I had the pleasure last week of participating in a bailout panel at William & Mary Law School. The William & Mary Federalist Society, which hosted the event, asked each panelist to address three topics: what led to the current situation, how the bailout plan will (or won’t) fix things, and suggestions for implementing a bailout plan. I’ve already blogged a bit about the first two topics — here I speculate on one of the causes of the mess (Fannie/Freddie); here I discuss the original (“buy troubled assets”) versus revised (“inject capital directly into financial institutions”) bailout plans. I thought I’d take a few moments to blog about the third topic — suggestions for implementing the bailout plan.
The overarching principle guiding any bailout plan, I suppose, should be a simple marginal cost/benefit analysis: for any intervention into the economy, the expected incremental benefit of that intervention should exceed the expected incremental cost. The relevant benefit, of course, would be the social wealth created by the facilitation of commerce; the primary costs would include out-of-pocket taxpayer investment losses and the inefficiencies occasioned by moral hazard and resource misallocation (i.e., the misallocation that results from centralized planning of economic activity and the crowding out of private capital).
So what specific principles should policymakers follow to ensure that the bailout plan is implemented in a manner that passes cost/benefit scrutiny? I’d proposed four (several of which have “subprinciples”). They are:
1. Intervene to Protect the System, Not Individual Participants.
During the William & Mary roundtable, one of the panelists referred to me as a “Hooverite,” which I presume is someone who is so skeptical of government intervention that he would just sit around and let the system implode. That’s an unfair characterization. As I said above, government intervention is appropriate if cost-justified.
The $64,000 question, then, is whether injecting capital into financial institutions in exchange for preferred stock is cost-justified. I’m no expert on money and banking, and I’m in no position to answer the factual question of whether the banks were really in so precarious a position that they (many of the biggies, at least) would have failed but for government intervention. My friend Peter Klein makes a good point when he complains about the lack of analysis underlying the doom and gloom claims. But if many of the biggies really were on the brink of failure so that a run on the banks was on the horizon, I would support government intervention to protect the financial system, without which many, many otherwise viable businesses would fail. On this point, I differ from many of my libertarian friends (including, presumably, some TOTM folk).
So what about intervening to protect really big businesses other than financial firms, businesses like the Big Three automakers? The case for intervention is far less compelling. Most notably, the systematic effect of a failure would not be nearly as great. Sure, lots of jobs are tied to the auto industry, but the bankruptcy of one or more of the Big Three would not shut down the economy the way the collapse of Goldman Sachs and Morgan Stanley, following the Lehman failure, would have done. The quick failure of three prominent financial institutions may well have led to a spectacular run on the banks, causing them to fall like dominoes. The failure of GM and/or Ford would not have the same systemwide effect. As Morgan Housel explains:
Comparing a Detroit bailout to a financial-system bailout is, quite frankly, stupid. When auto manufacturers go out of business, we lose jobs. When the financial system goes out of business, we lose the economy. If GM fails, Chevy trucks won’t simultaneously explode. If AIG fails, financial markets will simultaneously explode.
There are at least two other reasons to treat Detroit and Wall Street differently. First, Detroit has a practical option the banks lack: reorganization in bankruptcy. If the Big Three “fail,” they will not cease to exist and do business; they’ll reorganize under Chapter 11 of the Bankruptcy Code, which will permit them leeway to do some much needed house-cleaning (most notably, renegotiating ridiculous labor agreements that have put them at a tremendous cost disadvantage against foreign car companies with U.S. plants). A bank, on the other hand, can’t just reorganize and continue to do business. Depositor trust, which will be obliterated by a bankruptcy, is absolutely essential to a bank’s continued existence. Trust is also important for a car company (i.e., buyers want to ensure they can rely on warranties, suppliers want to ensure they’ll get paid), but there’s a tremendous difference in degree.
[For more on the Detroit bankruptcy vs. bailout, see this exchange between Gary Becker and Richard Posner. Becker’s a bankruptcy advocate; Posner favors a bailout, primarily because he doubts that Detroit can get debtor in possession loans to allow them to continue operations following bankruptcy. So why not let the government step in in the event that really happens? IMHO, Becker’s totally right on this one.]
The second key difference between Wall Street and Detroit is that the travails of the former are a historical fluke, whereas the problems of the latter are both perennial and self-imposed. The banks are in trouble primarily because of the bursting of an anomalous housing bubble, which was largely occasioned by improvident government policy. The banks have traditionally been quite healthy, and there’s nothing wrong with their fundamental business model. Detroit’s another story. As Becker explains, “The main problem with American auto companies is that during the good times of the 1970s, 1980s and 1990s, they made overly generous settlements with the United Auto Workers (UAW) on wages, pensions, and health benefits.” As a result of those “overly generous settlements,” GM’s health care costs tack on about $1,500 per vehicle, as compared to about $400 per domestically produced Toyota. GM also supports a staggering 2.5 retirees for each current employee. And who can forget the notorious UAW jobs bank, which pays employees not to work after they’ve been displaced by new production technology?
