The Case Against the Bailout

Although I agree with your other points, I think you are very wrong when you say that the bailout blends finance and government. They have been blended for the past 5,000 years--there have been large differences in degree across time and space, but there is no way that you can analyze the history of finance without paying attention to government's intervention in the mobilization and allocation of financial capital. It is this blending what makes so difficult to prevent government intervention in the current crisis.

In addition, you should have written this post at least six months ago.

Well done, Arnold. A lot of people who know in their gut that this bailout is the wrong thing to do are on the verge of doing it anyway because they are afraid. We need people to counter the fear. Keep up the good work.

Yes, the bailout is wrong. But there will be a bailout. The challenge is to prevent a terrible bailout--one that is very costly (I mean economic cost not just a transfer) and does not achieve the instrumental objective of restructuring the financial institutions whose liquidity problems are serious enough to become insolvent. You can bet that the political compromise between the President, Congress and the candidates will lead to a bailout worse than Paulson's plan.

freezing foreclosures for example, are counterproductive.

I think that it would be good if it were much easier to foreclose. The high cost of foreclosure reduces that value of questionable mortgages.

BTW Interestingly, I do not see many people who cannot pay their mortgages trying to rent out rooms or subdividing the homes.

Excellent post, though calling Sarah Palin a pig I thought was uncalled for.

Thank you, Arnold.

I have heard it overstressed again and again how dire the consequences WILL be if the bailout doesn't occur. I rarely hear/read of how dire the consequences will be of actually authorizing the bailout, and that makes me exceptionally skeptical. Additionally, no one - not Bernanke, Paulson, Bush or anyone else - has a crystal ball to see with certainty what will or will not happen either way. Yet I hear/read the 'experts' address these future consequences in terms of certainty rather than probabilities and magnitudes. That makes me even more skeptical. Those artifacts, and the panic nature/rhetoric associated with this argues loudly for not doing a bailout at all, let alone in the time frame (days) requested.

And I have questions I've not heard asked or answered ...
1.) Where precisely, and immediately will the government get the money? The assumed answer is it will sell Treasuries like it always does to fund its deficits. But it is no secret that the money is intended to be used to purchase distressed assets at inflated prices. A related, and seriously defective assumption is that the new Treasury debt will be purchased by lenders at current low rates. I seriously doubt that will be the case. Potential lenders will know what this is, and will likely demand both a higher inflation premium and a higher risk premium on the debt. Furthermore, ALL future federal borrowing will probably be subject to the same increased inflation and risk premium demands of lenders. Lenders are aware that government's debt is backed by its ability to tax its citizens, but they're also probably aware that even the U.S. government can't get 'blood out of a turnip.'

2.) Few, if any, are considering the inherently inflationary effects of injecting $700 Billion of 'new' capital into the markets. Furthermore, the inherent inflationary effects will be virtually uncontrollable by the Fed. During 'normal' periods of excess inflation, the central bank usually applies remedies such as contracting the money supply or increasing the cost of money to check inflation of the currency. Both/either of which at this point would be exactly counter to the stated goals of the bailout. And I see no escape from the almost instantaneous inflationary effects. The bailout is specifically targeted to re-inflate home prices and the 'toxic paper' financing those inflated home prices back to near peak-bubble levels. Certainly above what any element of the market is willing to pay for them now. Effectively, the $700 Billion is intended to be used to impose a price floor, above market equilibrium, for both classes of assets, and pay the costs to a few for the induced market imbalance. The induced inflation, coupled with the Central Bank's inability/unwillingness to check inflation, will have the inevitable result of currency devaluation. Everyone seems to be focused on the 'cascading effects' of not implementing the bailout. I hear no one considering the potential 'cascading effects' of authorizing/funding the bailout. Everyone seems to be concerned that no 'floor' is emerging for prices of homes and 'toxic' paper. My concern is who is going to protect the 'floor' in the value of the U.S. dollar, and how exactly can they do it?

The 'hope' is that markets will eventually bring equilibrium back above the floor for both classes of assets and everyone will live happily ever after and everything will return to 'normal'. But the inflationary effects, highly probable increased debt costs for all future borrowing, increased debt and increased tax burden induced by this bailout will postpone any return to 'normalcy' farther into the future. As a matter of fact, I don't see a very high probability of anything vaguely resembling 'normalcy' ever returning if this bailout is authorized.

The U.S. economy will most likely suffer setback either with, or without the bailout. But I suspect it is preferable to deal with the situation now with existing market and legal/regulatory mechnisms rather than use a credit card to postpone and magnify the ill effects into the future. The economy isn't robust just now, but I suspect it is in better shape to deal with this problem now than in the future when the tax bills are inescapable on current debt service, Medicare, etc.

