Thinking About the Bailout

I know I still owe my readers a post on what can go wrong with the stimulus, but I found something interesting about the bailout. Kip Esquire posts the following context-free tweet:

If A owes B $2, and B owes C $2, and C owes A $2, and nobody has any money, then the required bailout is not $6, but $0. Just saying…

It’s an excellent point. As a nation, all of us being in debt to each other should not be a very big problem. However, thoughtful supporters of government intervention would argue that while the bailout need not be $6, a figure larger than $0 might still be helpful. To understand why, consider the plight of C.

C has an idea for a business venture that could earn him some income. However, the venture needs some startup cash, and C is broke. Worse, C owes A two dollars. Meanwhile, M still has a bit of cash. Normally, M would be willing to lend C the money, but M is worried about C’s creditworthiness in light of his inability to pay A. In theory, C has money coming from B, but in this troubled, debt-ridden economy, that income is not a sure thing: B might never pay. So M refuses to make the loan, C doesn’t start his new venture, and the economy stagnates because the credit market is stuck.

Until one day, G steps in to save the day with a bailout package. G will loan A one dollar. A uses the dollar to pay off half his debt to B, B then uses the dollar to repay C, and C uses it to pay A. Now A owes B $1, and B owes C $1, and C owes A $1. Maybe this reduction in debt is enough to get M to make the business loan that C is hoping for. If not, A still has the dollar, and they can pass it around again to drive debt down some more. Eventually, C gets his business loan, A repays the dollar to G, and the economy is back on track.

This happy tale has a few unhappy complications. First of all, G doesn’t actually have any money to lend. Instead, G either (a) sends men with guns to take the money from P, or (b) borrows the money from M, who is willing to lend G the money only because M knows that G can always repay the loan by sending men with guns to take the money from P.

Second, in addition to A’s debt to B, A also owes $2 to D, $2 to E, $1 to its executives for their lucrative bonus plan, and $3 to China. When it gets its dollar from G, it pays those other guys instead of B and the credit market is still stuck. G has to loan A several more dollars before A finally decides to pay B.

Third, B hates being broke so much that when B finally gets a dollar from A, B decides to hang onto it rather than paying C and being broke again. G will have to pour even more money into the system to get B feeling comfortable enough to pay C and break the credit crunch.

Or maybe everybody just goes bankrupt and G has to rob P to pay M.

For those of you who had trouble following this little explanation, A through E are various banks and businesses, G is the government, and M is the private money lending market. Oh, and we the people are P. We’re the ones who get robbed at the end.