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 
 
 
 
 
 
 

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

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

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.

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.

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.)

‘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’.

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.