Wednesday, September 24, 2008


$700 billion is a lot of money, approximately equal to the annual output of the state of Florida, or of the six New England states. That's more than 5% of the total output of the United States. Only 16 countries worldwide produce that much in a year. And the Secretary of the Treasury has asked for that much in a one-shot attempt to stabilize U.S. financial markets.

As an economist, this seems to me a high-risk endeavor. The money will come from loans, which have to be paid back by future taxpayers regardless of the plan's success. As a taxpayer, I'm worried the proposal pursues a questionable goal: welfare for investment bankers?

Finance is not supposed to consume a large portion of a country's resources, but it's understood to enable growth. So when the financiers ask for their pound of flesh, do we pay up, or risk the consequences? Two countervailing credibility problems form the horns of this dilemma.

First, the prospect of a big bailout introduces a moral hazard. Investors at home and abroad should not be led to believe that Uncle Sam will cover losses once the cost gets high enough. Companies that become "too big to fail" are too big of a liability to us all.

Second, the prospect of a financial crash introduces a default problem that could become widespread. If insurers and loaners lack confidence in the ability of borrowers to repay - or to be backed up by the government - interest rates will rise, hurting the U.S. as a net debtor.

The recent history of this crisis is not encouraging. Remember the Fannie & Freddie bailout? The government made a commitment of up to $200 billion. That didn't save AIG or Lehman Brothers, and didn't turn the stock market around for more than a few days. Why should $700 billion now have any positive ripples when $200 billion a few weeks ago slid like a drop into the ocean?

Likewise, the oddest thing about the crisis is how limited it has remained in scope. Some economists say that financial markets are an important indicator of where the real economy is heading. Some economists say that consumer confidence is a vital indicator. Well, stocks have been falling steadily for a year, dwarfing the daily fluctuations. Consumer confidence is nearing all-time lows. But the real economy seems to be healthy! Unemployment is near long-run averages, labor productivity is rising, real wages are rising, and GDP growth is choppy but positive.

None of this guarantees that a recession is not "right around the corner." But it does cast doubt on financial and consumer confidence measures as indicators of economic activity. Do we really need to pull out all the stops to "save" an economy that's plugging along on the strength of export-driven activity? This is no boom, but the fundamentals of the economy are, ironically enough, strong.

These twin doubts - in the efficacy of a potential bailout and in the actual extent of the crisis - make me leery of any expensive bailout package. I offer a rare commendation to legislators from both parties who greeted the $700 billion Rube Goldberg machine with skepticism. Here's hoping they can't agree on anything, at least until we know more about the extent of the crisis and the likelihood of success.

This is cross-posted on Watchblog.


gary said...

If you think that Moral Hazard is a big problem...

Can you tell me what happened to equity holders in Bear, or AIG?

And can you tell me why the TED spread is so high?

Carol L. Douglas said...

And can you tell me why there's an email going around that says that the $85 billion AIG bailout will cost $425,000 per American adult?

And why anyone who can't divide a big number by a slightly less big number should be allowed to vote?

Curmudgeonly yours,

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