I know that the time isn’t right for this yet but I want to prep the conversation for whether or not bailouts as a general policy aren’t simply a good idea.
The obvious retort is that it just encourages risk taking. The question, however, is – are we certain that that is a bad thing?
Take TARP. The bank portion of TARP made a profit. However, some people fear that it only encouraged banks to take risks in the future. However, if in the future we bailout more banks and earn additional profits, are we sure this is necessarily a bad arrangement?
The gut reaction is that risk is bad and of course risk taking is unpleasant for most people. However, risk-taking is also the foundation for growth. Taking calculated risks is a social good and produces externalities.
Thus in the aggregate we should expect the problem society faces is not that people take too many risks but that they take too few. In such a case, subsidizing risk taking is exactly the right thing to do.
Now, at the same time there was a massive recession in spite of TARP. This is why the question of whether a more powerful monetary response could have beaten back the recession is so important.
I think monetary policy failed us this time around, but I think it failed for predictable reasons. We were too close to zero lower bound, we did not have price level targeting and there was widespread resistance to quantitative monetary policy. These conditions make a large drop in aggregate demand from any source dangerous.
I would suggest that a higher baseline level of inflation combined with some form of level targeting – I am open to NGDP or nominal spending – would have allowed the Fed to keep its winning streak.
If we have a means of stopping a wide spread bank panic and we have a means of stopping a general recession then we effectively have means of neutralizing the downside risks from financial implosions.
This may sound like unhinged purely academic musings but we do this all of the time. The most obvious example is the FDIC, which provides regular bailouts to depositors of commercial banks and for the most part has been extremely successful.
Even more fundamentally we regularly bailout actual fires. Fire spreading from one building to the next is a danger in a packed city and we could require that people build further apart to prevent this externality. However, density also offers enormous positive externalities.
We handle these dueling externalities by allowing very dense buildings and then employing a public fire department to cover the increase in fire risk. Most people have found this relationship highly advantageous.
So in the same way that we regularly bailout home fires, it might be in our interest to regularly bailout economic risk takers of various stripes. The core question is how important is risk taking to our economic system. I tend to think “extremely” but there is much more debate to be had.
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Wednesday ~ November 17th, 2010 at 9:09 pm
Brett
We definitely crossed the “moral hazard” bridge a long time ago, hence why we put out fires and allow people and companies to declare bankruptcy.
Wednesday ~ November 17th, 2010 at 9:55 pm
Sardonic_sob
If the FDIC were required to have the same loss reserves as a fire insurance company, what would that do to the premium levels of the member banks?
All moral hazards are not equivalent.
Wednesday ~ November 17th, 2010 at 9:25 pm
Michael
I wouldn’t go so far as to say that bailouts are always bad, but I would argue that in addition to encouraging risk-taking, the expectation of bailouts would divert resources from productive uses to rent-seeking and the cultivation of influence over policy makers.
Wednesday ~ November 17th, 2010 at 9:47 pm
Andy Harless
You and I are basically on the same page here. Theoretically, if there were complete asset markets (including for human capital), everyone would take the socially optimal amount of risk. But since asset markets (especially that for human capital) are incomplete and individuals find that much of their risk cannot be diversified, they will, left to their own devices, take less than the socially optimal amount of risk. Therefore, we have bailouts, to create an incentive for risk taking. It’s not the first best solution, but on balance moral hazard is a feature and not a bug.
Wednesday ~ November 17th, 2010 at 9:53 pm
Sardonic_sob
What possible justification do you have for believing that you have any freaking idea what the “socially optimal” amount of risk is? And why is your determination of society’s appropriate risk level better than, well, society’s? Do you intend to calculate it with a Calvin regression?
