President's Question:

What do we know about bailouts?

What do we know about bailouts from previous experience and existing theory? How can this inform the current public discussion of government actions in the US and other countries?
Elaboration: The US government has acted in recent days to rescue some enormous firms (but not others) and to try to stabilize volatile financial markets and is considering investing billions of dollars more in bailouts for the financial industry. The British, French and other governments around the world have also invested massive public funds in trying to save firms or markets that grew initially on the principle of private risk taking. What can we learn from previous bailouts both in other industries (e.g., Chrysler), in more conventional banking (Credit Lyonnais in France, Northern Rock in Britain, or the US Savings and Loan crisis of the 1980s), and in earlier directly financial crises (Long-Term Capital Management)? Are there ways to avoid the moral hazard of making speculation seem safe? Are there ways to avoid using public funds to reward private investors who took bad risks? Are there ways for public investments to be well-managed enough to eventually return initial capital or even profits?

Related Contents on SSRC.org:

21 Responses to “What do we know about bailouts?”

[+] Expand all comments
[-] Collapse all comments

  1. +
    Avinash Dixit :
    October 1st, 2008 at 5:21 pm

    What would Morgan have done?

    An essential feature of the bill is summarized in a CNN article:

    The core of the bill is based on Treasury Secretary Henry Paulson’s request for authority to purchase troubled assets from financial institutions so banks can resume lending …

    This seems exactly the wrong way to set about it. The government buys all the toxic stuff – the worst subprime and Alt-A mortgages – leaving the banks etc. holding the good stuff. The idea should be to stop contagion, that is, to stop the repercussions of the bad decisions from spreading to the institutions that did not make the bad decisions, and are holding basically good assets. Almost exactly 101 years ago, J. Pierpoint Morgan was the lender of last resort in the panic of 1907. Jean Strouse in her biography of Morgan gives a brilliant account (pp. 575-9). He, George Baker, and four others “would try and ascertain which companies were hopelessly overextended and should be allowed to fail, and which were essentially healthy and could be saved. Somehow they would find ways to supply liquidity where it would do the most good.” They scrutinized the collateral offered by all borrowers. They “could not determine whether [Knickerbocker] had enough assets to secure a loan. … Morgan decided not to intervene.” Finally the Trust Company of America came up with good collateral- “boxes and stacks full of certificates” – and Morgan said “This is the place to stop the trouble.” That’s what Bernanke and Paulson should be doing – find the boundary line of quality and offer to lend to all those with assets above that line, not below it.

    -
  2. +
    Dean Baker :
    October 2nd, 2008 at 8:55 am

    There are three important rules for a bailout to be successful. It must have clearly defined goals, specific break points where support can be ended, and it must be structured to avoid problems of moral hazard.

    While the first point should be obvious, in many bailouts it has not been clear what the goal or goals are. For example, in cases where governments bailed out major industries, it has not always been clear whether the main goal was maintaining employment or ensuring the survival of a national industry.

    In the proposed bank bailout, no one has set out clear criteria by which success should be evaluated. Obviously it is intended to maintain stability in the financial system, but does success imply an end to sudden bank failures, a sharp fall in interest rates and surge in credit, an end to the recession? Given the enormous drag from the collapse of the housing bubble, it would be unrealistic to expect that even the best designed bailout would end a recession, but a clearer statement of goals would be useful.

    Clear break points are important to limit potential losses. At any point in time, politicians will always feel pressure to provide more money if it appears a bailout is failing, because their political reputation is tied up with its success. Rather than acknowledge failure, they would rather throw in more money even if this will only delay the day of reckoning.

    Under the structure of this bailout, the $700 billion will be released in phases. The first $250 billion is made available immediately, with another $100 billion to be released at the request of the president, under rules which would make it almost impossible to stop. In fact, the rules make it difficult for Congress to stop even the remaining $350 billion.

    The real break point would come if the bailout threatened to cost more than $700 billion and required additional funding from Congress. That’s a high break point, but even then there may be considerable pressure to throw in more money once the government has embarked down this path. It would be reasonable to commit proponents of the bailout now to look to alternative policies, if $700 billion proves to be insufficient.

    Finally, a bailout should be structured so as not to give perverse incentives. If the government rewards people for running their companies badly, then we can anticipate that more people will run their companies badly. In this case, the bill does very little to restrict the compensation or in other ways punish the executives who mismanaged their banks so that they now need government assistance.

    The caps on executive compensation in this bill have wrongly been viewed as a moral issue. While there is obviously a moral dimension to these caps, they also serve an important economic function. The lesson should not be that if you wreck your company, the government will step in and save your job. This will only encourage more of the reckless behavior that we saw on Wall Street over the last decade.

    -
  3. +
    Robert E. Wright :
    October 2nd, 2008 at 1:04 pm

    British North America experienced a real estate bubble during the first phase of the French and Indian War. By the war’s second phase, the economy began to soften but low real interest rates kept real estate prices high. By late 1763, the bubble had burst, real interest rates skyrocketed, and land prices dropped by 50 to 75 percent. Creditors called (most mortgages then were for 1 year and thereafter were callable), the crisis rippled through the economy, and by 1768 thousands of Americans had lost their homes and their freedom. (We had debtors’ prisons back then, special prisons for people whose only crime was defaulting on debt.) British authorities not only stood idly by, they increased the colonists’ suffering by increasing trade restrictions (thus making it difficult to get gold and silver to flow into the colonies), restricting their ability to issue fiat paper money (bills of credit), and increasing their taxes. This was the back drop of the American Revolution.

    In 1792, Treasury Secretary Alexander Hamilton engineered a successful bailout of the young nation’s nascent financial system by inventing what would later be called Bagehot’s Rule: the lender of last resort (the Treasury and Bank of the United States in Hamilton’s time) should lend to all comers at a penalty rate on the collateral of what in normal times would be considered good collateral. Those who took on excessive risks, like William Duer, were allowed to rot in debtors’ prison. That helped to keep moral hazard low. The next major peacetime panic did not hit until 1819 but the government that time failed to help out and a steep recession ensued. Although the (second) Bank of the United States helped to stop the spread of a British panic to American shores in 1825, many Americans never forgave it for the 1819-1824 recession and backed Andrew Jackson’s decision to allow its charter to expire.

    The U.S. government did little to stymie panics in 1837-39, 1857, 1873, 1884, 1893-95, and 1907 but instead allowed financial institutions to fail and waited for the economy’s automatic stabilizers (under a specie standard) to kick in. After the 1907 panic (see Dixit’s excellent post on this episode above), a consensus arose that the government ought to take a more active role in fighting panics and other shocks, leading to the formation of the Federal Reserve. Because of its strong attachment to the gold standard, the Fed did not stop, and many think exacerbated, the downward spiral of 1929-33. That made necessary the unprecedented reforms of the New Deal, parts of which could be thought of as bailouts for banks (FDIC), the unemployed (CCC, etc.), the poor (the dole), farmers (price support programs), and the aged (Social Security). Many historians believe that without those extraordinary efforts, a revolution, probably fascist, could have occurred.

    Using Hamilton’s nee Bagehot’s rule, the Fed has in recent decades done an excellent job of containing actual and possible financial panics: 1987, 1997-98, Y2K, 2000-1. But the moral hazard problem has grown since Hamilton’s time because we no longer have debtors’ prisons (probably a good thing) and because of relatively new policies like Too Big To Fail (definitely a bad thing when untaxed as it was). In retrospect, the Fed’s earlier efforts merely emboldened financial firms to take on high risks. Those risks paid off handsomely at first but have now seemingly hit a return of -100%.

    The current crisis has come at a particularly unpropitious moment in our history, a time when the national debt is an almost unprecedented two-thirds of GDP and was growing rapidly BEFORE the crisis struck. The government’s ability to respond to the situation is therefore severely restricted. If the $700 billion plan, on top of the $300 billion Hope for Homeowners program and the direct bailouts, doesn’t succeed we could be in for some very difficult times ahead indeed.

