Arnold Kling  

Mark Thoma's Question

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Economic Crisis: Lessons from ... In Which Winnie-the-Pooh Uses ...

He writes,


I always wonder if the people making the decisions actually had these thoughts, i.e. if they explicitly made decisions based upon the assumption that there was a large possibility of a bailout if they blew things up. Do you think they did?

My guess would be, "No." They thought they were too brilliant to blow things up. I honestly blame arrogance and what I call the "suits vs. geeks" divide, rather than incentives.

Moreover, to the extent that there are problems with executives looting corporations, I doubt that government is the solution. If you want to see real looting, watch what happens when Progressive Corporatism kicks into gear.

The incentives after things blow up are worse than the ones that existed before. Now, some financial executives seem to think that they are entitled to a bailout. This is where I part company with the conventional wisdom. The conventional wisdom is that letting Lehman fail was a mistake. I still think it was the right thing to do.

The conventional wisdom is that unless there is a bailout, Really Terrible Things will happen to the rest of us. So far, I think that the most terrible thing that has happened to the rest of us is the bailout.

The bailout crowd keeps changing their story. A few weeks ago, we were being told that the institutions were sound--it's just that the securities were temporarily illiquid and underpriced. I'm not hearing that theory propounded much any more. Instead, we are hearing that banks need capital. My idea of what to do with insolvent banks isn't to inject capital. My idea is to close the doors and tell the executives, "Don't let the door hit you on the way out."

If there are banks that are borderline because their securities are not trading, then put them on a watch list, quarantined from other banks, until their situation clarifies. My hunch is that the healthy portion of the banking system is sufficient for the economy, but we have to get rid of the zombie banks first.


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COMMENTS (10 to date)
George writes:

Thank you, sir. I was beginning to think that there was hardly anyone out there that felt this way. It may be that the rush to the bailout is the first mistake that will lead to another great depression. It appears very likely that this will be followed by further bouts of huge spending, and then the twin whammies of protectionism and huge tax hikes - then followed by further spending and regulation. This is our future if we have a 58 to 60 seat majority in the senate.
The preponderance of commentary that supports all of this leads me to believe that it will be decades before free markets are embraced again. If ever.

MattYoung writes:

Is there a blow up?

People are cutting way back, smart move, and the suits are in a panic. The rest of us are way ahead in making the adjustment.

guy writes:

I think you could argue that, yes, many people probably discluded the possibility of a widespread liquidity crisis from their risk models because they assumed the government wouldn't let one happen.

Grant writes:

Arnold,

What I haven't figure out is, why is no one talking about the market working how it usually does? That is, the supply of X has decreased. Why can't new or existing firms expand to fill this gap and respond to the higher cost of X? Do things work differently when X = credit?

People have told me this will take too long, but the Paulson plan isn't exactly quick (its already been how many weeks since this fiasco started?). I understand that regime uncertainty is going to stop any entrepreneur from wanting to create a new lending institution in this environment, but if the political climate was laissez faire on direct intervention, wouldn't things be much different?

I'm having a hard time understanding why it would take so long for new entities to be formed, relative to the amount of time these political "solutions" seem to be taking. If the cost of credit really shot up, it seems like there would be tons of people eager to profit off of that. I wonder if microlending is expanding at all?

James A. Donald writes:

You write:
"My guess would be, "No." They thought they were too brilliant to blow things up."

Observe that too big to fail companies screwed up. Companies small enough to be allowed to fail were more cautious, and more sensible.

There are a few things I'd like to note:

"Moreover, to the extent that there are problems with executives looting corporations, I doubt that government is the solution. If you want to see real looting, watch what happens when Progressive Corporatism kicks into gear."

Yes, there is a lot of government action that would be bad, but that doesn't mean that all government action would be bad, or that all government institutions or regulations are bad. There is much that has been shown to be enormously good. So just don't do the bad government actions, but don't not do any, even the enormously efficient and good. Any well trained economist knows that there are market problems which can cause enormous inefficiency without a government role, such as externalities (especially the gargantuan positional/context/prestige externalities, the pink elephant of economics), asymmetric information, inability to patent, inability to perfectly price discriminate or come anywhere close, gigantic economies of scale and at the same time the gross inefficiencies that come with monopoly, and many more well established and accepted in economics, and in any college economics texts.

