A second-best theory of libertarian bailouts

Pete Boettke cannot bring himself to utter those few little words.

Let me nudge him (and others) again and try to make things easier for him.  General pro-market or anti-government arguments don't rule out the recent bailouts.  Let's take the hardest, least Friedman-friendly case, the insolvent banks.  For insolvent banks (and for some of the illiquid banks, which might have failed without bailouts), the alternative to those bailouts is calling in deposit insurance and the bankruptcy courts, both of which are, for better or worse, forms of government intervention.  In particular today's bankruptcy procedures are ill-suited for disposing of a large financial institution in a timely manner and this can be considered a form of gross government failure.

Note that even when the Fed "bails out" a large investment bank, or insurance company, they are checking a chain reaction which would likely spread to some commercial banks, thus bringing in deposit insurance as well, not to mention further bankruptcies.  And that's not even considering that Congress probably would have stepped in, I'm just looking at laws already on the books.

So if you're "opposed to financial bailouts," as a libertarian, you're not for the market.  You're saying that one scheme for governmental disposition is better than another.  Of course you are entitled to that opinion but the sheer force of libertarian doctrine is not necessarily on your side.  The general pro-market and anti-government arguments are not necessarily on your side.  I think it is quite plausible for a libertarian to believe that the Fed is "less bad" than the bankruptcy courts and the FDIC.

Now, all things considered, I don't see why this "libertarian two-step" move should be needed.  I think it's enough to simply ask whether the bailouts were a good idea and proceed accordingly.  But if you're concerned about compatibility with libertarian principle, this is one simple way of seeing why my view fits right in.  In fact I think it is the more libertarian of the views under consideration, as it keeps the very worst of the government interventions on the table at bay.

Addendum: Overall I think U.S. bankruptcy law works fairly well, just not relative to the high speeds of market demands when a major financial institution goes bankrupt; Lehman showed this.  This is an under-reported source of "regulatory uncertainty."  (Prepackaged bankruptcy ideas may help, possibly.)  If you are calling for the application of bankruptcy law to major banks, you are calling forth that regulatory uncertainty and yes I do think it is worse than the regulatory uncertainty from a bailout.  The result is that credit markets freeze up and that also leads to other bad interventions.  Another set of problems springs from the difference between a bank and bank holding company; current law doesn't handle this well although changes are in the works most likely.  Of course it is a kind of "super-libertarian" alternative to abolish deposit insurance in the midst of a crisis, as some of you recommend, would you really do that?  I don't think so.

Comments

This is not libertarianism. If it were then by that logic we would support No Child Left Behind because the only alternative is bad public schools, high taxes because the only alternative is debt financing, and wars in Iraq and Afghanistan because the only alternative is fighting an even costlier war on our soil.

This is garbage logic, literally: please Mr. Thug make me eat rotting trash instead of breaking my legs. Thanks a lot! Boy, freedom tastes great!

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You don't support your statement that "today's bankruptcy procedures are ill-suited for disposing of a large financial institution in a timely manner".

Mark me down for preferring a procedure that's established and known over some seat of the pants, unpredictable bailout.

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Bankruptcy proceeding from government courts is less bad than bailouts. Reliance on a "free-market" desparately requires we allow poorly run companies to go bankrupt.

Poorly run companies increased their counterparty risk irresponsibly when they bet bilions of dollars that AIG could pay off it's CDS. The compaines that were betting on AIGs ability to pay did not suffer for their poor judgement. Instead taxpayers suffered. AIG could not pay off it Credit Default insurance contracts. The banks that compete with Goldman Sachs should have benefited by having a elephant competitor eliminated, instead the banking institutions learned the lesson that they need to make more bigger political bribes. This is a bad precedent.

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I second Pat's last comment. We are in the world of the second best here, but allowing bank failures to work through established bankruptcy procedures reduces regime uncertainty and prevents *further growth* of problematic government powers. Tyler needs to read his Higgs: the powers now given to the Fed are not going to go away completely. Letting bankruptcy deal with it would be an increase in the *scale* of gov't powers but not the growth in *scope* that we've seen with the bailouts.

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"I think it is quite plausible for a libertarian to believe that the Fed is 'less bad' than the bankruptcy courts and the FDIC.

Plausible, maybe, but you'd need more explanation.

Bankruptcy courts and the FDIC are established, rule-governed institutions. Not immune to public choice criticisms, of course, but certainly on the "rules" side of the "rules vs. discretion" continuum as compared to idiosyncratic one-of interventions by the Fed.