    -
  4. +
    Bruce Carruthers :
    October 3rd, 2008 at 11:16 am

    Unless one is in a sinking boat, the connotations of “bailout” are decidedly negative. Bailouts are when one group in trouble, usually due to their own misbehavior, is unilaterally saved by another group. The latter bears the cost while the former enjoys the (undeserved) benefits. Today, it seems, the U.S. taxpayer is being called upon to “bailout” a Wall Street populated by greedy, misbehaving and overpaid financial titans. No wonder the first bailout attempt failed in the House of Representatives. The real complication in this case, however, is that we are all in the same boat. If Wall Street goes down, so does Main Street. The U.S. economy is a credit economy, and when no-one lends, even from one big bank to another over night, then a kind of sclerosis spreads throughout the economy and suddenly even credit-worthy people have a hard time getting a mortgage, student loan or car loan. At this point in our history, we cannot revert to barter or a strict cash economy. So if the credit system fails, our economy fails.

    Karl Polanyi would probably not be surprised at what has happened. From his perspective, the U.S. government is trying to save capitalism from itself. Unregulated and unrestrained markets have a tendency to undermine their own social foundations, and here unregulated and unrestrained credit markets have eroded some of the basic imperatives of prudential lending: that the lender make a good faith effort to determine the creditworthiness of the borrower, and that lenders should not lend to those who are unlikely to repay. Nor would David Moss be surprised, for the government is once again playing a role as the ultimate risk manager. The big losses born by U.S. financial institutions weigh down their balance sheets and erode confidence in their ability to function, so the bailout proposes to socialize those losses. Some bells and whistles have been added to the bailout to make it politically palatable and to reduce some of the moral hazard (cap salaries and shred the golden parachutes given to CEOs, give the taxpayer the chance to benefit from economic recovery, offer assistance to ordinary borrowers,, etc), but fundamentally this is about nationalizing the private losses suffered by financial institutions that collectively are too big to fail.

    A number of commentators have suggested that the bailout of the savings-and-loan industry in the 1980s shows how to intervene successfully and engineer a recovery. One might also notice that after the Asian Financial Crisis of 1997 laid low the financial sectors of South Korea, Indonesia, and Thailand, those countries engineered similar bailouts to remove non-performing loans from bank portfolios and lodge them in publicly run asset-holding companies, so that the banks could recover. Although they may seem unfair (why should we help firms that performed so badly?), bailouts can work. But bailouts can only lead to long-term recovery if the underlying problem gets resolved. In this case, that means re-establishing effective prudential regulation and oversight to make financial institutions, and their CEOs, behave themselves. The U.S. should think hard about how to reinvigorate its financial regulatory apparatus.

    -
  5. +
    Andrew Caplin :
    October 6th, 2008 at 3:04 pm

    1. YES, BUT WHAT NOW?

    Given the most likely alternative (inaction or more vote-buying add ons), passage of the bill was a good outcome. But the measure was deliberately vague. What happens next is crucial.

    2. A CRISIS OF CONFIDENCE

    There are three broad problems in the markets: lack of liquidity, possible solvency problems at major institutions, and a crisis of confidence. The intention is to use the funds to buy up illiquid assets, and to pay more than the sellers would reasonably get in a competitive bid. That will help with liquidity and solvency. The measure is based on the hope that the crisis of confidence, which proved resistant to “jaw-boning” (it will be OK if we all say its OK), will be solved by a commitment to put our childrens’ money at risk. Having failed with talk, the hope is that we can succeed by putting some muscle into the job.

    3.SHOW ME THE MONEY

    Muscle is not enough. Some brain power is now needed. In my view, confidence will not be rebuilt unless this money is used very wisely. After all, there are excellent reasons for lack of confidence. Why did investors not take account of the risk of sub-prime mortgages? And just how credible are the institutions that each are promising to support one another in case one defaults? Who checked the addition on these mutual promises to pay? Given that so many institutions have engaged in incomprehensible transactions, what other garbage might they have on their books? Who can say we will not endlessly play catch up, throwing more good money after bad?

    4. HOW CAN WE REBUILD CONFIDENCE?

    Rebuilding confidence is slow and painstaking. Generally it requires beginning to clarify value on hard to value items. In principle, it would be possible to use the purchases of securities to improve confidence, in particular by improving the resolution of values of mortgage backed securities, even increasing their value. This would require a well-designed purchase scheme with CONDITIONS PRECEDENT designed to cause appropriate information to be gathered. Once this information was put in place, it would be a relatively simple matter in principle to restructure relatively better quality such mortgages and clean up the mortgage mess. See e.g. ideas on shared appreciation mortgages.

    http://www.brookings.edu/papers/2008/09_mortgages_caplin.aspx

    Taking similarly pro-active measures to clean up accounts in other areas would lead to the slow rebuilding of trust in institutions. That would also require regulators to move their ideas into the 21st century.

    5. SO WHAT WILL HAPPEN?

    Nothing that we have seen suggests that the plan will be structured as a coherent effort to build confidence. Almost one year into the current crisis, we remain spectacularly ignorant of house values and of their impact on default. Most likely, the funds set aside for purchasing mortgages will be used either to avoid immediate tragedies or to buy off political opponents. Given the failure to address problems of confidence by opening up books, many more institutions worldwide will be tested for robustness and found wanting. More such defensive measures must be anticipated not just in the U.S., but in Europe, and then rest of world.

    6. NOT DEREGULATION, BUT INCOHERENT REGULATION

    The common verdict is that this is all the fault of “deregulation.” The real problem is not too little regulation, but rather incoherent and archaic regulation. Poorly thought through partial deregulation is just one form of regulatory incoherence. There are other forms which involve retention of archaic regulations. For example,
    shared appreciation mortgages, which offer the best way out of the current sub-prime crisis, have been effectively banned by U.S. regulators themselves.

    7. BUT THE HORSE HAS BOLTED

    It is probably too late to get the story told accurately. It has entered folk understanding that the problem was deregulation. The next step will be regulators taking yet more power, without any pressure to improve the coherence of their regulations. As so often, this crisis will not merely be wasted, but will lead to many future crises due to inappropriate reading of the implied lessons. Next stop Iraq!

    -
  6. +
    Uwe Reinhardt :
    October 6th, 2008 at 6:49 pm

    There are several lessons in the current financial fiasco – for different groups.
    As an economist it occurs to me that our profession might review what we teach our students about a modern capitalist economy.

    First, we might question more critically than we now do Adam Smith’s soothing theory of the beneficent Invisible Hand which, in the manufacture of pins and sausages, will channel the greed of individual economic actors into something called the common good. Does this felicitous theory also apply to modern financial markets, whose products are rather different from pins and sausages and which are beset by a host of conflicts of interest and externalities? If not, ought not basic economic textbooks penetrate more bravely beyond the pins-and-sausage story and include a more critical review of the financial sector in a modern economy, in both the micro- and macro sections of the texts?

    For the most part today’s introductory textbooks in economics are faithful copies of one another, and are all closely patterned on Paul Samuelson’s original text, penned over half a century ago, with scant innovation beyond that 20th century text. Perhaps the next revision of these texts, which comes every three years and usually does little more than update tables and scramble homework assignments, should be a genuine revision, preparing students for the 21st century. A special chapter in these texts should be addressed to the question: where the CEOs of our financial sector rational actors who maximized their own wealth by trashing their shareholders, employees and country, or were they nitwits who just made mistakes?

    Policy makers will have learned that our financial markets inevitably require social insurance of various forms, which requires corresponding regulation, including a new look at the compensation of the chief decision makers in the financial sector. Scrutinizing the compensation of executives is not only the moral issue Congressman Waxman tried to make it in grilling Lehman Brothers’ CEO Richard S. Fuld, namely, the issue whether Fuld’s multimillion dollar annual payments were “fair.” An even more important issue is whether the manner in which American capitalism compensates senior executives is at all conducive to prudent and efficient management of the enterprises entrusted to them. Should not much more of that compensation be based on long-term performance, including claw-backs on bonuses bestowed in earlier years? Economists undoubtedly have some good ideas on efficient agency theory in corporate governance and compensation; but little of it seems to have trickled out into the executive suite. Policy makers should make, ex ante, any benefits of social insurance for financial firms contingent on an efficient executive compensation scheme.

