The Economic Consensus v. Politics

by on October 3, 2008 at 7:10 am in Economics | Permalink

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.

1 Bob Murphy October 3, 2008 at 8:41 am

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.

2 zbicyclist October 3, 2008 at 9:16 am

Before reading this blog further, spend some time to FAX or e-mail YOUR U.S. REPRESENTATIVE, ESPECIALLY IF THEY PREVIOUSLY VOTED NO.

3 aaron October 3, 2008 at 9:39 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…”

4 meter October 3, 2008 at 9:43 am

Alex, can you please collectively get the attention of Greg Mankiw and get this in front of people who might have some sway.

5 david foster October 3, 2008 at 10:08 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?

6 ZBicyclist October 3, 2008 at 10:50 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.

7 jamesonburt October 3, 2008 at 11:01 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?

8 Gabe October 3, 2008 at 11:13 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.

9 Jeff October 3, 2008 at 11:34 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?

10 goodnessOfFit October 3, 2008 at 11:36 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”

11 Matthew Petersen October 3, 2008 at 12:32 pm

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.

12 Sean October 3, 2008 at 12:48 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.

13 David Heigham October 3, 2008 at 1:35 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.


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.

14 J Thomas October 3, 2008 at 1:47 pm

Would it make sense to separate out investments that look somehow solid versus the ones where mark-to-market is an issue?

If you could have a place on the list for the questionable ones — mark what you paid for it, and what it’s worth today, and what you think it ought to be worth. Then let anybody who needs to think about that, draw their own conclusions about how much uncertainty there is in the worth.

15 Jim October 3, 2008 at 2:59 pm

I just gave myself a chill.

Reading how the consensus of economists was against this bailout… is that analagous to the consensus of economists who begged Hoover not to sign Smoot Hawley?

16 J Thomas October 3, 2008 at 4:11 pm

Tyler has emphasized the importance of the bailout as a confidence restoring measure, I think your post misses (detracts from?) this aspect of the bailout.

Do you feel more confident now? I don’t feel more confident.

Should the stock market get more confidence? On the one hand some banks etc will have more money to play the market. On the other hand with interest rates rising, bonds will look relatively better than stocks compared to now.

If you were a foreign investor who’s thinking about putting money into the USA, would you feel more confident because of this?

I guess bankers etc who are friends of Paulson or Bush should feel more confident. I don’t right off see anybody else.

17 Gabe October 3, 2008 at 5:38 pm

If confidence was the problem would we have seen Bernanke, Bush and Paulson screaming at us the last three weeks “The WORLD IS ABOUT TO IMPLODE UNLESs YOU GIVE ME 700 BILLION!!!”

I can’t believe how illogical some of the supposedly “intellectual” people are here. This has all the signs of a 100% lie. We now have a economic czar even more powerful thatn the Fed. The country is so going down the drain.

Any academic theories here about the huge spreads we are seeing in physical silver and futures market silver?

18 Joshua Allen October 3, 2008 at 6:44 pm

Every time I hear “confidence” now, I think “confidence man”. I love how much confidence was instantly injected to the markets today when the bill passed. Didn’t the geniuses at CNN tell us the markets would rise if the bill was passed?

I bet all of those old ladies who were calling their representatives screaming “SIGN THE BILL TO SAVE MY 401K; CNN SAID IT WOULD WORK!!!” all feel like suckers now.

19 Bob Murphy October 3, 2008 at 10:15 pm

Jose said:

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?

OK, you are actually reinforcing my point. In my opinion, there are two separate things here: One is the huge malinvestments in real estate. Now why did that happen? I think the Fed played a huge role, though Tyler (not sure about Alex) would argue that the Fed needed an accomplice.

But there is a second thing going on, namely the “credit freeze.” Given that people are sitting on billions/trillions of dubious mortgage-related assets, this secondary problem is caused because people aren’t sure who is holding them. So I’m saying that if you want to unclog the credit markets and get banks lending again, the most obvious thing is to ask, “Why aren’t they lending right now, and how can we change that condition?”