Make the case that the situation in 2008 was too far outside the range of normal reach of the FDIC & bankruptcy courts, or that there was reason to believe that there were overriding public policy interests at stake that do not traditionally get balanced in FDIC or court decision-making. Maybe there is a second best argument for the consequentialist libertarian down that road, but look out for creating massive moral hazards down the road.

Comparing the Cowen post above to Boettke's linked remarks, I'm more persuaded by Boettke.

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So if you're "opposed to financial bailouts," as a libertarian, you're not for the market.

This is one of the silliest, most convoluted arguments I ever heard. I guess even really smart people make stupid mistakes sometimes.

Libertarians oppose government bailouts *AND* government deposit insurance, which is clearly not anti-market in any way.

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You should be careful Mike. Eventually you will start questioning the very coherence of libertarian ideology.

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According to Taibbi, Goldman pays about 10 million per year in taxes. They have extremely good accountants.

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This IS terrible logic. I should not be forced into only choosing 1 of 2 options. Why can't I support allowing banks to fail, removing the FDIC, and bankruptcy court reform? If you can sleep at night despite supporting the bailouts then good for you, but I couldn't because it doesn't seem consistent with my libertarian beliefs.

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Is there not any argument to be made that letting a complete meltdown begin to occur by doing nothing would have better long-term consequences than the "middle-ground" being argued above? Do we really believe that substantial social unrest would have resulted from a meltdown? Is it plausible (say, over 10% chance) that not intervening at all would have dropped us into a Depression? And would a "Depression" today look anything like it did 75 years ago?

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They have not brought this up, but many Austrians, including Steve Horwitz, I think, not quite certain about Pete Boettke on this matter, support free banking, so would like to see much larger changes in the entire system which are not addressed by these particular alternatives. Of course, this crisis period was or is probably a very hard time to implement such an alternative.

OTOH, there is the oddity that if one wants to get technical, the Fed is privately owned and thus "private sector," sort of, although clearly created by the government. So, all the pressure to get rid of it in favor of "private sector money" is slightly off, and any "free banking" system would of course have all kinds of government regs and oversight, but of a different sort.

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Robert, that's ridiculous. Goldman paid $1.6B tax in the second quarter of 2009 alone. In 2007 they paid $6B income tax.

The case for the Fed is providing liquidity when the crisis is a temporary condition in which banks can't find sources of capital at profitable rates. When the crisis is one of gross incompetence and the willful destruction of firm value by levering 80:1 or debasing underwriting standards then the you might as well replace the Fed with a Politburo. The reason this quasi-libertarian prefers (temporary) nationalization of insolvent banks is that it would reveal which banks are good and which are bad, which would go a long way towards directing capital towards well-managed firms and clearing the market of "toxic" assets.

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"Note that even when the Fed "bails out" a large investment bank, or insurance company, they are checking a chain reaction which would likely spread to some commercial banks, thus bringing in deposit insurance as well, not to mention further bankruptcies."

What is the theory backing up this claim?
Can you point to any historical examples as evidence?

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Actually, now that i think of it, there was a chain reaction;

Fed policy of low or acutely low interest rates for a decade --> Housing and stock market bubbles --> Housing bubble bursts, stock market collapses --> Large Wall St firms insolvent --> Economic gurus think "We do not have a model for this" --> Substitute with a vision of doomsday --> Problem is spread throughout the economy - via the taxpayer --> Taxpayers irrate, but no matter - the wise men know best.

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For proprietarians (who'd like to monopolize the word "libertarian" as well as their parcels of land and other resources), a bankruptcy court only settles contractual disputes between property holders. It rules contractual obligations essentially impossible to keep and divides a proprietor's assets as nearly in keeping with contractual constraints as possible, according to common law standards. In this sense, bankruptcy is ideologically "better" than bailouts by a central monetary authority. It's also better than the FDIC.

I'm not a strict proprietarian myself, not a Rothbardian or any other sort of "anarcho-capitalist" (which seems oxymoronic to me), but I prefer bankruptcy to bailouts, and I'd dump the FDIc altogether. For me, this approach is not radical. It's realistic. If true deposit insurance is feasible (which I doubt), no Federal insurance scheme is necessary. Why wouldn't a private insurer, with empirical knowledge of the default risks, sell me a policy? Continual meddling with financial markets affects the answer to this question, of course.

Instead of the FDIC, we need depositors well informed of the real risks of banking. In common parlance, a "bank" is not a hole in the ground where your gold is buried. If you want to bury gold in the ground, you don't need a bank for that. Banks extend credit, and extending credit is risky. We should confront this reality. Denial only confuses the facts and invariably leads to poor decisions.