    One cannot overlook here the fact the none other than Treasury Secretary Henry Paulson, previously CEO of Goldman Sachs, indirectly described his former colleagues on Wall Street to Congress as totally indifferent to the well being of their shareholders, their employees and of the country whose flag so many of them wear in their lapels – and this at a time when brave young American men and women in uniform risk their limbs and lives for their country, at annual salaries typically below the daily compensation of a Wall Street CEO. Paulson did so when he asserted before Congress that limits on the compensation of Wall Street CEO’s as a condition for federal help for their firms might lead these CEOs in a personal pique to shun such help, shareholders, employees and country be damned. In plainer English, he appears to think of his former colleagues as selfish, unpatriotic louts. If that is so, then one must worry about entrusting as important a sector as finance to these people without very tight social constraints on their behavior.

    Finally, on the back of the current crisis, numerous alternative ideas on efficient bailouts have already appeared on blogs around the world – for example, the Swedish model which gives taxpayers large equity positions in return for government-supplied liquidity. In the years ahead, economists and policy makers will sift through these proposals, some of which are quite imaginative, to tease out approaches more elegant and helpful than the ad-hoc, somewhat amateurish, seat-of-the-pants bailout sold to Congress by Ben Bernanke and Henry Paulson.

    One might chide the economics profession for not having had on the shelf several well researched alternative approaches to cope with crises such as the current one, where it not for the fact that economists themselves are captives of assumptions that fit their models better than the real world. For example, how many economists would have assumed, in their wildest dreams, that in the 21st century so many financial executives, most of them trained at excellent business schools, could be so reckless, so myopic and – let us be honest –so incompetent as to drive their firms’ leverage ratios above 90% and invest that debt in dodgy assets? Can rational, selfish greed alone explain such mismanagement?

    -
  7. +
    Alisha Kirchoff :
    October 8th, 2008 at 1:27 pm

    I have been thinking about these questions and this bailout extensively over the past days and weeks as are most in the US and all over the world, I am sure. Yet despite near-constant coverage of this situation in the media and in the public discourse it occurred to me that I did not fully understand what this latest crisis meant: How did it happen? How could a bailout help? Could a bailout cause some harm?

    I find it difficult to formulate an opinion on such big questions without the proper context and my sense is that many sources of information do not provide the necessary context for discussion on such issues. However, Chicago Public Radio’s “This American Life” beautifully explained this current crisis, the bailout, and its potential for success or failure given our economy’s current conditions. (the link to this episode is: http://www.thisamericanlife.org/Radio_Episode.aspx?episode=365).

    After listening to this podcast and reading the comments above, I would like to address the final question in the President’s blog posting above and suggest that yes, it is possible for public investments to be well-managed and still turn a profit. I believe that part of the predicament we are currently in is a result of opaque transactions and the freezing credit market can be attributed to this opacity as well. Lenders simply do not know if those asking for loans will be able to return the funds and are thus more hesitant to offer credit. My sense is that if these transactions were more transparent and the system for regulation was modernized, the system could be improved and public investments would be handled more responsibly. The payoff may come more gradually than in the past, but it would come eventually and without putting the entire economy at such grave risk.

    -
  8. +
    Bruce N. Lehmann :
    October 15th, 2008 at 2:14 am

    From the outset, the solution to this problem has seemed to me to be straightforward: the problem is the toxic nature of subprime mortgages so the solution is to detoxify them. The feds should deal with the systemic risk induced by subprime mortgages directly and it is easy to do so. The feds can forgive a portion of each mortgage, which will reduce the probability of default, and pay the mortgagee this partial principal reduction, which will add liquidity to its balance sheet (and which would be the only source of capital infusion in this approach). The feds can add a partial loan guarantee to the mortgage, permitting the mortgagee to sell off the guaranteed portion of the mortgage and thus liquefy these illiquid assets. There are many variations on this theme – for example, the feds could trade their partial loan guarantee for ownership of the cash flows generated by a mortgage after the guaranteed portion of the loan is paid off – and there is much room for fine tuning but the main point is that the solution is to detoxify these toxic assets and not to contribute capital to institutions directly.

    Detoxified mortgages are a lot easier to value and this solves many problems at once. Transparency is injected into the valuation process automatically, thus mitigating the risk of substantial mispricing, either through mismanagement or corruption, when mortgages are bought and sold at negotiated prices. Auctions would become the natural way to sell assets to reliquefy essentially solvent institutions and to proceed with the orderly liquidation of the assets of insolvent ones, another benefit of transparent and recognizably fair valuation. The Fed and the OCC can contribute to transparency by auditing the loan portfolios of major financial institutions. Partial loan forgiveness reduces default probabilities and thus the risk of default for credit default swap contracts. The derivative portfolios of Wall Street firms will then be more solvent, reducing the risk of further financial distress for the remaining firms and for those that took over failed institutions. The financial institutions that will remain at the end of this process will be safe and sound.

    This approach not only gets the prices of mortgages up, it gets them right. My best guess – and it is a guess because we do not have believable numbers on the magnitude of the problem – is that this remedy would be considerably cheaper than running an acquisition and sales program and making direct capital contributions to selected financial institutions, policies that will lead to government management of financial institutions for years to come. This is such an obvious solution that it immediately begs the question as to why it has not been the centerpiece of any bailout plan. Sadly I think the answer is quite simple: there is a lot more room for overpayment for mortgages in this setup and, with it, overpayment to those who precipitated the problem and who still represent a powerful constituency in Washington.

    -
  9. +
    Christian Weller :
    October 24th, 2008 at 9:15 pm

    This is an important question. I had written about the same topic on http://www.CreditSlips.org about two weeks ago. Here is the text, only slightly modified.

    This is a standard financial crisis, as many other countries experienced over the past twenty or so years. In a crisis four risks materialize: default risk, maturity risk, interest rate risk, and exchange rate risk. The United States are spared from the last one since the dollar dropped well before this crisis. The problem is that policymakers are not adequately addressing the remaining risks.

    Default risk is always part of finance, but it spikes in a crisis. Borrowers cannot pay back their loans and bad loans accumulate on the balance sheets of banks, taking down financial institutions. The bailout was intended to solve this problem. But, the $700 billion Wall Street rescue only cures the symptoms, not the disease. It does not make it easier for homeowners to stay in their homes. To do that, we would need additional steps, such as bankruptcy reform, easier workout solutions for struggling homeowners to refinance their loans, and a second economic stimulus to boost household incomes.

    Maturity risk exists because banks are supposed to bridge the inherent maturity mismatch between short-term deposits and long-term loans. But in a crisis this function is broken because banks are not sure that they will have enough short-term deposits to finance long-term commitments. Thus, maturity risk can bring down entire economies. When short-term capital, so-called “hot money”, leaves economies, credit markets cramp up because banks run out of cash.

    We now see depositors and other lenders to banks completely withdraw their funds or lend only on a short-term basis. Banks don’t know if they will have enough cash to meet all of the demands and thus stop making longer-term loans or even recall loans, e.g. by reducing credit lines.

    The Fed’s policies are intended to fill this gap. They are supposed to play the role of depositors, when depositors put their money under their mattresses rather than in a bank. Public pronouncements and FDIC insurance increases are meant to do the same.

    So, why is this not working? There could be several explanations. First, the gap may be too big for the Fed to fill. Second, there is a reputation problem. Banks that borrow from the Fed may be seen as weaker than other banks and thus may precipitate a bank run.

    What can be done? The federal government is already taking equity stakes in some banks, but it needs to get these banks to lend again. In essence, we may need a federal development bank that would extend credit for worthwhile projects. Treasury and other governments talk about “cajoling” lenders into lending again, but we need more than some ad hoc approach. The government needs to think how it can act like a banker not just like a lender of last resort. This can be done by having Treasury officials embedded in banks, have the Treasury be represented on loan committees, among other steps.

    Even if banks have all the money that they need to lend for longer-term projects, there is still interest rate risk. The interest rate on a loan is fixed for long time. A bank, though, finances this loan out of revolving deposits with shorter maturities. The interest rates on these can fluctuate wildly. Right now, all interest rates are low. If banks think that they are too low, they may want to wait to lock in higher long-term interest rates. More importantly, banks may be worried that short-term interest rates could go up again.