Another thing that is beginning to feel wrong to me is the idea that we want to keep families in their houses at any cost. When you consider a family that is struggling to make payments and has no equity in their home, it might be in the families long term best interest to find a less expensive home. All of the efforts by politicians to keep families in their home may actually be delaying hard decisions that people need to start making.

I agree strongly with Shayne. I wish I was able to articulate my thoughts so well.

I think were dumping money on a bubble. Putting these securities in goverment hands does nothing to address the risk that lenders are afraid of. It probably increases it. People may be more willing to default with the preception of goverment backing.

Here's my idea for a bailout plan - three sets of reverse auctions on MBS:

250B with prices capped at 60% of face value
150B with prices capped at 70% of face value
100B with prices capped 80% of face value

200B for either purchase of equity or loans at punitive rates

MBS purchased by the feds is held for a minimum of 2 years. During this period, individual contracts are audited, re-classified and, when appropriate, either written off as bad debt or the terms re-negotiated with the borrower. After the two years, they are auctioned off in chunks over the next 10 years (2.5% of the assets auctioned per quarter, with only the audited contracts being sold).

30 day window for amnesty/settlement to mortgage brokers on cases of fraud, conditioned on complete disclosure all information related to the fraudulent mortgages. Extension of statute of limitations on any cases not disclosed under this amnesty, to be prosecuted to the fullest extent of the law.

I pulled the numbers out of my arse, but the idea is to make adverse selection into a feature instead of a bug.

Barandiarin,

I don't buy the idea that this is a liquidity problem. I think its an inventory problem. Politically influential people are holding a large inventory of overvalued assets and refuse to accept the loss. They are using political influence to keep from having to accept the loss. If by liquidity, you mean the ability to take stupid risks and count on political influence to cover the losses, I say its a good thing that such liquidity is no longer available. I think that true liquidity, the ability to make and obtain quality loans, is probably already where it should be - or will be as soon as those who screwed up find themselves with no option but to sell to more competent lending organizations.

I agree with everything except this:

"we have an excess supply of housing units"

I disagree, unless we add the caveat: "given current immigration policies".

There is a backlog of affluent and middle class people who are trying to get into the USA. They would easily soak up the supply of excess housing in many markets. Greenspan pitched this idea.

Government is actively suppressing demand while propping up supply. This makes no sense, and it is unsustainable.

If we sold off citizenship slots for six figures to whomever passed a background check, we'd get the right people in the country to solve this problem. (Was this your idea?)

Hello Fellow American Citizens,

We the people ARE the United States of America. We founded this country for us, in our interest, to make a free society where we we can live or die by the fruits of our labors. This is the premise of American society that has stood until two weeks ago. We now face an unheard of crisis created by literally a handful of greedy people. This handful of people now expect the American public to subsidize them by providing hundreds of billions, if not trillions of dollars so that their private businesses can continue to operate. I reject this as an American citizen and I believe that overall this is unacceptable to the American public.

As the nation sits and watches the ongoing debate in Washington we sit enraged and helpless. Our elected officials debate small details of the bail out but it seems that Washington will be giving this money to these private companies.

It is time We The People use our power over this situation: Our votes and our tax money.

I intend to let our people in Washington know that if they vote for this private company bail out they will receive neither from me.

I encourage everyone that feels the same way to make the pledges I make below and to get this message out to everyone they know. This will send the message that WE THE PEOPLE control Washington as was intended by our Constitution.

I make the following pledges.

I hereby pledge that if the private company bail out is approved I will not vote for any incumbent in any race in which I am eligible to vote.
I hereby pledge that if the private company bail out is approved I will not pay my income taxes.

1) David G. Swanson, Prescott Arizona

Believe it or not, I have a friend who is looking to purchase his first home for a family of 6 right now. Their credit situation is good. They're pre-approved for enough to play in the south Orange County, CA market. They've made a few full asking price offers and been passed over for better offers. Strangely, the foreclosure prices are almost 10% higher than comparable normal sales, and of course, they have all the problems of foreclosures. Out here, it feels like things aren't terrible for people who have decent credit. But there is a dam holding the foreclosures out of circulation, especially if they've been on the market for awhile. While the dam is up, they represent blight on otherwise very nice neighborhoods. When the dam collapses and their prices come down, they are going to drag prices down until demand catches up.

