Tuesday, August 25, 2009

Looking Back at the Bailouts

Megan and Tyler ask whether the financial bailouts were a good idea, and what should have been done differently. Here's my take:

1) Recapitalize banks by recapitalizing consumers

A "good loan" is a loan that will be paid back, and a "bad loan" is a loan that will not. It's a simple difference. The solvency part of the financial crises was caused by banks having too many "bad loans" on their books, and the Government's solution to this was to give the banks taxpayer money.

The "bad loans" were bad because people did not have the money to pay them off. Therefore, the Government could have simply given taxpayers the money directly, or at least, started taking away less of it through a payroll tax holiday. This money would either have gone to i) paying down debt (making bad loans good), ii) savings (giving banks cheap liabilities), and iii) spending (stimulating the economy, and supporting aggregate demand). In addition, businesses would have more money to retain employees, and maybe even hire a few more.

Over a year, this would cost around $1T-$2T dollars, which is about how much Obama's "stimulus" and bank bailouts cost. The difference is that this way, American households would be better off, instead of the situation now where banks and favored political constituencies are minting money, and the American household is in the unemployment line.

2) The Fed should lend to banks unsecured

The liquidity element of the crises was driven by credit risk entering the overnight bank lending market -- the lending market that the Fed uses (and intervenes in) to set short term interest rates. There were ample reserves in the system, but the banks would not lend to others because of counterparty risk. This meant that there was no single overnight bank lending rate -- it depended on which bank was trying to do the borrowing -- and thus there was no way traditional way that the Fed could set short term interest rates.

The Fed should simply have lent unsecured to banks that needed reserves to meet their regulatory requirements. This would have given them control of that policy instrument bank and dealt with the liquidity issue.

3) Let the FDIC do it's job

The FDIC is basically a branch of the Government that puts its capital in last loss position. It can operate the bank in any way it chooses once the bank has lost the rest of its capital and is now out-of-compliance with capital requirements. We had the farcical situation where one branch of Government (the Treasury) was putting its capital in front of another branch of Government (FDIC). Someone should tell these guys they are on the same team.

The FDIC may have decided to handle the banks that it took over in a different way from the traditional, small commercial banks that are safe to fail, but the perverse market incentives that the Treasuries actions have taken are breathtaking. Because of them the financial system is rightly viewed as corrupt, Government agents included.

4) FDIC insurance should be unlimited

The limits to FDIC insurance are nonsense. Whenever they are almost broached, the simply get upped. The Government should have embraced reality and simply made FDIC coverage unlimited. This would have solved the liquidity problems in the commercial paper market, as demonstrated by money market funds "breaking the buck".

5) Banks are pro-cyclical, focus on households

The major capture connecting all of these bad decisions, cognitive, regulatory etc., that has gripped Libertarians, Liberals, Conservatives, Regulators, Politicians, and Financiers, is that the economy depends on the health of banks. This is the Big Lie. Think about how capital requirements work -- leverage is easier when prices are rising, and harder when prices fall. This is exactly the mechanism that would create an industry that is pro-cyclical, that simply amplifies whatever is going on in the larger market. If the market does well, Banks do well. If the market does badly, Banks do badly.

So the idea that having "healthy banks" will somehow improve the health of the economy is nonsense. If a household has insufficient income to manage it's current debt load, or take on additional debt, does it matter how well capitalized Wells Fargo is? Banks (usually) lend to people who can pay them back. Stuffing them full of money will not make banks make loans to households who cannot pay the loans back. Creating households who can pay loans back will automatically help banks. The tail does not wag the dog.

Where are we now?

We have a situation where the banks are recapitalizing themselves through high net interest margins, thus transferring even more wealth from main street to themselves. Moral hazard is even worse than it was 2 years ago, if that can be imagined. Unemployment, through triggering the automatic stabilizers, is the only thing putting a floor under aggregate demand. The output gap is frankly massive, as high unemployment and underemployment has been the rule for the last year and a half, and probably the next 2-3 years (unless we slip into a Japan situation, where it can continue for over a generation). The US economy is massively demand constrained, with a financial system that's good at getting paid, but lousy at, you know, allocating money.

Mainstream economics has been thoroughly discredited, not that it seems to have noticed.

The incompetence and ineptitude of the Obama administration in dealing with the financial industry may also be hobbling its attempt at healthcare reform. Unfortunately, that is the smallest cost of this debacle.


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