    If raising interest rates at this point seems silly, remember that this is what typically happens in a crisis. Central banks raise rates to prevent capital from fleeing a country. The Fed and other central banks are doing the right thing by coordinating their interest rates to avoid interest rate competition, commonly referred to as a “beggar-thy-neighbor” policy. The G-7 meeting in DC on October 10 reaffirmed the willingness of policymakers to solve the crisis, but they missed an opportunity to state that they will regularly consult and coordinate their actions in this crisis until there is a resolution. Such a desperately needed statement would reassure market participants that there won’t be harmful of policy competition and that policymakers in different countries won’t work at cross-purposes with each other.

    -
  10. +
    Algernon Austin :
    October 28th, 2008 at 10:10 am

    I have already argued that since the economic downturn hits black and Hispanic communities first and hardest, we should make sure that economic aid reaches these communities and reaches them quickly (see http://thedailyvoice.com/voice/2008/10/where-is-the-economic-aid-for-001210.php).

    But the issue of the bailout still fails to address the root of our economic problems. Even if we effectively address the foreclosure and financial crises, another economic crisis will be waiting for us down the road because the fundamentals of the American economy are weak.

    America has been competing in an increasingly global and integrated world economy—and losing badly. America’s losses can be measured by the wages of American men. Since the late 1970s, the wages of American men in the bottom 60 percent of the wage distribution have declined in inflation-adjusted dollars. These losses are the result of the American economy shedding high-wage jobs due to global competition.

    From the 1940s through the 1960s, male wages increased and American living standards followed these increases. Since the 1970s, living standards have increased largely because American women have worked more and at better jobs. But overtime, more and more American households have reached the limit of income gains from women’s work. For these households, the next means of increasing income was to go into debt. The financial and foreclosure crises ultimately are the result an American economy built on debt—debt absent of the growing incomes needed to repay loans.

    We need an American economy where the earnings of average workers—male and female—increase enough so that Americans can pay off their debt and save. This means we need a strategy for competing in the global economy. We cannot continue to simply watch high-wage jobs disappear without having a plan to replace them.

    There are many things that we need to do. Most importantly, we need political leaders who will see that business leaders build an economy to meet tomorrow’s challenges and not only to make a quick buck today. All the signs are that the energy future is clean and green, but once again the United States is lagging. We still have political leaders who get excited about drilling for oil—yesterday’s energy—when they should be devising a plan for how we will compete with Germany, Spain and Denmark in clean and green energy production. There a lots of opportunities for the United States to develop high-wage jobs manufacturing products for the world’s future needs, but we are not taking advantage of them.

    We can fix the financial crisis and the foreclosure crisis, but that will still leave us with a country with a broken economic engine. Male wages are declining and household debt is increasing. We cannot have a growing economy when each year the average household has less and less real income to spend.

    -
  11. +
    Donald F. Kettl :
    October 31st, 2008 at 3:18 pm

    We’ve been down the bailout road before, but the most recent bailout, the federal government’s rescue of troubled savings and loans in the 1980s, was a very different effort. In the S&L bailout, the feds acquired a remarkable range of marketable assets from failed S&Ls: apartment complexes, strip malls, and shares in the Dallas Cowboys. In remarkably short order, the government’s Resolution Trust Corporation sold off these assets and then put itself out of business.

    This time around, the underlying assets are toxic. There are no ready buyers, and it’s sure to be a very long effort. Moreover, this bailout is global, wrapped in a worldwide credit crisis. In the last bailout, many small savings and loans disappeared over several years. This time, giant and historic investment banks simple vaporized within days. The sheer scale of the problem is different, too. The savings and loan bailout cost the federal government about $125 billion. It cost more than that just for the tax breaks that oiled the passage of the $700 billion bailout legislation in 2008.

    In short, we’re in uncharted territory. This bailout isn’t like any previous one. It’s far larger and, in fact, it’s hard to know how big it will need to be. It’s harder to sort out the causes and even harder to figure out the fixes. It’s hard to know how long the federal effort will take.

    There are some important similarities to the S&L bailout, however. As in the S&L bailout, the federal government will be relying heavily on a network of private-sector contractors to do much of the front-line work. The Treasury is talking about hiring just a few dozen officials on the government side, and contracting out much of the work. The most likely source of financial experts, however, lies with the very organizations that helped create the crisis, so the fox-in-the-henhouse problem looms large. The feds will need to devise very careful contract management and accountability systems.

    We learned with the S&L crisis that transparency is critical. The feds will need to work vigorously to ensure that the strategy and transactions do not create a specter sense of insider training, which would further erode citizen confidence in the process.

    Government will need to be flexible and to move fast in dealing with this issue. In the S&L crisis, government officials learned that they needed to focus on the big problem and not let tiny details trip them up. The feds will need to devise a nimble system that remains accountable, which in this politically charged environment will be a tall order.

    Perhaps most important, the S&L bailout of the 1980s taught us the risks of government regulatory strategies that fall out of sync with private market innovations. Following the S&L bailout, the federal government revised its regulatory approaches. We will now need to launch a major effort to rethink government’s relationship with the private sector and, especially, with private financial institutions: how much flexibility these institutions ought to be allowed, what transparency in strategies and tactics ought to be required, and how far the government ought to go in rescuing companies and their customers from the costs (even if unintended) of their actions.

    We dealt with many these questions following the S&L bailout, but on a much smaller scale. Not only are the questions far bigger and more important this time. The arena is global, where the missteps of any country can quickly cause international fallout. The debate is inescapable. It will be complicated. But it will define the nature of private enterprise, and government’s role in regulating it, for the 21st century economy.

    -
  12. +
    Eric Maskin :
    October 31st, 2008 at 7:59 pm

    I think it is important to understand why bailouts are needed at all. Many markets work best with little or no outside interference. But others—especially those subject to big “externalities”—need a helping hand. The credit market is in this latter category.

    When a bank calls in a loan, it obviously hurts the customer in question. But it also adversely affects other banks that have lent to this borrower. They are now less likely to be repaid, and so can’t as readily lend to their own customers. We say that the original bank exerts an externality—a secondary effect that it doesn’t take account of—on these other banks. As long as everyone continues lending, all is well. But if some banks stop doing so—perhaps because a number of customers have defaulted—they may force other banks to call in their loans too. The chain reaction so generated could end up paralyzing the credit market altogether. Sound familiar?

    Yet government can help. By infusing money into banks, it allows them to begin lending again. With a big enough infusion, the chain reaction reverses, and ultimately the market is restored to health—at which point the government presumably gets its investment back.

    Such intervention comes, however, with an attendant risk. If banks anticipate government will come to the rescue should the credit market go awry, they may make loans that would otherwise be imprudent, e.g., subprime loans with little prospect of repayment. So a contingent bailout policy—implicit or explicit—must be coupled with some regulation of what banks can and cannot do. For example, a ban on lending to uncreditworthy customers probably makes a lot of sense.

    -
  13. +
    Jan Nederveen Pieterse :
    November 2nd, 2008 at 6:58 pm

    Crisis 08

    ‘I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.’ (Alan Greenspan, US Congress, October 2008)

    The financial crisis of 2008 brings American dilemmas into sharp focus. In September the focus was on the bailout of banks, which soon changed to the financial crisis spreading, recession and more serious interventions coming on the agenda, possibly including reorganizing the system of international finance.

    Karl Kraus described psychoanalysis as a symptom of the disease that it claims to be the remedy of. This also applies to the bailout and financial crisis management. The bailout of banks in the US and beyond is, first, a symptom of financialization, or the financial sector overshadowing the main street economy. During the past twenty years financial rents garnered an ever larger share of profits and revenues at the expense of wages and salaries. Infusing $1.5 trillion (and counting) into the financial sector adds to the ongoing financialization. Second, financial fixes have papered over American economic problems time and again since the 1970s (beginning with the decoupling of the dollar and gold in 1971). Most fixes have cheapened credit and provided easy money by lowering interest rates or other interventions, particularly during Alan Greenspan’s tenure at the Federal Reserve. In turn, this built the American bubble, layer by layer. Subprime mortgages were the last layer, until the bailout became the most recent pyramid scheme annex.

    Third, each financial fix set the stage for the next economic problem. Interest rate cuts papered over the dotcom bust, easy money generate the real estate bubble; the housing bubble paved the way for the subprime mortgage crisis, and so forth. Fourth, the assumption is that as the problem is financial, fixing finance will fix the economy, which again mistakes the symptom for the remedy.