I don’t think it’s the existence of the bad assets per se that is causing the freeze, I think it is fact that nobody knows who is holding them. Here too, I think the government is a huge culprit. I think these big institutions have been playing a big game of chicken, hoping to drag their feet and stay in business long enough to get a government bailout.

OK after my long-winded preface, back to your point: The reason a JP Morgan style, private sector liquidation process hasn’t occurred, is that the government is a huge interloper sitting on the sidelines who jumps in every few days to do something huge and unpredictable. It might buy your dubious assets at better prices than any private buyer, it might seize your company and wipe out your stockholders, or it might change regulatory requirements.

Anyway, since I think it is the interference / promise of ever more assistance that has caused the credit freeze in the first place, a government-led effort to “recapitalize” the banks will just reinforce the same things that caused the crisis. Purely private sector rescues will be even less likely in the future, and the aggressive fools who made such risky bets during the last few years are more likely to stay in the industry, rather than applying to be a greeter at WalMart.

20 Robert Olson October 4, 2008 at 5:45 pm

Didn’t want to spam the entire comment section…

21 Cdn Expat October 5, 2008 at 5:35 am

There are two associated problems: (1) a liquidity crisis; and (2) a solvency crisis. The proposal by Krugman et al. “solves” only the latter and leaves the former festering. Given that the latter is a product of the former, it’s hard to see how this would help. Krugman and others point to the Swedish experience but there the numbers of banks were small and the business model was conventional. Now, with all the credit default swaps out there, if the securities themselves are not taken off of (mostly bank) balance sheets, the melt down spreads to places and institutions we cannot even imagine. Would be counter parties know this, which is why recapitalizing banks would like be insufficient without either adding absolutely enormous injections or complete nationalization.

22 J Thomas October 5, 2008 at 10:24 am

What would have happened if a free market had worked correctly?

As we continued to import more than we exported, the dollar would have depreciated relative to the nations we imported from. We would have reduced our imports. We would find we could make various products as cheap as foreigners given the devaluation, and we would have done so. We can’t make our own oil, though — we have oil reserves to cover about 1000 days at our current consumption. Oil would continue to get more expensive for us, and everything that uses oil. As we economised on those things, our standard of living would drop further, our oil consumption would drop, and our oil imports would drop.

As we developed alternate energy etc our standard of living would level out, and at some point we might find new technology that let our standard of living rise.

But instead our imports mostly did not fall, and our production did not rise that much. We had the boom where we produced lots of software that quickly became obsolescent and that we had no market model for. And we produced a whole lot of houses in the USA that we absolutely cannot export etc.

Increasingly what we exported was debt. And risk. We played a shell game to get foreigners to keep lending to us. Were we fooling them? Were they fooling us? Both sides played along. We found various ways to hide the debt, and it worked for awhile.

There are two associated problems: (1) a liquidity crisis; and (2) a solvency crisis. The proposal by Krugman et al. “solves” only the latter and leaves the former festering. Given that the latter is a product of the former

Or is the liquidity crisis a product of the solvency crisis? We can’t afford to unwind the debt and find out who owes what, because when we do it will turn out that our institutions are essentially all bankrupt because we owe so much to foreigners. Or rather, in the debt shell game some of our institutions may have avoided the secret debt and be OK, but on average we’re bankrupt and we owe considerably more money to foreigners than the $13 trillion we admit to now.

And recapitalising banks just means we change the foreign debt from bank debt to T-bills. This is probably the right thing to do, if we do it successfully without another scam, because some foreign nations have various recourses if we default too far on our debts.

One thing is that the nations that have pegged or partly pegged their currencies to ours could let the dollar loose to find its own level.

Another is that they could drop the dollar as a reserve currency. When they have discussed that before they found no good alternative. But when the dollar becomes a sufficiently bad alternative they will do something else.

We could go through something like argentina, or the collapse of the USSR.

Is there something we could do about this, starting at the end of January? Or is it too late?

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