afraid to lend each other money and unable to raise cash through the sale of their mortgage related assets, and that these securities and money market funds are not really worthless (which Paul Krugman thinks is bullshit). If that is the case, the government may eventually be able to sell this stuff back at a profit over time, piece by piece, virtually eliminating all the new debt, but there's plenty of reason to be skeptical.

Here's Kevin Drum:

It's true that the Bernanke/Paulson bailout is aimed at illiquid debt
instruments. And those instruments are illiquid largely because they contain
lots of toxic mortgage securities and nobody knows how much this stuff is really
worth. It's unlikely that the toxic sludge makes these instruments literally
worth nothing, but who knows? The mere possibility that they're worthless means
that any bank who owns them might be insolvent, and since everyone owns
at least some of them, this in turn means that everyone might be
insolvent. Result: no one is willing to loan money to anyone else, because who
wants to loan money to a bank that might never pay it back? And since huge flows
of overnight interbank loans are the oil that lubricates the credit markets,
when this flow seizes up, the entire credit market seizes up. (What's more, if this
WSJ tick-tock
is correct, the seizure became critical on Wednesday, which is
why B&P changed their minds midweek about pursuing a systemwide bailout that
they'd opposed earlier.)

So if you, like most of us, are unconvinced that any of this stuff has any actual value, and that the government is just bailing out criminals and handing the bill to the taxpayer, let's ask ourselves just who "the taxpayer" is. It's a fact that the rich (including, we assume, most of these bankers and mortgage executives who are responsible for this mess) pay a disproportionate share of the taxes, even in the US. It's also a fact that lower and middle income people who built houses and took out mortgages that they couldn't afford should take some responsibility for their actions. It isn't all Wall Street's fault.

This is a collective failure, if not a universal one. There is no easy solution that will be entirely fair, nor that will directly target the culprits while leaving the innocent unscathed. All we can do is minimize the bloodletting and try to prevent another such disaster in the future.

Good places to start would be minimum down payments on new home purchases (regulations which most countries have, but are currently non-existent in the US), and stricter leveraging regulation for all financial institutions (to avoid the sight of companies like Lehman Brothers being caught with their pants down as people scramble for their money).

UPDATE: This guy is pretty sure that there are no profits to be found here:

Think of a drunk gambler at a slot machine. He starts with $100 and slowly
loses. Every now and then he wins some money, but he keeps putting the coins
back into the slot until he has lost everything. That is how this plan will

Unless there is a dramatic changes, there will be no upside participation
in the financial companies for taxpayers, and the taxpayers will recapitalize
the banks by, in Krugman's words, "having taxpayers pay premium prices for lousy assets".

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