    Fifth, the attention showered on the $700 billion bailout is overblown. Just a week earlier, in September 2008, congress approved $680 billion for the Pentagon; just a routine allocation, barely mentioned and not discussed in media. This excludes spending for wars in Iraq and Afghanistan which are dealt with in supplemental budgets. This indicates vast misallocations in government spending and fundamental gaps in public discourse.

    An underlying problem is that ‘money without policies is a waste’. This is how the director of the IMF comments on US policies (while sternly noting that ‘conditionality is part of our business’). The issue is not how much money but what are the rules of the road.

    Skipping details, key problems of the American economy include the following. The main problem is underinvestment: lack of investment in new plants and technologies has been a major cause of job loss and of the vast trade deficit and hence the massive and growing foreign debt, a pattern that has been built up over three decades. Rather than investing in industries at home, many corporations have preferred to invest in low wage zones and enjoying the perks of hegemony, with supportive Treasury, IMF and World Bank policies, Pentagon background music, the dollar as world reserve currency, and so forth. A major reason why European and Japanese companies have, by and large, maintained a balance between outward and inward investment is that they have had neither the advantages nor the temptations of hegemony. The second major American problem is lack of a national economic policy. More precisely, the free market flag hides crony capitalism and hides the link between the Pentagon and Wall Street, which operates as a default economic policy and is a tad inefficient. The third problem is deregulation, in effect easing the way of crony capitalism.

    This implies a sequence and priorities. You can re-regulate, but that doesn’t amount to a national economic policy. You can have a national economic policy but that, per se, won’t fix private sector underinvestment.

    Thomas Friedman notes, ‘the point is, we don’t just need a bailout. We need a buildup. We need to get back to making stuff, based on real engineering not just financial engineering’. The 2008 elections have been part of the reassessment. Normally, elections are transactional politics rather than transformational politics. But these are exceptional times. Conservative and neoconservative overreach have brought the country, and the world, to the brink of disaster. Course corrections and an economic stimulus are in the cards, though financial crisis narrows the margins of maneuver. Bringing the American economy back to life however requires much deeper interventions and a fundamental overhaul of perspectives and policies. The larger problem, to redirect private investment, touches on the central nervous system of American capitalism according to which corporate self interest is an invisible hand that guides the economy. However, since corporate self interest leads to the Pearl River Delta, the research parks of Bangalore and offshore havens of the Caribbean, this is no longer valid, or it is, but no longer in the sense that ‘what is good for GM is good for America’.

    -
  14. +
    Ha-Joon Chang :
    November 5th, 2008 at 5:47 pm

    Back in July, the Republican Senator Jim Bunning of Kentucky famously denounced the $200bn nationalisation of Fannie Mae and Freddie Mac, the mortgage lenders, as something that can only happen in a “socialist” country like France. However, in recent weeks the US has decided to use taxpayer money for a wide range of government intervention. Most notably, Congress has authorized $700bn for the purchase of “toxic assets” that are choking the financial system and – horror of the horrors – partially nationalised the US banking system. Moreover, when introducing the bailout, the leader of Senator Bunning’s party, President George Bush, argued that rather than being “socialist”, the plan was simply a continuation of the American system of free enterprise.

    Bush’s statement is not only an ultimate example of political doublespeak, but also reveals America’s long-standing pragmatism towards the free market. Throughout history, Americans have supported the free market when it suits them.

    For example, when it was struggling to catch up with Europe, the US resorted to blatant protectionism both in trade and finance. Between the 1830s and the 1940s, it had the highest average industrial tariff in the world. In the 19th century, non-resident shareholders in US banks could not even vote in shareholders’ meetings, while foreign investment in coastal shipping was banned. However, after it became top dog, the US started to champion free trade and unregulated finance because these suited its interests.

    In a version of “don’t try this at home”, America (which dishes out huge subsidies in agriculture and publicly-funded research & development) began to tell other people that they should adopt a free-market, free-trade model regardless of local conditions. Rich countries didn’t have to listen, but the story has been very different for developing countries. If they ignored this advice, they suffered when dealing with US-dominated international institutions like the IMF.

    In its 1997 financial crisis, for instance, Indonesia was forced by the IMF to close 16 banks at the same time, prompting a bank run. It was made to raise interest rates to 80%, and the president of Indonesia was humiliated by being photographed signing terms of agreement with the IMF, while the Fund’s managing director stood over him with arms folded. Similarly, Korea had to shut down close to a quarter of its financial institutions and raise interest rates to 30%. The country was forced to run a budget surplus, even though it had the then second lowest public debt (as a proportion of GDP) in the OECD. Only when its economy took a nosedive for six months was it allowed to run a small budget deficit equivalent to 0.8% of GDP. Today, America’s $700bn bail-out package alone will increase US budget deficit by 5% of GDP.

    Thus, now that the financial crisis is exposing the limits of free-market doctrine, the US should openly admit that, if markets need the state, it is better to have the state intervene regularly and prevent a free-market mess. Moreover, the US must accept that all countries, and not just itself, have the right to use a pragmatic mix of the market and state.

    (Reprint, in condensed form, of “The Economics of Hypocrisy,” which appeared in The Guardian, Monday October 20, 2008.)

    -
  15. +
    Robert Reich :
    December 9th, 2008 at 4:13 pm

    The Big Three needs a hybrid vehicle, if you will — a combination of chapter 11 bankruptcy and a bailout. For every taxpayer dollar, the automakers should be required to come up with $2, gleaned from their stakeholders (creditors, shareholders, executives, white and blue collar employees). This is the only way GM, Ford, and Chrysler will have enough money to survive and restructure, it’s the way to avoid favoring the Big Three over foreign automakers in the US, and it’s a means of avoiding moral hazard.

    In general, bailouts are terribly inefficient ways of dealing with companies in distress. The only reason for any taxpayer dollars at all in the Big Three’s case is the significant social costs associated with rapid shrinkage of any one of these firms — unemployment insurance, increased liabilities for the Pension Benefit Guarantee Corporation, lost tax revenues, and costs associated with large numbers of people who would directly or indirectly suffer losses of wages and employment.

    Chapter 11 bankruptcies are far betterm in general. Chapter 11 should be used from here on with regard to Wall Street, instead of the second tranche of the Troubled Assets Relief Program. Chapter 11 could have been used by Lehman Brothers, but Lehman apparently refused to consider it, and chose instead to play a game of “chicken” with the Treasury, hoping the Treasury would bail it out. When the Treasury refused, Lehman was pushed into liquidation. Chapter 11 also should have been used by Citigroup.

    Chapter 11 allows a firm to pay off its creditors and wipe the slate clean. It’s ideally suited to the Wall Street credit crisis because it creates a forum in which creditors are forced to negotiate and ultimate accept lower prices for the securities they hold — thereby accomplishing what the Treasury first tried to do under the Troubled Assets Relief Program: creating a market for these otherwise unmarketable securities.

    Prior to 1978, a company could seek Chapter 11 protection only if it was insolvent or was unable to pay maturing debt, and Chapter 11 normally meant that a company’s managers would have to relinquish control. In 1978 Congress amended Chapter 11 to delete the insolvency test, and also to allow managers to keep control of a company unless a bankruptcy judge explicitly finds them to be incompetent or untrustworthy. Instead of presiding over meetings of creditors where claims are bargained out, since 1978 judges have left most decisions — even major ones — to existing managers.

    -
  16. +
    David Backus :
    December 9th, 2008 at 4:27 pm

    NYU Stern Professor Ed Altman’s testimony to Congress last Friday: 
    http://pages.stern.nyu.edu/~dbackus/temp/Altman_testimony_Dec_09.pdf

    -
  17. +
    Clifford Winston :
    December 9th, 2008 at 4:29 pm

    A bailout arises as a policy option when a private entity is losing money and is heading toward bankruptcy and possibly liquidation. Government can delay—and possibly prevent—both outcomes by providing the private entity with an infusion of cash or by purchasing the enterprise. For example, current discussions about the auto bailout involve the federal government providing the Detroit automakers with cash, possibly in exchange for a modest ownership stake. In contrast, when private transit companies were experiencing severe financial losses—in large part because of regulations—the federal government helped local government authorities purchase these companies.
    Government bailouts can be justified as preventing a market failure—that is, the social value of the output produced by the failing firm exceeds the public funds required to keep the firm afloat or to enable the government to purchase and operate the firm.

