The title is from Oliver Hart and Luigi Zingales writing in the WSJ:
Practically every day the government launches a massively expensive new
initiative to solve the problems that the last day’s initiative did
not. It is hard to discern any principles behind these actions. The
lack of a coherent strategy has increased uncertainty and undermined
the public’s perception of the government’s competence and
trustworthiness.
By principle, Hart and Zingales mean economic principle such as intervening only when market failure in the technical sense is an issue. Bankruptcy, for example, is not the end of the world (As you may recall I have been pushing the idea of speed bankruptcy for which the FDIC has developed significant expertise.) For example,
…what would have been so bad about letting Bear Stearns, AIG and
Citigroup (and in the future, General Motors) go into receivership or
Chapter 11 bankruptcy? One argument often made is that these
institutions had huge numbers of complicated claims, and that the
bankruptcy of any one of them would have led to contagion and systemic
failure, causing scores of further bankruptcies……This argument has some validity, but it suggests that the best way to
proceed is to help third parties rather than the distressed company
itself. In other words, instead of bailing out AIG and its creditors,
it would have been better for the government to guarantee AIG’s
obligations to J.P. Morgan and those who bought insurance from AIG.
Such an action would have nipped the contagion in the bud, probably at
much smaller cost to taxpayers than the cost of bailing out the whole
of AIG. It would also have saved the government from having to take a
position on AIG’s viability as a business, which could have been left
to a bankruptcy court. Finally, it would have minimized concerns about
moral hazard. AIG may be responsible for its financial problems, but
the culpability of those who do business with AIG is less clear, and so
helping them out does not reward bad behavior.
I just read that piece myself. While many have clearly changed their views recently, I don’t think that anyone that is both principled and knowledgeable has.
The headline writer does the authors in injustice. They refer to “policy makers” abandoning principles, not the overly expansive term “economists”, many of whom (such as me, Hart and Zingales) maintain their attachment to principles.
Bernanke and Paulson are economists, policy-makers and principle abandoners. Let’s not tar us all with so broad a brush, when a finer one exists.
AIG may be responsible for its financial problems, but the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior.
The culpability may be less clear, but bailing them out still creates moral hazard. Certainly it still suggests a winning strategy for ripping off taxpayers: just make sure you’re the creditor for the counterparty that can’t deliver, not the counterparty itself. The ‘best way to proceed’ is to help no one, or rather, to provide the usual safety nets for individuals against starvation and the like.
I have yet to hear a clear exposition of how, exactly, the failure of AIG et. al. would have been so great a catastrophe that we had to embrace an additional trillion (or more) in public debt in order to avert it. The whole thing has more in common with a combination bomb threat / extortion attempt than sensible public policy.
AIG’s business consists of nothing but obligations and the management and administration of those obligations. The argument presented here is that it would have been cheaper for the government to BECOME AIG, as opposed to simply buy them? So the authors prefer organic growth, rather than growth through acquisition. I’m not sure if I agree.
“the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior”
On the contrary. Principled economists should demand equity stakes from AIG’s creditors for the simple reason that they are the ones who should have been monitoring AIGs solvency/liquidity position — and therefore may have been trading on AIGs “too big to fail” status.
I read the suggestion about AIG as saying that the government would guarantee all _current_ contracts, but issue no new ones. If AIG went bankrupt behind such protection, then there would be some period of winding down during which the government would have to pay claims, but no lasting business. If, on the other hand, it did not go bankrupt, then the government would pay for nothing.
That sounds pretty sensible. Agree it involves some moral hazard, for rewarding those who ignored counter-party risk, but that’s less bad than rewarding AIG’s shareholders.
bbartlog,
“It is too big to explain” is the only explanation I have heard/read.
Assume as a fact that Something Had to Be Done to protect the rest of the financial world from AIG’s failure. Would the guarantee of AIGs obligations been a better approach than handing over cash to the company that put itself in this position. I like the moral notion that at least you’re helping the victim.
Since Tyler seemed to approve the bailout, it’d be interesting to know if the guarantee is, in his hindsight, the better approach. (I say “seemed” because the equivocator in the blogosphere today is hard to pin down.)
mike,
The claim was that the supply of credit to the general economy has not “frozen”. If you look at the sources of that Minneapolis Fed paper, you’ll notice the supply of credit to “main street” has in many cases not even dropped.
mike,
Can you point to some data showing this freeze or significant slowing (i.e., not just a 5 or 10 year low) of credit to the non-financial sectors of the economy? I’m not trying to keep my “head in the sand”, I just haven’t seen the data.
The bailout WAS a bailout of AIG’s counterparties (and to a lesser extent, its debt-holders.) AIG’s shareholders were basically wiped out. Having already seen their shares plummet 90% in a year, diluted 80%, and since diluted further by the Treasury’s $40 billion preferred shares bought with the TARP. AIG’s policyholders — in its legitimate, standard insurance businesses — always were protected and those units always were well-capitalized.
The problem was what a failure would have done in terms of triggering swaps and collateral calls. At mid-year, credit default swaps written by AIG totaled $500 billion. This says nothing of how much of the $63 trillion swaps market was written ON AIG. Thus far, the federal government’s loan and liquidity package has totaled $150 billion. And it IS a loan — initially accruing interest at a punitive 850 basis points over three month LIBOR, but since reduced to 300 basis points over LIBOR. Then, the preferred shares are kicking back a 10% dividend, which steps up over time. And the company does have attractive assets to sell, although selling them right now in this market is going to prove difficult.
Even if you want you can also toss in $20 or $30 billion the company is funding through the commercial paper facility, you don’t get near the amounts that could be triggered by letting the company go down, much less any cascading effects should their failure have triggered more failures by other institutions. One could make the argument it would have been better simply to nationalize the company outright, or simply to let it fail. But arguing that it would have been more prudent or less expensive to simply to have the government clean up the mess AFTER a failure is just nonsense.
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