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August 25, 2009

Has the burden of proof for justifying the banking bailouts been met?

The FT, Tyler Cowen, and Megan Mcardle are saying that we may make a small amount of profit or lose very little on on the banking bailouts. Arnold Kling says that this would make him revisit his beliefs about whether they were really bailouts or just liquidity interventions. A profit on the bailouts would also change my perspective on them. Alas, the holes are sufficiently huge in aggregate that this is pretty unlikely even if several do. I also want the opportunity cost of capital counted in any such reckoning.

They are demanding critics of the bailouts propose an alternative:
McArdle says

That said, they were probably the best thing we could have done. If you disagree, you need to sketch out a plausible alternative scenario.

Cowen says
Maybe you think that the bailouts will have disastrous long-run consequences. And maybe they will, I worry about this too. But if anyone should know that modern politics can only stand so much short-run panic, it is libertarians and fans of Bryan Caplan's book. If we had not done the bailouts we did, we would, within a few months' or weeks' time have received a much worse and costlier bailout run by Congress and Nancy Pelosi. How does that sound?

I'd be against those too. It is too easy to be seduced into supporting bad policy because not doing something could eventually trigger an even worse one.

In the long run it would have been better to allow the entire financial system to burn to the ground then bail out the people who made these mistakes.

If you absolutely positively had to invest a trillion dollars in the financial system, it would have been better to summon solvent banking firms to NYC and hold Dutch auctions for their assets and liabilities. That is, who wants AIG plus a subsidy, and the subsidy increases (price drops) until the bank sells. No reward for failure. One could also have done a massive capital injection into the solvent banks at favorable enough rates that all would want to participate. One way to force the management to put their money where their mouths are is to require management to inject their own (outside) money into the new firms at some leverage ratio. Even if they have to borrow it against everything they have.

You could also try huge quantitative easing. If the federal reserve had done a trillion dollars worth of open market operations and driving real rates negative and injecting massive amounts of liquidity into the system, then I believe that market mechanisms could have been leveraged to restart lending if it failed.

Finally, how about investing in the publicly traded companies directly. Put substantial orders in to buy new equity in the 3000 largest publicly traded firms that can be sold at any time. Make these shares assets of the FDIC or assets deposited as seed capital for privatized social security accounts.

But here is my turnabout for advocates of the banking bailouts:
Have you also noticed that this hasn't turned out to be much of a great recession? Though unemployment is sharply up, consumption and output have changed little, and we may have already reached the trough. One interpretation of this is that the package of stimulus and bailouts worked. But given what we know about how these were implemented, isn't at least as likely that the panic wasn't as bad as it was sold to us?

I know that the insiders were telling us how calamitous it was. However, given the stigma of messing up when supposedly in charge of the economy and the human love for power, they have the right incentives to exaggerate the problem.

Posted by OneEyedMan at August 25, 2009 7:03 AM

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