    What is the evidence on the welfare effects of bailouts? Specifically, do the public funds expended exceed or fall short of the social value of the output that would have been lost had the firm been allowed to go into bankruptcy or fail? It is difficult to answer this question because of the importance of properly forming the counterfactual. What would have happened in the absence of the bailout?

    That said, the track record of government in correcting market failures is generally abysmal. Evidence developed over thirty years and presented in my GOVERNMENT FAILURE VERSUS MARKET FAILURE indicates that government interventions have had no effect or made matters worse. http://aei-brookings.org/admin/authorpdfs/redirect-safely.php?fname=../pdffiles/php3v.pdf

    I particularly note the poor performance of bailouts that resulted in local government’s takeover of public transit. Evidence indicates that both urban bus and urban rail may not even be socially desirable given their huge subsidies. Current research is exploring privatization of urban transit to eliminate the vast inefficiencies that have developed under public production. I cannot offer a rigorous counterfactual of what would have happened had Chrysler not been bailed out; but I strongly doubt that social welfare would have been reduced given the superior Japanese and European producers were expanding their presence. I conclude that if subsequent evidence indicates that the bailouts to the Detroit Three were justified and well-managed, it will be a rare case that the government has corrected a market failure and significantly raised social welfare.

    -
  18. +
    Doug Guthrie :
    December 10th, 2008 at 10:45 am

    Inefficient Deregulation and US Economic Crisis

    The recent credit crisis experienced by the US financial community has raised a groundswell of concern over the impact of this crisis on the US financial sector and the US economy more generally. To be sure, the stakes are significant: In the Spring of 2008, when Federal Reserve Chairman Ben Bernanke defended the governmental bailout of Bear Stearns, which provided up to $30 Billion to facilitate the bank’s sale to JP Morgan Chase, he argued that the bailout was necessary because “the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain” for the US and global economy. Beyond the macro-economic issues, also at stake are the economic livelihoods of thousands of US consumers who face potential mortgage foreclosure brought on by the crisis. By the summer, some were predicting that the number of people that could experience such an outcome has not been seen since the Great Depression: As James Parks, writing on behalf of the AFL-CIO, recently put it, “Millions of America’s homeowners are facing disaster after years of predatory lending. This is the first time since the Depression of the 1930s that so many U.S. homeowners owed more on their mortgages than their homes are worth.” The actual numbers are beginning to bear out this rhetoric. According to RealtyTrac, the number of foreclosures for the United States overall is up 100.1% over last year for similar periods; in the state of Massachusetts, foreclosures were up 11 times over last year; in the state of Delaware, foreclosures are up 800% over last year; in the state of Ohio, foreclosures for the year ended up at 83,230, an all-time record. By the time Henry Paulson was pulling together the plan that would constitute the greatest transfer of wealth from the government to the financial industry in the history of this nation, the extent and depth of this crisis had become indisputable.

    Despite the declaration that we haven’t seen an economic crisis like this since the 1930s, I have a distinct feeling that we have seen this dynamic relatively recently. Perhaps it was not this bad, but did we learn nothing from the Savings and Loan Crisis of the late 1980s? Is there any connection between this situation and the accounting crises of 2000-01 or the bailout of the airlines in 2004? The current crisis may indeed be worse than any we have seen since the Great Depression, but the narrative is actually fairly common in the recent history of American capitalism. The last 30 years of US economic history is littered with examples of two dissonant themes: On the one hand, we have a corporate sector advocating deregulation, singing the praises of a laissez-faire market, and criticizing government interference as fundamentally inefficient. On the other hand, we have corporations—and the population—asking for bailouts when they can’t survive the realities of the free markets they have advocated.

    What do we make of crises like these? There are three issues that we might consider in this analysis: one of them simply relates to our ability or will to actually run the market system that we idealize; the other two have to do with the relationship between corporations and the state. For these latter two issues, I will use China’s emerging economy as a point of comparison and raise the question that state-directed economies might actually function significantly better on a number of dimensions than so-called free market economies.

    The first lesson to take away from this crisis is that, although many love the idea of the unfettered free market, we simply do not have the political will for a free market in the US economy. Or perhaps we simply do not understand what a free market is. One of the key aspects of a well-functioning market is the ability of the market to discipline actors who make bad economic decisions. Just as markets can reward risky behavior, they must also be allowed to discipline risky behavior when the bet turns out to be wrong. The incentive system simply cannot work if we reward risky behavior but then bail out the economic actors when they end up on the wrong side of the risky outcome. The irony of our time is that corporations want it both ways: they want a deregulated system so that they can take on increasingly risky behavior in financial markets and then want a government handout when the same risky behavior that those deregulated markets allowed leads to potential bankruptcy.

    The recent crises in the financial sector are clearly tied to this push and pull over deregulation and bailouts. The risky behavior that led to the S&L crisis of the late 1980s can clearly be traced to the Garn-St. Germain Depository Institutions Act of 1982, which gave Savings and Loans institutions many of the same opportunities as commercial banks but not the same amount of federal oversight. As a result of this deregulation, S&L’s were able to make very risky loans in real estate without Congress or the Federal Home Loan Banking Board (FHLBB) stepping in to shut them down for those risky loans or insolvency. Eventually the crisis grew to a level that Congress was forced to step in and bring forth an aid package that would cost the American tax payers somewhere between $125 and $160 Billion. What message does it send to the risk-taking actors—who lobbied for deregulation in the first place—if they can take risks and then count on being bailed out by the government?

    In the current crisis, the relaxation of the Glass-Steagall Act over the course of the 1990s and the eventual repealing of the Act in 1999 with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act allowed commercial banks to operate in a number of areas (insurance, investment banking, securities) that Glass-Steagall had forbidden. As a result, commercial banks could begin to deal on both sides of the fence: they could lend mortgages to their commercial customers and they could turn these same loans around and securitize them in the form of mortgage-backed securities, selling and trading them on the fast-moving securities markets that were emerging during the 1990s. While everyone was making money, all seemed copacetic. However, banks were now removed from the main incentive to be vigilant about risky borrowing behavior—they now no longer held the note on the house of the individual they loaned to. As a result, there was no disincentive for them to compete for business in a riskier and riskier loan pool. What was the downside? As long as the real estate market continued to rise, everyone would come out ahead; and if it didn’t, they wouldn’t hold the note on the foreclosed home anyway, as that mortgage had long since been packaged with a larger group of mortgages, securitized, and sold off to some other institution (which likely sold it again). Some individuals working in the industry have estimated that, by the time these mortgages had reached the end of their securitization life cycle, they would have been repackaged as parts of new financial instruments as many as 20 times. All the while, the risk assessment agencies that typically assess the viability of these financial instruments had incentives to keep the market booming, and they continued to award AAA ratings without a second thought. This type of risky behavior generated a great deal of wealth; but it was risky behavior nonetheless, and just as these risks yield rewards, they should also be subject to the discipline of the market when the system unravels. By what logic should the individuals gambling at this table receive a bailout?

    Many in the industry and in political realms make the case that we must bail out the banks because (1) massive bankruptcies, like Bear Stearns and Lehman Brothers, would disrupt the economy and even cause a disruption of global markets (for which the US would be blamed); and (2) foreclosures would hurt American consumers, many of whom stand to lose their homes. Which brings us to the second culprit in this crisis: politicians, who also want it both ways. In essence, the politicians want to appease the corporations—many of whom donate significantly to their campaigns—but when it comes time to deal with the results of the economic incentives they have created, they want to protect the American voter from these outcomes. The reality in both cases is that if we let the market work in a truly unfettered fashion, banks would have had the opportunity to record the record profits they have accrued over the last decade, but they would also have to be prepared to bear the consequences of the risky behavior that led to those profits. A painful S&L bankruptcy would have been a powerful lesson as to what can happen without federal oversight in the banking sector; and Bear Stearns’ bankruptcy would be a valuable lesson in the realm of corporate oversight the same way that the debacles of Enron and WorldCom have become important lessons in the realm of lax corporate oversight in other sectors. Individual consumers would certainly have a different attitude about the virtues of an unfettered market if they learned the difficult lesson that risky behavior can bring about foreclosures and even recession. Maybe they would even vote differently.

