Arnold Kling  

Hold a Hearing

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With so much riding on the pending bailout, I would ask Congress to hold a hearing this weekend, with two people testifying: Ben Bernanke and Roger Cole. Cole is head of the Federal Reserve's Division of Bank Supervision and Regulation, fondly known as "soup and reg."

Here is how mortgage securities markets could affect good borrowers:

1. The securities lose market value.
2. The banks mark the value of their securities to market. This eats into their capital.
3. The banks have to cut back lending to good borrowers in order to comply with capital requirements.

To help good borrowers, you have to intercept one of these three steps. The Paulson plan and all its variants are an attempt to intercept step 1. Getting rid of mark-to-market accounting is an attempt to intercept step 2. Easing up on capital requirements is an attempt to intercept step 3.

The Paulson plan is awful. For one thing, I don't see how the Paulson plan can really kick in for several months, because it will take that long to figure out implementation. With capital forbearance, you could have new rules up and running within a week.

Getting rid of mark-to-market is not what I would want if I were a bank regulator. That's why I would want Cole at the hearing. Ask him: if you had to choose between relaxing capital requirements and getting rid of mark-to-market, which would you choose? If he disagrees with me, then go with what he says. Incidentally, there is an op-ed in today's Wall Street Journal that says we should keep mark-to-market accounting.

The question for Bernanke is this: if the Paulson plan is defeated, can he do enough with capital requirements and other tools to keep money flowing to good borrowers, particularly small business? If the answer is "yes," then I think there is a credible alternative to the Paulson plan. Wall Street may not like it, but the public will be protected from a Great Depression scenario. If Bernanke says he doesn't have the tools to free up bank lending, and if he thinks that things are going to really freeze up for good borrowers, then I guess we have to default to the Paulson plan.


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COMMENTS (12 to date)
Brad Hutchings writes:

For one thing, I don't see how the Paulson plan can really kick in for several months, because it will take that long to figure out implementation.

Maybe that's why we're not seeing the proverbial dead body. Bernanke and Paulson see the shooter and the weapon and know when the victim is coming to visit the water closet (tying in the plumbing metaphor).

Given the timing of the election, the transition, and the uncertainty of who's next, it seems smart for everyone to show their hand and think this through. In that context, it is just shocking that Bush had to drag Obama back into town and set up a summit style meeting to keep McCain from looking unimportant and Obama from looking uninterested.

David Thomson writes:

Should I hold my breath waiting for the MSM to ask Barack Obama about the Clinton administration's politically correct policies which started the financial mess? The Democratic Party is mostly responsible for our current economic crisis. Here is an article written almost nine years to the day, September 30, 1999, that everyone needs to read:

http://tinyurl.com/6dcccq

If this above article is read by the majority of American voters---the Democrats will be demolished on Election Day.

Cent21 writes:

I don't like shaving capital requirements. We've got enough leverage as it is.

There is an argument for treasury making preferred equity investments as perhaps the least bad of the bailout options.

Having the govt act as insurer of last resort for complex instruments the private sector didn't know how to price is a non-starter. The Paulson plan of buying the same instruments probably not much better in terms of rewarding the failures. As a lesser of evils, preferred equity has to be considered.

But how exactly would any of these compare with the way WAMU was dismanted today? Who's getting burned by the WAMU collapse, other than equity holders, executives, and those that will lose jobs in a merger? How would that be different under various govt interventions?

Eric Hanneken writes:

I heard a different attack on step 3 from David Henderson. He wants the government to create an additional IRA that would never be taxed, similar to a Roth IRA I guess. The idea would be to build up bank capital by encouraging individuals to save.

TC writes:

Questions for you:

Are we headed into a recession if Congress does nothing?

What if Congress decided to, instead of passing a bailout, to (a) make the Bush tax cuts permanent, (b) abolish the Alternative Minimum Tax and (c) cut the corporate tax rate in half? Would there still be a recession?

And I am using the following definition of recession: Two consecutive quarters of zero or negative economic growth.

I ask these questions because the Paulson plan and the argument for a "deal," any deal, is based on the presumption that if we don't do this, we're headed for a recession or a depression. But are we headed for a recession or a depression even if we do pass the Paulson plan (the original one)?

Let's put it this way. If prior to the Paulson plan GDP growth was expected to be X and the economic impact of the Paulson plan is Y, what is a reasonable estimate of X and Y?

Having watched financial news for the last year, many people predicted recession two years ago and we still haven't had 2 consecutive quarters of negative growth. So, how much value can we place on the "you have to pass this plan or we all die" rhetoric?

David R. Henderson writes:

Arnold,
You have way too much consequence in Bernanke.
Best,
David

another bob writes:

Dr. Kling,

What do you believe the consequences for the municipal and state bond market would be of a large (let's say 30%) decline in home market values?

Can the Paulsen plan have any possible affect on that market?

Is that the next bail-out market?

How big is that market compared to the home mortgage market?

E. Barandiaran writes:

Arnold,
If you define the terms and conditions of the purchase of assets along the lines that I suggested a few days ago, the Paulson plan can be implemented in a couple of days.
Please stop using your libertarian hat. It's blinding you.

