Is a Potential Bailout Making Things Worse?

by on September 27, 2008 at 7:14 am in Current Affairs, Economics | Permalink

Ken Rogoff says yes.  Elizabeth Warren at Credit Slips summarizes Rogoff’s discussion at a Harvard Roundtable (video):

Any liquidity crisis is caused by the promise of a government
bailout. Ken said [Actually this was Greg Mankiw, AT] that his many friends in investment banking said that
there is plenty of money to invest in financial services, but right now
it is "sitting on the sidelines."  Why?  Because the financial services
industry does not want to pay the terms required to get that money back
in circulation (e.g., give up equity).  As he put it, why do business
with Warren Buffett who will negotiate a tough deal, if you believe
that the government will ride in soon with cheaper cash? 

Ken [this is correct, AT] also talked about the need to shrink the financial services
sector. He thinks it is good that the investment banking houses are
failing and many people on Wall Street are losing their jobs because,
in his view, we have an oversupply in that sector and our economy just
can’t support it.   

Ken’s background with the IMF and on the Board of the Federal
Reserve add a certain credibility to his assessment of conditions on
Wall Street.  If he is right, the $700 bailout is saving some
investment bankers’ jobs in the short term, but overall it is just
making the financial system worse.

In a related point Felix Salmon suggests that the Ted Spread may not be a valid measure of distress when the Fed is providing lots of liqudity.

…if you’re a bank, you really neither want nor need three-month
interbank funding right now. Global central banks, led by the Federal
Reserve, have flooded the system with so much overnight liquidity that
you can get as much cash as you need, at a much lower interest rate,
directly from your central bank, overnight. The choice between that and
locking in a high interest rate for three months is a no-brainer.

1 ogmb September 27, 2008 at 7:28 am

Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity).

That’s the No. 1 reason why any bailout plan without debt-for-equity shouldn’t be considered. The govt as lender of last resort has one advantage over private lenders: it has no death point. As such it can impose harsher conditions on debtors than private lenders. Any attempt by Paulsen to extract more lenient conditions from Congress is just special pleading on behalf of his former colleagues.

And of course I wonder why (or maybe if) nobody has asked Paulsen the crucial question: if you’re so adamant that your plan is what’s necessary to save the economy, are you willing to step aside in order to get it passed?

2 K. Williams September 27, 2008 at 7:47 am

Was Ken Rogoff on this planet last week? You know, when Lehman went bankrupt, Goldman and Morgan Stanley were on the verge of going under, AIG was taken over by the government (without which we’d likely be dealing with the aftermath of a 1987-style crash), more than a trillion dollars in market cap was erased in a couple of days, and Treasury yields fell to 0%? This was all before the bailout, but to me it looked pretty much like a liquidity crisis, and all of that momeny that’s supposedly sitting on the sidelines didn’t look too interested in investing on any terms. As for Rogoff’s invocation of Buffett, Buffett explicitly said he would not have made the Goldman investment if he didn’t think some form of rescue package was coming. That doesn’t suggest that there’s lots of private money ready to jump into this market in the absence of a bailout — which which is what Rogoff is, bizarrely, arguing.

3 Matt September 27, 2008 at 9:41 am

I am with Ken.

The economy sucks for reasons having nothing to do with being over leveraged. The over leveraging simply makes the financial system crash when the economy sucks.

I would let equity values fall until equity values match the lack of yield in the economy. If that is 8,000 on the DOW, then I suggest we find something more useful to do with our corporations.

The only macro theory I have tells me that the federals do not innovate very well, and investing another $700 billion in a federal financial corp will not find any new innovation for the economy.

4 David September 27, 2008 at 10:11 am

Why? Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity).

The #1 reason. I’m with Ken.

5 y81 September 27, 2008 at 1:18 pm

This is certainly a new one on me: the idea that there can be two markets for the same thing (overnight money) with wildly different prices because, you know, not too many people are buying in the high-priced market and so no one cares. Why is anyone buying in the high-priced market?

In other words, I can understand the market for a particular commodity (say, video cassettes or LIBOR money) disappearing completely, because there is a better substitute available (DVDs or fed funds), but I don’t understand how there can be two functioning markets for the same thing with wildly different prices. From which I infer that LIBOR money and fed funds money are not at all the same thing, because one comes with interbank credit risk and one does not.

6 Howard September 27, 2008 at 6:04 pm

Like millions of Americans, I am really skeptical about this whole 750 Billion bail out. And, I’m especially skeptical about the RUSH to spend the 750 Billion dollars of tax payers money … which does not allow independent economists the time to properly investigate and evaluate this plan. In addition, Bush and the Democrats seem to be united on this bail out. My guess is that Bush wants to pay back big money Wall Street people, who helped him over the years … and, since the Democrats expect to rule both houses and, possibly the White House … they are salivating at the chance to control spending the 750 Billion. In spite of all the rhetoric about careful spending and oversight, the Democrats have already allocated 20% of this huge sum to fund crooked liberal programs, like Acorn. If we simply print Billions for bail outs, even if the market returns, inflation will make our currency virtually worthless.
P.S. Did anyone ask Alan Greenspan what he thinks???

7 Peggy McGilligan September 27, 2008 at 10:03 pm

When Bill Clinton eased banking restrictions, he dished out $8-billion dollars for “community reinvestment loans.† The money just evaporated. When the “creative financing† schemes fell through, as is their wont whenever 30-million Mexican nationals buy inflated properties and default, it left banks in the lurch. Never mind that the aforementioned demographic is the new face of the Democratic Party; the mortgages morphed into “toxic† instruments. Hillary Clinton counted heavily on the loan giveaways to buy votes. Interestingly enough, had Hillary secured the nomination; she, instead of Barack Obama would preside over the bailout. So, why should Americans perpetuate the housing bubble? Because it’s a scam! And, this is its well-timed exit strategy. Where is that $8-bilion plus dollars? The crooks stole my money; they even stole my car. The bubble is the problem, let it burst:

8 phineas September 27, 2008 at 10:19 pm

Here’s a quote from Ken Rogoff from an article published on 8 Sep 2008 at “The idea that the world’s largest economies are merely facing a short-term panic looks increasingly strained. Instead, it is becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning…. After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions’ key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit…. Efforts to block a healthy and normal [pruning] dynamic will ultimately only prolong and exacerbate the problem…. The financial industry is undergoing fundamental shifts, and is not simply the victim of speculative panic against housing loans…. Today’s financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future.”

9 Ned September 28, 2008 at 9:57 am

“Ken also talked about the need to shrink the financial services sector. He thinks it is good that the investment banking houses are failing and many people on Wall Street are losing their jobs because, in his view, we have an oversupply in that sector and our economy just can’t support it.”

With all due respect to K.R., the financial sector in the US has been shrinking for quite some time now. Even before the latest crisis, (say at beginning of 2007) the number of people working on Wall St. was well below its peak in early 2000, while the US economy has grown substantially since then.

I’m not sure what numbers he and others are using for the total size of the financial sector, but the percentages of all US companies’ profits earned by the financial sector are usually useless because they fail to take into account that many large firms have established financial subsidiaries (GE Capitial, GMAC etc.) that generate the lion’s share of profits in nominal terms, while representing only a bookkeeping change in terms of financial/non-financial industry breakdown.

10 mark September 29, 2008 at 7:49 am

this is a bunch of bullshit

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