Note also that government has improved greatly over time with experience, academic study, and other learning. Look at how much more professional and objective the civil service had become over the last 100 years, unfortunately until the conservative Republicans predominantly took power 28 years ago.

"My idea of what to do with insolvent banks isn't to inject capital. My idea is to close the doors and tell the executives, "Don't let the door hit you on the way out."

If there are banks that are borderline because their securities are not trading, then put them on a watch list, quarantined from other banks, until their situation clarifies. My hunch is that the healthy portion of the banking system is sufficient for the economy, but we have to get rid of the zombie banks first."

Why would the zombies be such a problem in preventing the healthy portion of the banking system from providing adequate liquidity, if that healthy portion is, as you have a hunch, sufficient? Clearly from the various financial measures reported, there is, and especially was before the recent government actions, a very serious liquidity problem.

In any case, a hunch is not strong enough to risk a severe recession or depression for, not given the relatively small expected cost of acting in the way Krugman and Eichengreen recommend. If you have a hunch that you will not have a fire, that's not a strong enough reason to risk not buying fire insurance. If there's even a 1% chance of having your house burn down, that makes it worth buying insurance, even though 99% of the time you'd be able to say, "Ha Ha, see my hunch was right."

As far as letting the bad companies go bankrupt, I basically agree, but in a fast track way – i.e., the government takes them over, gives the shareholders nothing, if the firm is really worth nothing, gives the bondholders only what their bonds are really worth, no more, and tells the executives, "Don't let the door hit you on the way out.". But then the government keeps at least most of these companies running, so as not to risk a "house fire" over your hunch. It injects capital, cleans up the balance sheets, and then re-sells the newly healthy companies back to the private sector.

If instead you let these companies go bankrupt the conventional way, it could take years for them to complete the standard legal bankruptcy process, and for other companies to take over their earlier liquidity provision. Waiting for the long run means potentially allowing a severe credit crunch to start a demand-decrease chain reaction that leads to an acute recession or depression.

eccdogg writes:

Mr. Serlin,

Wasn't your proposal essentially what we were doing before the bailout (or close to it).

We took over fannie and freddie, facilitiated a sale of Bear, Merril & Wachovia, and essentially wiped out the equity of AIG and capitilized it enough to have a orderly wind down of its assets. And we let Lehman go.

All the while we kept interest rates low and allowed banks to post dodgier assets with the Fed.

Why did we need a bailout? It seemed to me that the Fed/Treasury could have simply have anounced that any large financial institution that was on the brink of failure would get essentially the same treatment as AIG/Merril/Wachovia.

First we would try to find a buyer, barring that we would infuse enough capital to insure an orderly wind down of the institution and take an equity upside large enough to wipe out almost all of the value of the existing equity. We could have also announced that some debt would be written down in this process by some order of preference.

To me this would have avoided a depression/financial meltdown but also let the market work itself out.

What I am saying is pretty much what was done with AIG, but as Krugman and Eichengreen recommend, it needs to be done on a much larger scale, and along with other measures, and hopefully with global coordination. We've really started to see this kind of plan recently. Otherwise, things would probably be much worse. But we acted too late, and so we're already in recession. Thus, we also need more traditional recession fighting measures from the worlds national banks, and fiscal demand stimuli. Hopefully, in an Obama administration, that will mean demand is stimulated by spending on high return government investments of the kind the free market will grossly underprovide due to well established in economics market problems. A good example is alternative energy investment. It's far better to employ people in this than with tax cuts for the wealthy employing people in producing $200 dinners and $2,000 suits, things of little long term productive value.

hhoran writes:

I'd modify your point to illustrate how the incentives actually worked. In any hierarchical organization, the folks at the top can control the cultural norms. The bigger the compensation at stake, the greater the tendency to enforce very narrow norms that protect the clique at the top, and marginalize anyone who might question the huge payouts, the logic of the compensation system, or any other basic assumptions. Some of this shows up as "suits" vs "geeks" but this is where it starts.

True, these folks are convinced of their brilliance, and no one ever said, "who cares, it'll just be the taxpayer problem". But more importantly, no ever said, "if I can fill the Board and senior managers with cronies and yes-men, the I can push bonuses wildly beyond any plausible notion of merit or shareholder value" but that's where the groupthink starts. It takes years before it gets to the point where the incestuousness and lack of accountability drives the business totally into the ground.

Greg writes:

An economist arguing that incentives were not the problem? The end truly is near.

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