Tuesday, March 24, 2009

Why a second best bailout may not be good enough

It’s not often I find myself disagreeing with Mark Thoma, but on the issue of the Geithner bailout plan I think I do. Thoma is a careful and reasoned writer, so what comes below I say cautiously, but nonetheless with some conviction.

Thoma writes:
So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Let me start by nailing my colours to the mast: I am not convinced the Geithner plan is a good one, and would greatly prefer to see a much more thorough reform of the financial sector, including a bankruptcy-like reorganization of insolvent firms. I understand that this sort of “solution” is much easier to consider in the abstract than implement in the real world and that such a plan would encounter formidable political obstacles at a time when the policy response needs to be rapid. So my argument below against Geithner-type plans is made neither lightly, nor simply to play devil’s advocate to optimists.

My opposition to the Geithner plan stems not primarily from outrage, concerns about equity, or even book losses borne by taxpayers, but from major concerns about future economic output and stability. The other issues are important and certainly things I care about, but my feeling is that even these are of secondary concern next to the signal issue of how today’s bailout will affect tomorrow’s broader economy.

For the moment, let’s categorize bailout plans into those which seek to recapitalize the banks while maintaining the current system in roughly its present form and those which go the route of bankruptcy-type proceedings and (given the breadth of the current crisis) would involve a much more thorough overhaul of the financial system. The Geithner and Paulson plans are of the first kind, and the “Swedish” plan (and its many variants) of the second kind. I’ll call these “bailout” and “restructuring” plans respectively. Clearly this nomenclature hides a lot of detail, but I think captures a key axis of difference between the various plans.

Two things about the aetiology of the crisis stand out. First, perverse incentives for agents within the financial sector played a central role in bringing about the crisis. Second, there were (and remain) issues of poor system design in the financial sector: even perverse incentives might have had limited consequences in a robust system. The problem with the Geithner plan is that even it works in terms of stabilizing the economy in the short-term, it does relatively little (the uncharitable would say almost nothing) to correct either incentives or system design. But the business and cultural norms and system-wide conflicts of interest which form the backdrop to the crisis run deep, and will not change without substantial impetus. It is precisely these deeper issues that we must address if we are to reduce the risk of a re-run of the crisis, probably on a larger scale, in a few years time.

I sympathize with the point of view which says that the political window of opportunity is narrow and the need for action urgent, so let’s accept the bailout plan for now, and deal with these wider issues later on. But the very fact that political momentum is limited means that if these wider changes are to be brought about, the process has to begin in earnest at once. Does anyone seriously believe that in a years time, if following massive government support the banks are stable - or can be made to appear stable – there will be any political will to break up very large institutions, or any real change to underlying norms in the financial sector?

However, absent these deeper changes, it is entirely possible that we will see a replay of the crisis - but on a larger scale - in a few years time. Naturally, one cannot say with certainty that such a cataclysm (and if it were much larger than the current crisis, it really would be a cataclysm) will occur. But if it does, the resulting costs will be huge. Martin Wolf has written persuasively about the costs of major economic dislocation. Net of unemployment, political instability and even wars, the human costs of a sequel could dwarf even the current crisis. Then, the choice in the present between the “bailout” and “restructuring” plans hinges on whether expected cost (in the broadest sense), conditioned on the “bailout” strategy is higher than expected cost conditioned on “restructuring”. One could formalize this argument as a decision problem, but it comes down to a judgement call on the relative probability of such a cataclysm under the two strategies and the magnitude of the dislocation. My feeling, admittedly subjective, is that the gloomy cataclysm scenario is substantially more likely under the “bailout” than “restructuring”, and that the costs would be immense.

This case can be put very simply: if we do not use current political momentum to fundamentally reform a system which has shown itself to be unstable and even dangerous, a second opportunity may come at a very high price. And this is not a gamble I wish to see our leaders make.


Anonymous said...

I agree with you that reforms are necessary. However, when I think of how reforms could occur it seems to me that a reform of finance could only come as a part of much greater reforms that would involve the whole of economy and would entail a substantial change in people's thinking and values. After all, way before the present crisis, there was that singular substantial change in thinking regarding the whole of economy, when the opinion makers, elected leaders, financial regulators, business leaders, etc decided to favor finance over manufacturing (strong dollar), which then led to repeal of the old regulatory rules and an atmosphere of laxity. A reform without a counter-change in thinking, whereby finance is apportioned a more reasonable place in the whole of economy, is not a reform, but a bailout and back to the old ways.

Another question is whether a reform, as a change in economic priorities, is possible simply because the country has certain cultural and economic predispositions that have not really changed substantially over great times. As someone said “speculation in land and paper is as American as appeal pie”. Going back before the Great Depression, many thought that the country would be a great agricultural powerhouse and not a manufacturing base. It took the Great Depression, and according to that Russian historian - who may be right - 7 million lives that ended prematurely due to hunger, disease and despair, followed by WWII to change that. So it is what it is: real estate going strong – no shortage in housing, speculation and agriculture. Unless another massive dislocation comparable to the Great Depression occurs, that's how it may continue.

Vasilis said...

"Another question is whether a reform, as a change in economic priorities, is possible"

It took a president who put it thus

"We had to struggle with the old enemies of peace — business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering. ... Never before in all our history have these forces been so united against one candidate as they stand today. They are unanimous in their hate for me. And I welcome their hatred!"

plus another president who looked at things this way:

"This conjunction of an immense military establishment and a large arms industry is new in the American experience. The total influence -- economic, political, even spiritual -- is felt in every city, every State house, every office of the Federal government....In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex.The potential for the disastrous rise of misplaced power exists and will persist."

but yes, change was possible from what happened in the 20s. The most prosperous times in the "American Century" were the times America looked most like a social democratic country.

Anonymous said...

I have more faith in the potential for an effective two step process of bailout followed by restructuring. Overlap is allowed.

The key question is whether a distinct step one threatens the chances of success for step two.

Nevertheless it is ironic that a two step process seems to be in contrast with Obama’s “walk and chew gum” approach to an overarching range of issues of which the banking crisis is only one.

Anonymous said...

Geithner’s modified Paulson plan to use taxpayer money to purchase bank toxic assets at above market prices, which the Democrats and especially President Obama should be deeply ashamed and mortified for supporting, does zero to help the US economy and just transfers federal money to politically favored recipients. Obama/Geithner’s bailout plan is a money grab, pure and simple. The banks have not and will not lend into a severe recession, it isn’t profitable. Nothing will change after the financial elite loots taxpayer’s money except Wall Street bankers will unfairly have the money that they rightfully lost leading up to the world recession that they caused. Geithner/Summers/Bernanke couldn’t be bigger toadies working for the money changers and against the common good.

The Obama administration’s solution of piling more and more debt on the problem will eventually make the recession much worse, instead, we need debt forgiveness paid for the directors, executives, stockholders and bondholders of insolvent institutions which should go into receivership and then be reorganized. Any other course condemns those who are politically out of favor to a decade, or more, of misery.

Blissex said...

«when the opinion makers, elected leaders, financial regulators, business leaders, etc decided to favor finance over manufacturing (strong dollar), which then led to repeal of the old regulatory rules and an atmosphere of laxity.»

It was a very big industrial policy shift, and it was a shift from unionized manufacturing towards nonunionized services, as a way to break the political power of the unions.

It was also a deliberate shift towards a plantation economy, with a tiny hyper-rich elite, a cadre of trusties and supervisors, and a vast mass of labourers; because a vast layer of prosperous working class (largely from northern progressive states) has proven unruly and too liberal.

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