I am not in support of a bailout of any kind. I also live in an ivory tower when it comes to economics, and a short, unexperienced or well taught one at that. I am confused somewhat by the push for a bailout. Why am I confused? Well, on the one hand, I can see where the people who are going to get free money want it, and I can even see how the republicans, who generally are against free money for people, are ready and willing to give free money to banks. I understand that Bush is once again saying, “my way or the highway.” Why wouldn’t he? it has worked every other time he’s done that. That stuff is not confusing.
What is confusing is the economic reasoning for a bailout. The entire point of capitalism is that it is the best known method for increasing the standard of living of a society. It does this by selecting ideas that are winners and ideas that are losers by rewarding people who have good ideas, and making people who try to long on bad ideas go broke. Of course, one would hope people with bad ideas get the picture before they go broke, but sometimes they don’t. This idea is called Creative Destruction. I just recently finished Alan Greenspan‘s book, The Age of Turbulence, which stated the importance of this in no uncertain terms. It also stated that as you increase socialism and other safety nets to insulate people from risk, creative destruction occurs less often and the ability of the capitalist system to increase the standard of living decreases.
All that is happening here is creative destruction. Some firms, are going to go out of business. They are going to go out of business because they had some bad ideas and they ran to far with them. There is nothing wrong with these firms going under. They actually increase the standard of living in the long run by going away. Of course, not all firms will fail completely, some will merge and what not, and be able to survive. This is because they did not run as far with or have as bad of an idea as the ones who did fail. They will, however, suffer pain, as a result of the bad risks they took. Everyone who took bad risks will suffer pain, and as a result people will not take these same bad risks again. That’s how its all supposed to work. That’s clearly an ivory tower way of thinking.
But what about the credit market? When firms go out of business it is usually because there is a glut of supply, too many firms are in the market, producing too many goods. This was in fact the problem a year or two ago (or more). There were too many people willing to lend money and not enough people to which to lend money. To solve this they expanded the pool of people they to whom they were willing to lend. Clearly that was a bad idea, and the market is telling everyone who did this that it was a really bad idea, and it is telling them this in a big way. It seems obvious now that it was a bad idea, but we only know that because of the market.
The problem now is that there isn’t enough credit. People can’t get loans. There is a lack of supply, because in effect all the firms who took bad risks can’t loan money, so they are no longer in the market. The call for a bailout is grounded in the idea that we need these firms to re-enter the market so that supply will increase, and people will be able to get loans. I agree that we need more firms in the credit market, or at least that we need to increase the supply of credit. But why do we need these firms? Firms are in the end just people. These people have proven themselves unfit to be in a credit market; that is they have bad ideas about how to make money in the credit market. We should not help them to re-enter a market that they so clearly have failed at.
But how do we increase the supply of credit without them? There is no reason why new firms won’t stream in to the credit market now that there is a shortage. These new firms will need promises to their investors that they won’t repeat the mistakes that were made. They will need to not take as many risks. Investors, who are reeling from taking too much risk will flock to these new firms. This will provide them with the capitol they need to provide the loans, for which people are apparently clamoring. These new firms will flourish with their new ideas, and the old firms will die; creative destruction. As I said before, die is a simplification, some old firms may survive by doing the same thing the new firms are doing. However, if they can’t survive that way, we should not help them, just let a new firm take their place. This whole thing will take time, I don’t know much, but I bet that we can have new firms in the credit market in 2-3 quarters.
What do we do for the next 2-3 quarters? Well, it won’t be easy. There is a shortage of credit, and so people who need credit will have to stand in long lines, and accept higher interest rates (pay more for it).
Who will they borrow money from? Anyone who will lend money of course, be it small banks who see a profitable new opportunity to expand their business, or the vestiges of the old firms still limping along. There is also the federal reserve of course, they are the lender of last resort. They always have money to lend (that’s the point). In the past, large banks have been their customers, but there is no reason why they can’t make loans, at appropriate rates, to smaller customers, or anyone really. Lastly, don’t forget overseas investors.
The only real problem is that there needs to be capitol, money to lend. There is an easy way to generate capitol; raise interest rates until people who do have money are willing to lend it. There should be no free money from the government. There is no reason to think that the only people who have money are the government. There is plenty of money in the country, and even more in the world. If we want people to loan it to us so we can buy houses, we need to provide them with an attractive interest rate. When we do that we’ll get the money, and we can loan it out, to anyone who wants the money badly enough to pay for it. As time wears on the risk premium that is currently going to be required will diminish and things will return to normal. Change leads to normalcy. We need to change the big names in banking, if we just sit tight, this will happen for us. If we meddle, we’ll loose in the long run.
What might really happen? From what I’ve read, which is only a little, they are considering a type of reverse auction where the banks will all place bids. What they are actually bidding in is too complex for me right now, but the way it works out is that the banks who are better off will be able to off the government a lower bid. The lowest bid wins, and every bidder may make trades to the government at that rate. Anyone who can afford that rate, who can avoid bankruptcy by trading some amount at that rate will survive, and those who can’t still go out of business. As you can tell, Bush did not come up with this plan, which is being called his. This plan is reasonable, in that those who took the worst risks still get creatively destroyed. It lesses the short term pain, and the cost of some, intangible amount of long term prosperity. The risk to reward trade off is probably there in this plan, especially since who knows how much prosperity, how far in the future we’re talking about.
So am I for the plan? Well, I still think we should do nothing, but what they plan to do is not brain dead. What the democrats are pushing for, more regulation would be bad. It all sounds good, but markets don’t like regulation. I don’t much care how much CEO’s get paid. As the paper pointed out to day, they are losing a lot of money right now, if you count stock. If you put a cap on how much you can pay them you could end up with a shortage of qualified CEOs. One may argue we already have that, in which case we clearly need to pay more to get the actual good ones, not less. What we really need is a populace who is educated enough to participate in the credit market on both the lender and borrower sides. Until we have that, the only sensible regulation, increased transparency, is worthless. This is roughly the same remorseless conclusion that I came to in my last econ rambling. What I want to see then, are some educational riders on this bill. Assuming the risks the taxpayers are taking on comes up good and we win big. Lets require all that money we made go to education.
Maybe someday soon I’ll have time to see what Greg Mankiew thinks of all this, but I’ve been too busy at work to keep abreast of his position.
I’m not going to agree that high compensation in any way assures getting a decent CEO. I do believe that CEO’s who have gotten their companies into this mess should have their pay capped if they want to participate in the “bailout”. If they want to keep their pay, then they can decline the publicly funded bail out. Otherwise, I thought it was a pretty interesting and to-the-point blog. [In spite of the occasionally distracting spelling.]