Arnold Kling  

Misplaced Priorities

One-Two Punch on Mark-to-Marke... Natural Allies or Natural Enem...

Consider the following list of candidates for government assistance, via financial bailout or stimulus:

a) banks and other financial institutions
b) the nonfinancial business sector
c) underwater homebuyers
d) other consumers
e) state and local governments

In my view, (b) is getting the shaft, while (a) and (e) are getting way too much.

If we are going to have something other than a socialist or crony capitalist regime five years from now, we need a robust nonfinancial business sector (b). That is why my preferred stimulus is cutting the employer portion of the payroll tax, as originally suggested by Bryan.

Regarding the financial sector (a), I side with folks, including Simon Johnson and Nouriel Roubini, who want to see failed banks fail. I disagree with those, notably Ben Bernanke, who are determined to treat banks as temporarily illiquid and thus seek to "tide them over" by buying toxic assets or injecting capital. I think that Bernanke, far from being the right man in the right place at the right time, turned out to be the opposite. Last year was not 1930, in which bank runs were threatening otherwise sound institutions. It was 2008, in which thinly-capitalized institutions that had sold securities that behave like put options or insurance no longer met regulatory standards for solvency. They should be shut down in an orderly way as soon as possible, not kept afloat.

I think that the amount of aid being given to state and local governments (e) in the stimulus is disproportionately high. For all the whining about having to "fire cops" and so forth, the layoffs in the public sector amount to rounding error in the overall employment picture. Yes, the state and local governments are hurting. But they are not hurting more than the rest of us. They are getting a relatively large share of the stimulus funds because the Democrats care a lot more about public employees and their unions than they care about the private sector.

As you know, my views on households with underwater mortgages (c) is that we should pay their moving expenses, but no more. It's time to get the housing market back to some natural balance between supply and demand, with legitimate, unsubsidized ownership of the housing stock.

Personal tax cuts and various assistance programs to other consumers (d) are not objectionable. However, I don't think that they promote recovery as much as assistance to the nonfinancial business sector.

My overall point is that the stimulus and bailout efforts suffer from badly misplaced priorities. The federal government is running up a huge debt in a way that favors narrow interests (bankers and public employee unions) while only minimally serving the goal of economic recovery.

Comments and Sharing

COMMENTS (7 to date)
TA writes:

"institutions that had sold securities that behave like put options or insurance"

I take it you mean by this that banks that securitized loans are on the hook for the securities. If so, I'd love to know how much of this (off-balance-sheet) liability is out there. Do you? If you mean something else, would you clarify, please?

Thomas DeMeo writes:

The problem isn't the securitized loans themselves so much as the securitization of the risk of the loans. This created the illusion that the risk was gone, and all manner of bad behavior resulted.

The question is what will happen when you allow the weak banks to fail. Will the counter party risk cascade, taking down banks that were well managed? Did modern risk management in the banking industry create a situation where the whole industry would collapse?

Maniel writes:

I agree with most of your post. I would add that, with respect to government - the unions not withstanding - almost all useful services are provided at state and local levels. Federal spending and taxation are very high by comparison and provide next to nothing of any value. The idea that the federal government might give some of the money back does not bother me. Obviously, it would be far more efficient for the feds to try to turn the ship around, to dramatically reduce all federal spending. Unfortunately, the prevailing wisdom is that federal government spending is a solution. Sigh!

The Student writes:

Of course, the only non-ideological consensus I can find is that without a functioning financial sector able to provide finance to the non-financial business sector, we will most likely fall into a decade of stagnant growth ala Japan in the 1990s.

Of course, as the Fed recently released, the financial position of the average american over the last eight years has not improved in any noticeable way, meaning that we already have basically had a decade of no growth...

Regardless, the key to improving the business situation as a while is to prop up demand and ensure that the financial sector can lend at a reasonable rate to the non-financial business sector. The problem we have now is that forcing one bank under, and we saw with Lehman, will dramatically hurt the value of all other banks, since there was such a huge degree of inter bank lending.

But don't let that cloud the ideological purity of LET THEM FAIL. It's a row of dominoes, and the masonomics answer is let the weak ones fall and hopefully they won't knock over any of the stronger ones.

Doesn't work that way...

Dave writes:

What are the benefits of letting banks fail? Certainly, I understand the moral hazard arguments against bailouts, but most economists seem to agree that at this point that ship has sailed.

Let's say we could perfectly rank the banks from least solvent to healthiest and tomorrow we could shut down the bottom 25% in an expedited and fair manner: wipe out the shareholders, sell off assets, and divy up the proceeds among debtholders. What exactly does that accomplish? What would happen next?

The Snob writes:

Dave: "What are the benefits of letting banks fail?"

Because it may be the only, or fastest way to restore trust in the system at large.

Look at it this way: Imagine Campbell's soup announced that due to a quality-control problem, one of the million cans of chicken soup made today contains a turd, but no reason to panic, because the other 999,999 cans are just fine. Now imagine that a week after announcing that the bad can was found on a shelf in Phoenix, five more such surprises turn up around the country. Thus would end the business of Campbell's.

In the banking world today, the soup-to-turd ratio is off the charts. No one believes we have a good idea where the bottom of the hole lies. Certainly no one believes it when a bank says that it's in fighting condition but still takes a number to get in line for government cash. Liquidity depends not only on bank capitalization but on confidence that said capitalization is reality-based.

One way to restore trust is by waiting it out--at some point the government will stop infusing cash, banks will stop folding, loans will start flowing more freely, and people will begin to believe the sun has again risen. We have no way of knowing whether this process will take months, years, or decades. Alternatively, we put the banks up against a wall, fire, and dissect the corpses in full public view. This way we get to the bottom faster.

All of this ends up as speculation, since there are no more than a few dozen case studies which are essentially impossible to compare apples-to-apples. So whatever you think of the folks in DC, you better hope they're lucky.

Lance writes:

If banks "no longer meet regulatory standards for solvency", yet report high regulatory capital ratios, which they do, does that mean they are committing accounting fraud?

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