Thursday ~ November 18th, 2010 at 4:59 pm
Andy Harless
Society does not make a determination about what risk level to choose; individuals make decisions, and society gets the result, whether it’s a good result or not. In welfare economics, it’s possible to model the way that individually optimal decisions aggregate, and under complete markets, they produce a socially optimal amount of risk. I don’t personally know what the socially optimal risk level is, but on the basis of economic theory, I can surmise that it is greater than the level that results from decisions by individuals who are constrained in their ability to diversify risks. And what the hell is a Calvin regression, anyhow?
Friday ~ November 19th, 2010 at 10:57 am
sardonic_sob
(To Mr. Harless: the reply system on this blog is wack, man.)
All decisions, obviously, are made by individuals. The point being that every individual has a given level of risk they will accept. As experience shows, some people accept less risk than a pure logical analysis might indicate their situation can safely withstand (as far as loss reserves, future earning power, volatility, etc) and some take more. As a society, this will average out to some general level of risk acceptance. You may believe that you have some gee-whiz math that shows that this societal level is lower than you think society can and should tolerate. I have two problems with this, one theoretical, one practical.
The theoretical problem is that I don’t believe that anybody has either the theoretical rigor or the computing power to out-think society at this stage in our development. Society may be stupid, but you have no way to know whether you are being more stupid or less stupid when you do that voodoo that you do. This is only indirectly an argument to the wisdom of crowds: I’m not saying you might not be smarter than the crowd, I’m saying you have to convince me.
The practical problem is that so far, every approach I’ve seen to trying to “improve” things in this arena has one or both of the following characteristics:
1) It looks just like what you’d do if you were just trying to kick the problem down the road. Call me cynical, but when sophisticated economic management always looks exactly like what the later Roman Emperors would have done had they had computers and a constituency less likely to crucify them for failure, I find myself doubtful as to the real motivation for implementing it.
2) It has a tendency to work for quite some time and then fail spectacularly.
Panics were quite common before the days of managed economies, don’t get me wrong. But they tended to be quite sharp, fairly localized, and resolve themselves quickly. To get the Tulip Mania, you need a lot of people in a small area to make silly decisions. To get the Great Depression takes concerted government action.
And this is a Calvin regression: http://picayune.uclick.com/comics/ch/1986/ch861126.gif
It seems to be the preferred risk analysis method of people who want to convince other people that it’s not gambling if you run it through multispace calculus and big honkin’ computers.
Wednesday ~ November 17th, 2010 at 9:49 pm
Sardonic_sob
Because it works until it doesn’t. This is akin to the remarks made by Dr. Feynman when he was told that because no crack in the Space Shuttle’s main engine had ever gone more than a third of the way through a turbine blade, there was a “a safety factor of three.”
Those blades are not supposed to crack *at all,* so there is no safety factor *at all*. You don’t know why it is cracking. You don’t know why the cracks stop where they do. If a blade cracks all the way through – which you have no way of predicting – the engine will fail catastrophically, quite possibly destroying the vehicle.
Yes, we bailed it out the last time, so the system assumed it had a safety factor. Then we bailed it out this time, so the system assumes it still has some safety factor. Eventually the blade will break, not just crack, because *there is no safety factor and never was.* There are only non-catastrophic failures whose causes are not being addressed. Eventually one will be non-non-catastrophic.
Thursday ~ November 18th, 2010 at 10:54 pm
Tony
The space shuttle ‘catastrophically’ failed because it physically blew apart. The proper analogy to America would be to nuclear war, not an economic downturn.
In this sense, the bailouts were irrelevant: the system collapse would have happened this time without them. All you’re saying is that they’ll still happen next time. But what exactly will be collapsing? A highly levered system of debt based on fractional reserve banking. Something designed to collapse, collapses. And you are surprised?
And no, I’m not an Austrian. The Austrians, like the Marxists, have the right diagnosis but the wrong cure. The kind of collapse described above is psychology, not physical. It is a crisis of capitalism, a cultural system, not a crisis of nature. It does not mean that people will not eat, or even that they will not be able to live in nice houses, drive nice cars, and go to movies on the week-ends if society chooses.