El Presidente writes:

The number of "good" borrowers declines when real incomes are shrinking. I feel there is a more general breakdown in relative income distribution that must be addressed through fiscal policy. We can dance around the concept of a liquidity trap, or we can do something about it. If all Uncle Ben learned about the GD was that the Fed screwed up, then I think he missed something important.

In the run-up to the GD, wealth had been concentrated; the means to purchase the labor of others was consolidated. When the power to direct economic decisions is reserved to a few, it must be relinquished or guarded with force. The former is highly improbable and the latter does not sit well with people who have been told they are free and empowered. The velocity of money declines when the incentives for exchange become disparate. People find common ground for fewer and fewer exchanges.

Eccles offered a similar description of the national economy in testimony before the Senate Finance Committee in February of 1933. Anyone who is concerned with our present dilemma should read this testimony. The more things change, the more things stay the same. This is not going to be an easy or quick fix. It doesn't happen in a weekend. You're gonna need more than a hearing to solve this one.

We can summon stoicism to say that there is not a deeper problem here. We can put a band-aid on our financial owie and hope it goes away. We can do that, or we can look a little deeper. If we have a vision of a better society, a more productive workforce, a brighter future, why won't we pay for it? Why do we persist with this retarded exercise in delaying the inevitable? Maybe the answer lies with the people who have accumulated so much of the wealth that would be required to produce such a benefit for others and for society. I can almost hear them saying, "Those aren't my children."

TC writes:

El Presidente,

The tone of your comment makes it sound like you thought FDR's "let's grow the government" strategy brought the US out of the Great Depression. But actually FDR's expansion of the federal government made the 1930s a unique decade in US history, one where almost no economic growth occured.

It is important to point out that when the Great Depression started the US was on the Gold Standard, so the Federal Reserve ended up cutting the money supply by 1/3rd in order to protect its Gold Reserves from being all purchased up. That was the main cause of the financial confusion. But FDR also made it clear that he would demonize businessmen and that strangled economic growth as well. That's why years after the stock market crash of 1929 unemployment was still 20 percent.

This really isn't rocket science. The 20th Century is a series of real live case studies proving that free enterprise grows economies while socialism creates poverty. The economic differences between North and South Korea are perhaps the most obvious example.

El Presidente writes:

TC wrote:

The tone of your comment makes it sound like you thought FDR's "let's grow the government" strategy brought the US out of the Great Depression. But actually FDR's expansion of the federal government made the 1930s a unique decade in US history, one where almost no economic growth occured.

That's a question of measurement. Investment in public infrastructure is economic growth, albeit through an investment that pays dividends for years to come, not all at once. Cutting unemployment improves the material wellbeing of those who were otherwise out of luck. To say the economy didn't grow is, pardon my arrogance, missing the point. Growth, like anything, has opportunity costs. We can grow our GDP while driving people into grinding poverty. We can have a stagnant GDP while bringing people out of poverty. Which one is growth?

My concern is not your typical bleeding-heart-liberal, nanny-state-advocate position. It is instead that we must grow in an equitable way if the progress we call growth is to be sustainable and meaningful. Grow? Yes. But how, how much, and for how long? The roaring twenties were not without consequence. The consolidation of industry and wealth was not without consequence. We don't seem to be comfortable recognizing the effects of consolidated wealth the same way we recognize the effects of monopoly. We know that monopolies drive output down and prices up. Why doesn't consolidation of wealth do the same thing?

Is it because we aren't comfortable discussing the utility and opportunity costs of growth? I would think that's an easy discussion to have. Obviously, we all have a bias in favor of growth. Yet even Friedman advocated a negative income tax. Why would he do such a thing? He's a libertarian if there ever was one, right? He did it because he understood that our economy is a circular flow in the most basic sense, and that if things get dammed up the flow will cease and output will fall.

That was the argument Eccles made. He said that we did not have an absence of wealth. Rather we had an absence of exchange. The terms of exchange were the sticking point and the only way that they could become so was for a few people to have significant enough leverage to spend their time holding out for a better deal while many died for want of basic necessities. To break the stalemate, the government acted as the competition to those reluctant employers and did so to construct public infrastructure, perhaps the most productive activity it could have pursued.

The inhumanity is what necessitated the New Deal. In that light, who cares if there is growth in GDP for a few years. Is there a decrease in poverty? Is there a decrease in infant mortality? Is there a decrease in unemployment? Growth will come, and come to stay, when average people prosper from industrious behavior. The working stiff has been taking it in the shorts for years while the added gains of increased productivity have gone to their employers and not their real wage.

We can do something about that with tax policy that we've been unable to do with, forgive me, "the free market". We went too far in the direction of capital gains tax cuts and not far enough in broadening the base of the Federal income tax. That changes the rate at which money flow upward. The advantage of the few become the hardship of the many if we are not careful to keep society whole.

Dave Tufte writes:

I don't want to get rid of mark-to-market because it is a bad idea.

I want to get rid of it because only one party in the transaction has to abide by it. The people who took out the mortgages that are at the source of the problem didn't have to mark-to-market in the first place, and they still don't. Why should their bankers?

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