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I should have said,

not voluntarists but imperialists.

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A crime was committed here - my wife and I and my children were
robbed to enrich crazy rich people priviledged and protected by the government.

Tyler's recommended procedure only works to make that theft larger -- and more inevitable again down the road.

Liberal market society is grounded on negative rules of justice constaining such things as theft behavior -- when the people see the whole system as a theft regime targetted at them, the legitimacy of liberal system is destroyed at everyone begins
to see everything as simply a game of who can ge away with the most theft.

So Tyler is advocating measures which undermine the very legitimacy of a society based on free rule governed exchange and not arbitrary theft in favour of the priviledged and government protected.

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Woolsey,

you are 100% right.

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Tyler seems to miss a huge point.

Suppose that a bank goes bankrupt and the government (specifically, the bankruptcy court) steps in. In a reorganization, it would reduce the bank's liabilities to its creditors, many of whom would end up with equity. In a liquidation it would sell off the assets and pay the proceeds to the creditors. In any case, it divides up the assets among people who voluntarily interacted with each other. The only cost to people who did not voluntarily interact with the bank is the cost of maintaining the court system. This would also be true of any of the many versions being circulated of a compulsory write-down or conversion of junior debt.

Now compare that to a bail-out. In a bail-out, the government uses injects money into banks. In a Fed action, the Fed loans money into existence; if the bank fails to repay the loan, the value of the money all of the rest of us hold is diluted. Under TARP, the government borrows money from the world and invests it in the bank (by loan or equity). If the bak fails to repay the investment, the rest of us have to make it up through taxes. If the FDIC steps in, it injects money raised in taxes from other banks (or, if that reserve is inssufficient, from general taxation). In all of these scenarios, parties who did not voluntarily interact with the bank end up picking up its debts.

That is why bankruptcy (or a compulsory write-down) is better, from a libertarian point of view, than a bail-out. If you don't want to take the risk from bankruptcy, you can refuse to deal with the bank. But you can't avoid the risk of of a bail-out.

Max

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In micro theory, the exit of a competitive firm under oligopolistic conditions, would, by moving the supply curve to the left and therefore increasing price, improve the profitability of the remaining firms.
The 'bank contagion' concept suggests that, in the financial sector at least, the opposite affect can be true. Namely, the loss of a competitor could have negative consequences for the remaining firms.

First question for TC: What is the theory behind the bank contagion concept?

In my opinion, you are confusing a top-down economic system like Socialism, which is indeed brittle, with the distributed bottom-up organization of Capitalism, which should in theory, be free of any chain-reaction type problems.

Second question for TC: When you speak of chain reactions, what social/economic system are you implicitly considering?

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Tyler,

Chris Whalen of Institutional Risk Analytics has covered the issue of banks vs. BHC's in his writings and (I'm nearly certain) before Congress. In short, what he recommends is to use powers already granted to the regulators (in regard to the subsidiary banks) to effect a board and management change at the holding company level (they could be held liable in the event of a failure -- no one in his right mind would fight this). The existing board would be replaced with one committed to a voluntary restructuring of the debt. In other words, they would have to have what Whalen calls "an adult conversation with the bondholders." We've done nothing like this whatsoever -- we haven't even tried. Why the govt is committed to protecting the bondholders is beyond me, but I assume it has something to do with the massive numbers of CDS pertaining to these bonds. Interestingly, 95% of these CDS are concentrated in the four or five big banks -- it's not as if XYZ Regional Bank is going to have a swap book waiting to blow them up if Citi's bondholders take a hit. The problems are with the large banks primarily and unfortunately, the politicians and regulators (or do I repeat myself?) have neither the will nor the skills to do the right thing by the taxpayer.

Here's Whalen's article: http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=354

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@Lee Arnold

I missed the argument between 1. here are some problems with assumptions made by libertarians and economists... and 2. the thing to do is bail out the banks.

There's a lot missing here about time horizons (better now, or better later) and about what constitutes "better" ( I know you didn't use that word, but it seems to be implicit -- i.e. bailing out the banks is "better" than going through some other process like bankruptcy).

Explain why transfer payments going from me to Goldman Sachs is preferable to their bankruptcy or voluntary restructuring of their debt? Even if the price of foregoing the bailouts is steep (i.e. a more severe recession), by what criteria do we judge whether one scenario or the other is "better"? Suppose Americans called, wrote and faxed their representatives opposing the bailouts 10-1 (or better)? Would the bailout option still be preferable? How so?