Arnold, enjoyed your post, and it’s about time we start seeing things from a different perspective rather than that of CNN or what the media is proposing to be correct. The bailout to me seems like trying to stick a finger in a hole in a dam, and hoping that the water will hold back. It doesn’t address the flaws and cracks, as these things require “cement” solutions, methods which are so concrete they cater to the root causes of the issue, in such a manner that that they do not reoccur. We are living in much different times than that of the 30’s however we can still take lessons that were learned from that period to be applied today, especially given our significant strain on liquidity. I read that The U.S. in September, 2008 is a far cry from the U.S. as it was in September, 1998. A new world order is fast developing. I must agree with this point that we are seeing some sort of NOW being created in front of our eyes, which has been overshadowed by the media and our President saying that this is what is good for us. This perspective is strengthened even further when we read about how Pauslon wants to RUSH the deal asap. We’ve gone months without the bailout, what’s the urgency in rushing it now? I believe that we are NOT doing our DD as thoroughly as we should and the transparency of this deal seems as clear as a BRICK WALL. Just my 2 cents.
Source: www.stockresearchportalblog.com

VoteNoBailout.org

It makes little difference about the bail out. In the 1970's our economy was strugling. Yes with gas shortages. When the houseing market went down, so went new construction. Which led to layoffs. Ending with double digget unemployment.
If the employment rate drops you not only have to pay unemployment, but you will also see the welfair rolls grow.

It seems clear enough that this bailout is a terrible idea. My question is, what is broken in our political system, that we have reached this point?

What is broken in the Republican Party, that they are seriously proposing socializing the financial services sector? What happened to their free-market fundamentalism? And if that fundamentalism was working, why the crisis?

What is broken in the Democratic Party, that they seem to be more spineless and gullible in the face of this ridiculous proposal by their 'opponents' than the House Republicans are? Am I dreaming?

What is broken in the American financial services sector, and government regulation of it, that allows so much money and so much highly-educated labor to be squandered on gambling and speculation? How on earth can anyone still claim that Wall Street is doing a good job of making sure that capital is allocated efficiently?

I guess one question I have: I've looked at this blog now and then through the years and it seems as if Mr Kling was always on the fence about the housing bubble. I don't remember the particular blog posts, but it sure seemed like he thought these housing prices made sense. Which never made sense to me. It's sort of like that DOW 36,000 book--or whatever it was--which seemed like nonsense at the time.

So I'm wondering: What credibility does Mr Kling really have on this issue?

It surprises me to see people limiting the discussion to the housing bubble.

True, that's at the root of the problem, true it's a bubble, but the problem is that the crisis has now engulfed the entire financial system.

It's not just about mortgages anymore, it's about credit lines to companies in completely unrelated industries, about credit defaults swaps and other derivatives that investors and companies use to hedge against various risks, it's about the entire functioning of the financial system.

The Paulson bailout plan might not be the greatest thing since sliced bread and certainly, pressure should be put upon lawmakers to improve it and limit the losses to taxpayers, but just saying NO to a bailout plan when banks are currently borrowing at the rate of $200 billion per day from the Fed (that's $200,000,000,000) just to keep afloat seems very short-sighted.

The following is the only sensible comment by a member of congress I have heard or read on this matter:

"The financial meltdown the economists of the Austrian School predicted has arrived.

We are in this crisis because of an excess of artificially created credit at the hands of the Federal Reserve System. The solution being proposed? More artificial credit by the Federal Reserve. No liquidation of bad debt and malinvestment is to be allowed. By doing more of the same, we will only continue and intensify the distortions in our economy - all the capital misallocation, all the malinvestment - and prevent the market's attempt to re-establish rational pricing of houses and other assets.

Last night the president addressed the nation about the financial crisis. There is no point in going through his remarks line by line, since I'd only be repeating what I've been saying over and over - not just for the past several days, but for years and even decades.

Still, at least a few observations are necessary.

The president assures us that his administration "is working with Congress to address the root cause behind much of the instability in our markets." Care to take a guess at whether the Federal Reserve and its money creation spree were even mentioned?
...."
-Ron Paul
Read the rest at http://www.lewrockwell.com/paul/paul481.html

[Comment elided and link provided. Please do not paste to EconLog large blocks of material that have been published elsewhere. Please give sources for quoted material.--Econlib Ed.]

The financial sector is definitely overdeveloped - great point! It is hangover from the excessive liquidity of the Greenspan years which juiced the economy and cushioned us from downturns, but you don't get something for nothing - and the bursting of the housing bubble (2nd wave after the bursting of the stock market bubble), is the aftereffects of that excessive liquidity.

Dave
See my blog post:
Just Say No to the Bailout Plan

The farther away from the intersection of Wall and Nassau street the more unnecessary Treasury's plan looks. But that distance only fogs the vision of a banking system ready to fail, with massive implications for our nation.

I wrote about it here: http://dougist.com/index.php?p=36

Lets hope that tomorrow Congress will finally do the right thing and we will never have to find out if I, and ever other finance executive in New York are right about the depths of this crisis.

Doug
www.dougist.com

Well, surprise, surprise, and thank goodness, they have temporarily halted the juggernaut. Here's hoping that the administration actually goes back to the drawing board and tries to come up with a good plan. Sigh. I suppose that would be too much to hope for. I saw something over on clusterstock.com that was breath-taking better than the administrations plan.

http://www.clusterstock.com/2008/9/hank-paulson-and-ben-bernanke-please-read-this-now

What do you think about it, Mr Kling? I would really like to get your take.