Nothing Profound On the Financial Crisis

As an economics blogger, I feel I should say something about the current economic crisis hitting our financial institutions. However, my libertarian philosophy isn’t helping me as much as I’d like when it comes to the current financial crisis. It’s not that pure free-market economics doesn’t provide an answer. It does. I’m just not confident it’s a good answer.

The straightforward libertarian response to the plunging prosperity of these giant financial institutions is simple: Let them splatter on the pavement, then let the remaining financial firms pick at the remains like vultures gobbling up the juicy bits.

(It’s possible I’m more angry about this than I realized.)

This plan is the classical microeconomic prescription for all failing enterprises: Let them fail so their resources can be put to more productive use. This approach has the advantage of requiring no legislation or government funds. It also serves as a lesson to other financial institutions that they should be more careful because they’re not going to get a bailout.

The problem with the let-em-bleed approach is that such massive disruptions of the financial markets might end up affecting the real economy, slowing the production of goods and causing massive unemployment. Don’t ask me how. I don’t understand financial markets well enough to explain it. But enough people are worried about it that I’m willing to believe it’s possible.

Preventing that won’t be easy, even with careful thought, and we aren’t going to get careful thought:

Because the markets are eager for a final deal and because Congress is trying to adjourn for the fall elections, lawmakers are bypassing the normal committee process and working toward an agreement in hopes of votes in both chambers within days.

Part of what makes this so difficult is the need to prevent macroeconomic disruptions without rewarding financial institutions for taking on too much risk, and thus creating a massive incentive for them to keep on making the same mistakes.

One approach would be a policy that before we bail out a financial institution, we first shoot the executives. A slightly less extreme solution currently under consideration is to add a provision to the bailout bill requiring limits on executive compensation for firms that seek help. (I think much support for this provision stems from the obssessive hatred some people have for highly-paid executives, but it may make sense from a viewpoint of discouraging bailout-seeking behavior.) On the other hand, since we’re offering bailouts for the good of the economy, we want institutions to use them, so maybe it’s a bad idea to give the people who make the decisions a hard time.

Then there’s the push to do something to save homeowners facing foreclosure. We got into this mess by encouraging way too many people to buy homes, so I’m not sure we can stay on that path without running into even more trouble.

There’s also the problem of foreign banks. They want in on the bailout too. Ideally, there’s nothing wrong with that: The purpose of the bailout is not to save banks, but to prevent damage to our economy. If a foreign-owned bank is a large enough participant in our financial markets that its bankruptcy would cause us problems, then it makes just as much sense to bail them out as to bail out our own banks.

The problem with that line of thinking is that even though we’re only supposed to be doing the bailouts for the good of the economy, the recipients of the $700 billion in loans (or loan guarantees or whatever) will almost certainly benefit greatly, so we might want to try to keep it in the family.

My understanding is that large-scale liquidity problems produce externalities, which may make it good policy to use public funds to increase liquidity. However, the mere insolvency of a financial institution—no matter how large—is not a public problem. We want to help the economy, not the financial institutions. Unfortunately, the problems of illiquidity and insolvency are inextricably entangled, making it impossible to affect one without affecting the other.

I’ll even go so far as to say that no matter how much we try to make the bailout program about the economy, once it gets going and people stop paying attention it will eventually turn into a giant corporate welfare operation.

The foreign bankers clearly realize this. Just look at what they have to say:

Gaining access to the relief was a top priority for European foreign financial institutions with banking operations in the United States, according to officials in industry and government.

They argued that the reputation of Wall Street and the United States government would suffer immensely if properly licensed foreign banks in the United States were shut out of the system.

“Who would open a bank again in the United States?” asked one executive of a major European bank who has been following the discussions.

Who would care if they didn’t? If you don’t think you can operate a bank profitably in this country unless you are promised a massive bailout, we don’t want you to try. This is precisely the kind of bailout-seeking behavior we want to prevent.

Finally, what are we to make of this gem found in one draft of the bailout bill?

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Because everyone knows that boundless executive power is the key to national success.