    (Now, one might make the case that there is nothing wrong with the current cycle as it is playing out—that a good deal of economic growth has come from the deregulation of these sectors, and that economic growth has been, in the aggregate, good for the US economy and American consumers overall. What does it matter if we extract the tax burden up front, which might curtail risky behavior and growth, or on the backend in the form of a bailout? This is a fallacious argument, because over the last 30 years, the aggregate growth of the US economy has largely benefitted the economic elites of the system—those engaging in the risky economic behavior—creating a much greater disparity in earnings between the wealthy and the middle and lower classes. Yet, when a government bailout occurs, the tax burden is shared by all.)

    I will turn now to the issue of state involvement in the economy and the strategic alignment of the Chinese state sector with national interests. Since the early 1980s, most of the capitalist world has converged around the consensus that state-owned enterprises are fundamentally inefficient. With the privatization of national energy conglomerates from Britain to Italy to the privatization of tobacco and salt corporations in Japan to Mexico, Turkey, Zaire, the general consensus is that state involvement is fundamentally antithetical to the type of efficiency that comes with private ownership. The assessment of the inefficiencies of state planned economies in the Soviet Bloc and China seemed to confirm this view. Dating from the scholarship of famous economists like Janos Kornai through Jeffrey Sachs, the basic position has been that state ownership simply could not provide the right incentives for efficient market behavior. The success of China’s economy and many state-owned firms within it has caused us to revisit some of the key assumptions upon which those arguments are based. The reality that China has revealed is that the issue is not ownership per se (state versus private) but, instead, the ability to create the right incentive structures that lead to efficient market behavior.

    Take, for example, the formation and transformation of PetroChina over the last decade. With the formation of the Chinese National Petroleum Corporation (CNPC) in 1988, we saw an organization that carried all of the ills of a classic state-owned organization—bloated workforce (about 1.5 million employees that produced about the same amount of crude oil as StatOil’s 80,000 employees in the mid-1990s); a hefty bill of nonwage benefits; inefficient assets; soft budget constraint in the form of an open checkbook from the state. However, CNPC’s actions over the next decade showed its resolve to create a more efficient operating system. CNPC took all of its best assets and formed the corporation PetroChina as a subsidiary of CNPC in 1996. CNPC took on all of PetroChina’s social welfare costs; PetroChina executives were given performance-related compensation packages. All of these changes preceded close work with Goldman Sachs, China International Capital Corporation (CICC), a joint venture between the China Construction Bank and Morgan Stanley, and McKinsey on preparing PetroChina for an IPO (NYSE and HKSE) in 1999. The result has been a firm that has been profitable, gained the respect (and investment) of investors like Warren Buffett, and recently become one of the most capitalized firms in the world (with market capitalization briefly eclipsing $1 trillion as a result of its IPO in the Shanghai Stock Exchange in November of 2007).

    But one of the issues that comes to the fore with successes such as these is the question of what a successful alignment of incentives under a state mantle means. If the incentives can indeed be aligned such that these organizations can perform efficiently, it is not surprising that state-directed corporations may actually have a better ability to serve the public interest. It is an obvious point that state-owned enterprises like PetroChina may actually be in alignment with the strategic interests of China’s national energy policies. In an example closer to the current crisis in the US, it is difficult to imagine the Industrial and Commercial Bank of China (ICBC), which was recently in the news as the largest IPO in history, becoming mired in the type of crisis that many US banks currently face. Despite the fact that Chinese banks have not had the barriers that Glass-Steagall provided for US banks up until the 1990s (i.e., they can operate in both commercial and securities markets), they do not allow individuals the opportunity to act like the lone rangers that banks like Citigroup, Merrill Lynch, and Bear Stearns act as. The Chinese government simply does not allow for this type of unfettered behavior. This might cost the individual banks some growth opportunities, but it also likely saves them from the types of missteps that now hamper US banks and the US economy more broadly.

    There is a third part to this argument that runs counter to most perceptions of China and state-directed economies more generally and is perhaps the most uncomfortable to face for believers in the superiority of the market as a coordinating system. There is a way in which the US system is actually less transparent than a state-directed economy such as China’s. While we typically believe that even if China’s economy is proving successful in its transformation, we have them beat in the areas of corporate and political transparency. But do we? The ways in which the corporate lobby plays a fundamental role in shaping the US economy—whether in the area of oil subsidies, bank deregulation, or corporate bailouts—is one of the more opaque processes within the US political system. In the Chinese system, while no one would argue that the processes that define Chinese politics are transparent, the alignment between the state and the corporate sector is in some ways more above board than it is in the US system.

    I am not arguing here that the Chinese system is better than the US market economy; nor am I arguing that Chinese firms are more effective than US corporations. However, it is important to note that we do not seem to have the stomach or political will for the type of system we idealize. Over the last 40 years our economic heroes have become individuals like Milton Friedman, advocating the freedom to pursue power and plenty in the unfettered markets of the US system. But when the risks lead to default, we do not seem to have the will to connect those outcomes with the economic or political system we advocate. In the end, we may have something to learn from the state-directed economies of China and Singapore. These are economies in which the state has an unapologetic interest in directing toward the public good. And, in the end, that approach may be more in the public’s interest and more transparent than our own process of behind-the-scenes corporate lobby and after-the-fact bailouts.

    Doug Guthrie
    New York University

    -
  19. +
    Michael S Barr :
    December 10th, 2008 at 4:46 pm

    See my recent testimony:

    http://domesticpolicy.oversight.house.gov/documents/20081114091233.pdf

    -
  20. +
    Mario J. Rizzo :
    December 10th, 2008 at 4:54 pm

    I am not a macroeconomist. I am not even a financial economist. So much of my reaction to the current financial and economic problem may seem a bit out-of-step with what most commentators are saying. Yet I think it is important.
     
    The macro-economic frame of mind is quite peculiar, it seems to me. In the name of the emergency, the  macroeconomic way of thinking dismisses most concerns about the efficient allocation of resources and throws almost total emphasis on maintaining levels of expenditure and employment. The implicit assumption is that the central problem is a collective irrationality that inhibits people from spending on consumption or investment. The root of the central problem, conceived in this way, is the initial financial meltdown. This involved a kind of domino-effect in which the collapse of the housing market and of mortgage-backed securities, packaged in many complex ways, undermined the liquidity and perhaps solvency of many financial institutions.  The system’s ability to provide credit and thus expenditure was compromised. Thus the solution lies is returning to the status-quo ante. Restore the condition of the financial institutions perhaps by buying toxic assets or perhaps by infusing capital into them. Restore the conditions of the housing market by getting the Fed and/or Treasury to buy Fannie and Freddie mortgage securities, thus sending capital into housing and lowering mortgage rates. Restore the condition of industries with large numbers of employees and others indirectly dependent on them. So far the automobile industry qualifies. I realize that no economist believes that complete restoration to the previous situation is possible, but the basic philosophy is clear. Once economic agents believe all of this will take place, confidence will be restored.
     
    I believe that the above analysis is an intellectual disaster that threatens not only the intermediate-term economic condition of the United States but its long-term reliance on market institution and the liberty they undergird.
     
    The conventional macroeconomic diagnosis and proposed cures ignore many important factors, including the following:
     

    The “irrationality” is not primarily in the system’s response to the initial financial impulse but in the unsustainable expansion of the housing and other capital markets in the first place. Proposals to prop up the housing market as if its contraction is some kind of unfortunate over-reaction are not credible. Too many resources went into the housing market due to the low interest-rate policy the Fed followed for too long. While housing prices have fallen recently in many markets, they need to fall further. Markets should be allowed to equilibrate.
    Equilibrium in the housing  market would provide greater transparency to the value of mortgage-backed securities. Lack of certainty about housing prices and the ultimate extent of foreclosures only adds to the problems surrounding the illiquidity of these securities.
    Government infusion of capital with the purpose of restoring the status-quo ante ignores the fact that, for example, Fannie and Freddie were over-expanded, the domestic automobile industry is a destroyer of scarce capital, some financial firms did a poor job of allocating risk, banks extended loans under the pressure of the government to people who should not own homes and so forth. Resources were misallocated.