Contrary to the popular imagination, the U.S. today has the capacity to produce more manufactured goods than ever before in our history. Our actual assets are not in accounting paper but the physical plant and education and skills of our workforce. These things are not at risk. And it’s not like the 15 million currently unemployed persons are physically disabled from working and creating more wealth.
In fact, the only thing holding us back from producing at full capacity (and full employment) tomorrow are that we choose not to ‘redistribute’ our paper accounts. A.k.a. socialism. But if the system were to really melt down entirely, people would stop caring about that.
Then eventually, perhaps after a very long time, capitalism would come back once more.
Friday ~ November 19th, 2010 at 11:02 am
sardonic_sob
Neither of the two orbiters which have been lost were lost because of main engine failure. I was waiting for somebody to try to refute me by pointing that out.
As far as the rest, I’m not sure what you’re trying to say. The closest I can come is to try to reply that yes, we have tons of excess capacity, and this is easily explained by an Austrian as malinvestment during a boom producing capacity that is not needed. Society always wants or needs something, but when we don’t allow malinvestments to be flushed out, we build more and more capacity to make what it turns out society doesn’t want or need.
Thursday ~ November 18th, 2010 at 1:04 am
bob
i find your argument compelling, bail away.
but, fire the management, claw back the bonuses, and prosecute the fraud.
Thursday ~ November 18th, 2010 at 9:02 am
Why the government profiting from the bailout is a bad thing « Modeled Behavior
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Thursday ~ November 18th, 2010 at 9:03 am
Craig
“or, How I Learned to Stop Worrying and Love Bailouts…”
If we think we can just keep this up indefinitely, you might really have some points. The questions, as I see it, are of equity and responsibility.
Equity: “bailout culture” protects the interests of investors, executives and managers foremost. The banks must be saved, the homeowners on the other sides of their trades must be liquidated. That is difficult to support.
Responsibility: If bailouts are simply a part of the landscape, they must be funded. The money must be fronted even if it is paid back with interest. Is this to be done out of general revenue or expansion of the money supply? Then we really do have “capitalism on the way up, and socialism on the way down.” That can’t be right. The bargain must not be about preserving Vikram Pandit’s compensation package. Quite the contrary. If these idiots can’t keep from shooting themselves in the foot every ten years, they can not deserve the profits that our bailouts make possible.
Thursday ~ November 18th, 2010 at 9:31 am
Dominic Pazzula
I was going to respond but Barry says what I was going to say:
http://www.ritholtz.com/blog/2010/11/banks-prepackaged-bankruptcy/
Thursday ~ November 18th, 2010 at 10:32 am
Mike
Karl, two things:
1. You might like this paper, from Adam Levitin, which I haven’t gotten the chance to read yet:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1548787
2. It would be helpful to distinguish “bailouts” from “insurance.” If I fall off a ladder and break my leg, I’m bailed out in the sense that my health care provider pays most of it and I don’t go homeless. I pay for that.
The financial industry viciously fought prefunding the resolution mechanism (to start), the equivalent of paying upfront for government intervention (like FDIC does). It’s very frustrating.
Thursday ~ November 18th, 2010 at 7:25 pm
Reconciliation Internet Related Technologies Reconciliation
[...] In praise of [...]
Friday ~ November 19th, 2010 at 5:20 pm
Tony
There is no such thing as “excess” capacity. Any “excess” capacity can be solved by increasing demand.
Friday ~ November 19th, 2010 at 5:25 pm
sardonic_sob
Tautological cat is tautological.
Friday ~ December 10th, 2010 at 11:07 am
Brauchen wir ohne Moral Hazard Kolumbusse? « Kantoos Economics
[...] hoffen, damit jemand überhaupt noch die risikoreichen Unternehmungen macht? Diese Frage wirft Karl Smith von Modeled Behavior auf. The gut reaction is that risk is bad and of course risk taking is unpleasant for most people. [...]