You might suggest separating politics from economics, but how? Politics may demand one thing, and economics may demand another (assuming we can separate them), but in the case of the bailouts, democratic politics sided with Boettke and the anti-bailout argument. It seems that you (and others, though not Cowen) are implicitly assuming that maximum GDP in the near term is central criterion for judging the merits of the bailouts. Clearly, most citizens preferred to risk a severe recession (or believed it was unavoidable anyway) rather than to bail out very wealthy failures.

Finally, I'm not sure how you expect the kind of super-duper regulatory regime you envision if rationality, as you say, is not "in full and cosmic supply." This is precisely the basis of Boettke's argument, but accepting this as fact in no way supports bailout + new regulation over bankruptcy or FDIC receivership.

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clawback,

Maximum GDP in the near term is not quite the central criterion. It is payrolls and mortgages -- the accounting of them is done by the financial system under question. Perhaps you yourself might have made out okay, but there are millions of others who would now be in trouble or have been forced to take more steps backwards in their lives. The likely collateral damage was huge.

You are speaking about one bank (e.g. Goldman Sachs) as a synecdoche when it was really an unknown portion of the system -- perhaps much or all of it -- where the holdings, interconnections, and valuations were (and still partly are) unknown. You'd need a lot of time to hire the people to sort that out, then they would have to figure out how to sort it out, then they would have to sort it out. We would still today hardly have begun it, or we'd still be in the bankruptcy courts, and we would be stifling the regular economy even more with unproductive activity.

It was not merely "risking" a severe recession; it was very likely to have been much worse. So "democratic politics" would be whining instead about how the politicians had botched that, or about how the FDIC-insured deposits are a "bail-out." Because basically, whining is what we do around here.

TARP assets may be largely repaid, and so the "transfer payments" from the taxpayer may make a profit.

The reasons a regulatory regime (and I did not describe a "super-duper" one) can make up for the inability of individual rationality to fully act in a complex system, have been discussed by many people including I believe Hayek. Today the most precise way to say it is that institutions can reduce transaction costs.

So now we should try to fix it. Whether that is possible in this era of misconceptions, cynicism and regulatory capture is another question, I'll grant you that.

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Tyler,

It seems your libertarianism has eloped with dirigisme. There seemed to be a secret romance going on in the background, but now it's out in the open. It's sad.

Adam

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Wow! Tyler's logic is so disturbing! I don't know where to begin. But let's start with "You're saying that one scheme for governmental disposition is better than another." Except for hardcore anarchists, this is exactly right! From a Hayek/Mises libertarian perspective, the state has a role to protect property and carry out justice. The proper place for that role is in the courts. The state performing its proper role certainly is preferable to the state performing an illegitimate role. And the shear force of libertarian argument minus hardcore anarchism is on our side. Mises wrote a book on intervention and I don't believe he ever considered that the courts were an illegitimate intervention in the market economy, but rather very necessary.

"I think it is quite plausible for a libertarian to believe that the Fed is "less bad" than the bankruptcy courts and the FDIC."

For the short run, maybe. But for the long run, the only time period an economist should concern himself with, it's definately not "less bad." If for no other reason, every economist should oppose the bail outs on the grounds of the many moral hazards they create.

On the libertarian principles mentioned above, the Fed is no less illegitimate government intervention than the FDIC. So we shouldn't prefer one to the other. But the courts are a different matter. But on practical grounds, we should prefer the FDIC solution to the Fed because it would probably cost a whole lot less. Besides, the FDIC money would go to the common people who bore no responsibility in creating the crisis, while the bail out money rewards the investment bankers who did cause the crisis.

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Just because someone claims to be a libertarian it does not mean that he is a libertarian. One cannot be true to libertarian principles and make excuses that allow government meddling in the social or economic lives of individuals.

True libertarians do not compromise on principle. They understand that the state has no rights that the people themselves do not possess and demand full liberty, not some compromised monstrosity that only leads to serfdom or slavery. Libertarians believe that no individual or group of individuals may initiate force against the person and property of another. This belief is not based on whim but is based on the idea of natural rights. For those that believe in natural rights there is little compromise possible on a number of issues. If one believes in natural rights then one cannot but come to the conclusion that conscription is slavery or that taxation is theft. In a true libertarian world there is no room for a Department of Education, HUD, the Federal Home Loan Banks, GSEs, FCC, SEC, Social Security Administration,etc. What government exists would be much, much smaller and have no power to regulate voluntary transactions between competent parties that do not initiate force or fraud against others.

Libertarians have lost their way and are very few in number. Sadly, most of the people that call themselves Libertarians do not have the courage to defend the principles that are the basis of true libertarianism.

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