But for crazy labor agreements, there’s no reason cars can’t be profitably produced in America by American workers. As Becker explains:
[T]he American plants of Toyota and other Japanese companies, and of German auto manufacturers, have been profitable for many years. The foreign companies have achieved this mainly by setting up their factories in Southern and border states where they could avoid the UAW, and thereby introduce efficient methods of production. Their workers have been paid well but not excessively, and these companies have kept their pension and health obligations under control while still maintaining good morale among their employees. In recent years GM and the other American manufacturers have chipped away at their generous fringe benefits, but their health and retirement benefits still considerably exceed those received by American auto workers employed by foreign companies. As a result of lower costs, better management, and less hindrance from work rules imposed by the UAW, about 1/3 of all cars produced in the US now come from foreign owned plants.
Improvident (and voluntary) labor contracts are the albatross around Detroit’s neck. Bankruptcy would enable Detroit to renegotiate that mess, retool a bit, and hopefully emerge profitable. A bailout, by contrast, will simply delay the inevitable. Congress would do well to resist Detroit’s entreaties by adhering to the principle that intervention is appropriate only to protect the system, not individual businesses.
2. Heed the Insights of Public Choice.
A key insight of public choice analysis is that government officials do not cease to act as rational self-interest maximizers once they step into the public arena. If politicians have public money to dole out and are able, by so doing, to attain control over the recipients of “their” largesse, they may well call for unwise management decisions that benefit neither the businesses they’re “helping” nor society at large. (See, e.g., how politicians effectively damned Fannie and Freddie, and facilitated a housing bubble, in an attempt to get a political free lunch on afforable housing.)
In light of public choice considerations, any bailout plan should do three things: (a) limit the trough (as explained above) so that it’s available only to avert systematic failure; (b) avoid giving the government voting rights (so limit the government’s equity stake to non-voting preferred stock); and (c) include a plan for divestment once the crisis is averted.
3. Don’t Forget Hayek’s Fundamental Economic Problem.
Writing at a time when socialism was all the rage among the intelligentsia, F.A. Hayek explained why socialist economies were ultimately destined to fail. The problem he highlighted was not the oft-mentioned motivational problem resulting from redistribution (i.e., why create wealth when the government is going to take it from you and give it to someone else?) but was instead an informational problem: how can economic planners allocate resources to their highest and best uses, and thereby maximize wealth, when the planners are not privy to the time- and space-specific information that determines what those uses are? In Hayek’s words:
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources — if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
Any government bailout requires some picking of winners and losers, and bureaucrats in Washington simply don’t have access to (and wouldn’t be able to process, even if they could obtain) all the information needed to ensure that this is done in a way that maximizes wealth. In Hayekian terms, the bailout managers are expected to “utiliz[e] … knowledge which is not given anyone in its totality.”
So how should we manage a bailout so as to minimize the risk of resource misallocation? Greg Mankiw suggests a promising approach under which the government would act as “a silent partner to future Warren Buffetts.” Mankiw explains his plan as follows:
Whenever any financial institution attracts new private capital in an arms-length transaction, it [could] access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date. This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control.
Treasury is apparently considering some version of Mankiw’s plan, which would harness the insights of “the market” (i.e., millions of individual investors betting their own money) and would go a long way toward avoiding the difficulties Hayek foresaw in centralized economic planning.
4. Take the Hippocratic Oath.
Finally, a hodge podge of things the government should do to avoid exacerbating a bad situation:
(a) Privatize (to the extent possible at this point) Fannie and Freddie. They were major contributors to this mess. We need a truly competitive secondary mortgage market — not one that’s distorted by an implicit (now explicit!) government subsidy, coupled with political pressures to achieve social objectives at the expense of sound business practice.
(b) Don’t shoot the messenger. Stop going after short-sellers, always the first ones to ferret out overvaluation, and don’t over-regulate hedge funds, whose short-selling often provides the first warning that something’s amiss at a company. At the same time, as Jonathan Macey recently argued, companies should be free to respond to manipulative short-selling of their stock by engaging in share repurchases without fearing SEC charges of manipulation.
(c) Minimize moral hazard and the crowding out of private solutions. As Macey explained, the original Bear Sterns bailout “hurt other banks’ efforts to raise capital and was a contributing factor in the failure of Lehman, which failed to find a white knight because potential buyers (and their shareholders and directors) expected the same sweeteners from Uncle Sam that J.P. Morgan got for absorbing Bear Stearns.” The moral hazard and crowding out to which Macey refers could be avoided under something like the Mankiw plan. Because true zombies would be unable to raise private, and thus government, capital, the companies that had really screwed up would fail. Permitting them to do so would help reduce moral hazard. Moreover, the Mankiw plan would encourage firms to look first to private markets for needed capital.