David R. Henderson  

Tyler Cowen Discovers Public Choice

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You might claim: "they didn't nationalize it the right way" and maybe they didn't. Still, once you proceed down the nationalization path, you have to live with the nationalizations you will get, not the nationalizations as a professor might recommend they be done. The AIG transition was overseen by Bernanke and Geithner and of course Congress isn't nearly as smart or as well-informed as those two guys.
Beware. The mere ability to write, from the sidelines, "it should be done like X" doesn't eliminate the lessons of public choice economics.

This is from Tyler Cowen, "We've already done some nationalizing."

Question: where was this clear thinking when Tyler advocated the bailout?


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CATEGORIES: Public Choice Theory



COMMENTS (4 to date)
Tyler Cowen writes:

David, first of all there were multiple bailouts, not "the bailout." On some of what was done, it was my judgment that hundreds of failed and insolvent banks would have -- for public choice reasons -- led to worse economic policy than what we are now getting. I continue to uphold the public choice banner. I would warn against seeing public choice arguments only when they militate against government action and ignoring them when they favor some government action, to prevent an even worse outcome.

Bill Woolsey writes:

Perhaps I misunderstand, but I think Cowen continues to support bailing out the current owners as the least bad option. As losses are
realized on their bad assets, reducing their assets and capital, the government purchases stock, providing more assets and more capital.

The banks, then, can continue to meet capital requirements. As old loans are repaid, (the
good ones,) they can make new loans.

The banks, then, continue to make loans and hopefully make profit on the new loans. People
will lend to these banks because they believe that
the banks will be able to pay them back because losses will be covered by the new governent investment.

Eventually, the banks can buy out the government.
In effect, they will have made enough profit on their operations to cover the losses from past bad investments and retain enough earnings that the net worth of the institution rises enough that is is recapitalized.

If the government didn't inject capital into the banks, then as old loans are repaid, the bank cannot make new loans because they aren't meeting their capital requirements. Debtors are repaid with funds from old loans (the good one.) What is left is assets that are, on average, worse.

From the point of vew of the entire credit market, this isn't a problem if those debt holders being repaid buy debt from some other bank or deposit the funds in some other bank, and that other bank makes the loans. Cowen appears to think this is impractical. There are no sound banks to do this. Or if they are sound, they cannot expand because they must raise more capital and it will take too much time.

Cowen's crticism of nationalization is that private investors who might be willing to do the same as the government--cover losses and maintain sufficient capital to meet requirements--in the hope of future profits, will be deterred by fear of nationalization. (An all at once recapitalization shouldn't be subject to this problem if the private investors can correctly identify the bad loans and are willing to pay enough to create a trully sound bank. But threat of nationalzation of insolvent banks does cause problems for private investors that just keep the bank limping along like the government is doing.)

Cowen also complains that the economy will be depressed for a long time, because banks operating in this fashion are doing a poor job of providing financial intermediation.

Some of the proposals for nationalization appear to involve having the government use its capital injections to buy out current owners. Then the government will run the bank, making money on the difference between its good loans and the quasi-government bonds it issues as deposits.

Eventually, the profits on these operations will cover the losses on the bad loans, build up a capital reserve, and the government can then sell the bank.

Other proposals for nationalization appear to involve seizing the bank without compensation (which can be done with an insolvent, FDIC insured institution.) The government then runs the bank as above.

Zingales argues for various schemes of reorganizing the banks such that what remains are fully-capitalized banks, owned by what were debt holders in the bank. By splitting the bank in to a "good" and a "bad" bank, you can have a fully-capitalized fully-sound bank ready to go. The "bad bank" would be owned by former debt holders too, and it wouldn't do anything but try to collect what it can from the toxic assets and pay it to the former debt holders of the "old" bank, partially compensating their losses.

Why are these proposals ignored? Zingales' proposals cost the taxpayer nothing. Presumably, the "problem" is that if this were done to Citibank, then Bank of America would no longer be able to sell new debt to pay off old debt as it comes due. In other words, the result will be a panic as after the failure of Lehman Brothers and "frozen" credit markets.

This suggests that just about all of the major banks will need to be reorganized more or less at once. If FDIC were handling these Zingales' reorganizations, then is resolution team might be overwhelmed.

Here is a second role for "nationalizatipn." The governent takes over and runs bank until there is time for a resolution. The government bank should be able to issue government debt to pay off old debts as it comes due, though telling some debt holders--no, we aren't paying you, should be an option. To limit the panic (if any,) the government owned bank can pay off classes of debtors that they hope will continue to lend to other banks that haven't been nationalized yet.

For example, sell government bonds to pay off loans made by other banks. Announce that those making interbank loans are not going to lose money in these reorganizations.

But as the resolution teams can do the reorganizations, new, reorganized private banks are created, fully capitallized and sound. And bad banks as well.

The more money that the government is willing to contribute to resolving the issue, the less the loss to the debtors who are targettting for losses. Aside from limits on government funds, there is nothing to prevent former debt holders from avoiding all loss and getting stock equal in value to the debt they have lost.

David R. Henderson writes:

Tyler,
Good point, but don't you have to, in your words, "live with the nationalizations you will get, not the nationalizations as a professor might recommend they be done?"
Also, I don't use public choice arguments only when they militate against government action. That's almost entirely what they do but in those rare cases where they go the other way, I use them there too. So, for example, I used to buy the "starve the beast" theory. But Bill Niskanen and others have convinced me that it's wrong. And it's Jim Buchanan's public choice reason: when taxes fall, people imagine that the cost of government is low and so they demand more of it or, at least, drop their resistance to more of it.
Best,
David

John V writes:

David,

Tyler only writes about a third of what he's thinking at any given time.

It's part of his charm.

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