     
    Recessions are not simply crises of confidence or of insufficient demand (due to increases in the demand to hold money). They also have their allocational – or microeconomic – aspects. I suggest that these systemic distortions have an important role in creating the aggregate phenomenon we are witnessing. To treat these distortions and their cure as relatively unimportant is a mistake. In my view investor and consumer confidence follows the correction of the underlying causative distortions and does not precede them. In fact, the dominant macroeconomic policy-framework does not leave room for correcting distortions at all because its basic theme is to restore, prop up, and maintain the current direction of resources.
     
    I do not think that these hastily devised macroeconomic schemes will succeed in promoting recovery because they ignore the microeconomic fundamentals. I do fear, however, that will succeed in fundamentally transforming our economic system for the worse.
     

    Mario J. Rizzo
    New York University 
     
     
     
     
     
     

    -
  21. +
    Horacio Ortiz :
    February 18th, 2009 at 7:23 am

    Given the organization of credit distribution and money creation, the bail out of major banks and private financial companies has appeared to be the only technical possibility to avoid an accumulation of bankruptcies which could have ensued in economic recession and possibly social strife. I would argue that the bail out plan cannot be only considered as a technical issue concerning economists, but is a major political issue that can and must be dealt with by social scientists in general. I would therefore like to bring up three sets of questions concerning the bail out plan for the financial sector in the US that can be drawn from the growing field of the social studies of finance. They concern the impact that the bail out plan can have on 1) the social organization of the financial sector 2) the distribution of resources that was the result of that organization and 3) the rationales and the narratives of legitimization that accompanied the two previous points.
     
     
    1) The impact of the bail out on the organization of the financial sector
     
    So far, the financial sector was organized by a set of more or less independent private companies that managed the savings of important parts of the population by directing them as investment in financial assets available in regulated or OTC markets. It was within these institutions that the expertise to define financial value and to direct investment was situated. While there was no outright oligopoly for fund management, it is less clear that that is true for the companies defining financial value, notably when it comes to valuing debt, as this is the de facto privilege of three major rating agencies.
    Since the regulation of the financial sector and the definition of its professional rules had its main source in professional associations and lobbies, it can be considered that the definition of value and the distribution of credit were mainly located in this set of private companies.
    The social organization within these companies, that developed strongly in the last thirty years, evolved consistently towards the creation of a financial professional elite, composed of traders, fund managers, financial analysts, sales, structurers, asset allocators, and other specialists. As a professional group, they managed to capture an important part of the profits generated by the financial industry through high salaries and especially through bonuses that were supposed to reflect the impact of each employee and each team on the generation of profit. This distribution of returns within the companies was supposed to be the sole responsibility of the companies themselves and a guarantee of overall efficiency, since only the best professionals would be rewarded.
    The Paulson bail out plan aimed quite clearly at not touching this aspect of the financial sector. The payment system and the organization of the bailed out companies was meant to be left to those responsible of it before the crisis. The current bail out plan, on the contrary, by setting strong limits to salaries and bonuses, may disrupt considerably the hierarchies that organized the creation of specialized teams oriented towards short term independent profit making, a feature that visibly played a role in the blindness with which major financial companies invested in MBSs until the crisis erupted.
    It is still early to observe what the new bureaucratic hierarchies will be, and if the concentration of power by an elite of specialized professionals will remain the one we saw until now. Bureaucratic rationales more akin to state administration may gain preeminence in the bailed out companies. For instance, we may see fewer struggles between employees, teams, departments and companies in order to control assets to manage and to evaluate with the aim of extracting commissions and bonuses out of them. Only the observation of the new organizations could tell what they are, and they cannot simply be judged a priori by the mainstream idea that the state is inefficient (the current private institutions have in any case proved to be inefficient enough not to be simply left to use taxpayer’s money without external control).
     
     
    2) The impact of the bail out plan on the distribution of resources by the financial sector
     
    When a series of major localized crises erupted at the end of the 90’s, professionals and state regulators, often in unison, argued that they would eventually only make the system stronger and more efficient in the distribution of monetary resources around the world. The argument that they were countering could nevertheless still be brought up ten years later. The financial big bangs in the developed countries during the 80’s and the broad opening of developing countries to international financial flows through financial markets seem to have failed to deliver the economic growth and accumulation of wealth that other countries have known in the same period, without following that receipt, most notably China. This should not sound as the portray of China as a model to be followed, but should remind us that as far as the global distribution of resources is concerned, the financial sector has so far failed to deliver what was promised about it. The current crisis comes thus after 20 years of an experiment with results that are probably not simply negative but that are certainly mixed.
    What remains certain is that for most investors and financial professionals around the world, the US treasury bonds remain the safest investment, in spite of its current economic situation. The bail out plan in the US can thus have a strong impact on the way in which resources are distributed not just in the US, but more globally. In this sense, the plan can only be understood within the broader context of the economic rescue plan and the major state intervention in the US economy that should ensue from it. It is still to be seen whether a more or less state controlled financial sector will come to play a major role in the management of state investments in the economy, but the question must be raised.
    A bureaucracy less oriented towards short and mid term profits generated by independent teams of specialists may indeed be more docile to evaluate projects and direct investment according to different rationales, such as employment creation, the development of new industries for environmental issues, and so on. In any case, it seems too early to assume that the state will simply sell back its shares in the bailed out companies and refuse to use them for its own economic agenda. It is even less warranted to assume that if that was not the case, the result would be an even less efficient economic system than the one that private finance has delivered so far.
     
     
    3) Legitimacy and the financial imaginary
     
    Several studies have analyzed the philosophical and moral content of the concepts used in professional finance, which define the objects of investment and the rights and duties of the agents involved in the exchange of them. These concepts, such as “the investor”, the “risk free rate of return”, “market efficiency”, “transparency” and “fair value” are not only present in the financial techniques used by professionals, but also in the regulations of financial exchanges and even more broadly in the media and political discourses that have accompanied the increasing presence of financial markets and institutional investing in social life, from the regulation of pensions to discussions about the justice of the distribution of resources.
    The current crisis has severely hurt the symbolic stability of many of those concepts, such as the idea that “transparency” is enough to avoid massive investments in risky assets, that the statistical valuation of “risk” is a good basis to predict future volatility, that a high number of independent investing institutions cannot all go wrong at the same time and that the trustee legal bind really links the aims of investment funds and investment banking to the interests of the real owners of the assets, i.e. among others, American middle classes whose savings were being managed.
    If the financial system had so far been able to rely on a strong if not totally consistent set of narratives asserting that it was the best system to ensure the most efficient distribution of resources globally and in the US in particular, the crisis has not ensued in the issuing of a new narrative that would legitimize the bail out and rescue plans with the same depth of political and moral content. There is for instance no return to a full-fledged official Keynesianism, at least so far. The bail out plan is still justified on technical grounds, and the economic rescue plan has had little ideological discourse surrounding it before it came to be voted. It may still be early to see what narratives of legitimization will accompany the bail out and rescue plans, especially when their first results may come under attack. But the study of political narratives concerning the concrete technical concepts that are mobilized along with the new policies is necessary to understand not only their social acceptance, but also part of their effects.
     
     
    In these brief comments, I have tried to highlight that the social studies of finance, from anthropology, sociology, political science and science studies have important questions to raise in a moment where several aspects of the financial system seem to be on the verge of changing: the organization of the definition of value and the direction of investment, the distribution of resources that it renders effective, and the legitimizations that accompany it. If anything, the crisis and the current bail out plan in the US are an occasion not to take their answers for granted based on the narratives that have been mainstream since the 80’s.
     
    Horacio Ortiz
    LAIOS-IIAC

    -

Leave a Reply

Please note: All comments will be approved by an administrator before they appear on this page.

Craig Calhoun, President uses Thank Me Later

Social Science Research Council - One Pierrepont Plaza, 15th Floor | Brooklyn, NY 11201 USA | P: 212.377.2700 | F: 212.377.2727 | E: info@ssrc.org