Wednesday, September 24, 2008

A Reluctant Defense of the Bailout-to-End-All-Bailouts

This is one of those rare times when perhaps we should be grateful that most Americans have little understanding of how our economic system really works on a day-to-day basis.  Because if everyone understood how close the American economy came to a meltdown last week, we might have an old-time, widepread panic on our hands.  

If the financial system is the circulatory system of the American economy, then the market for short-term, high-quality debt is the economy’s heart.  The most prominent form of this type of debt is commercial paper.   Banks constantly trade massive amounts of commercial paper between themselves to finance their own lending to businesses and consumers, and very large companies with excellent credit ratings issue commercial paper to finance their day-to-day expenses (like meeting payroll).  Much of this paper is bought by money-market funds, which investors large and small invest in.  Usually, this system works well for all parties involved. Money-market funds, and their investors, get a higher return than they would from investing in instruments like U.S. Treasury notes while still putting their money in very safe places, Big borrowers get to finance their short-term capital needs more cheaply than they could by borrowing directly on bank credit lines.  The system allows for the very efficient movement and use of massive sums of capital, but if it ever shut down the consequences for the economy would be extremely dire

Last week, it began to shut down.

The nearly simultaneous failures or near-failures of Lehman Brothers, Merrill Lynch, and AIG last Sunday and Monday were a huge blow to the already damaged high-quality debt markets. The pre-existing uncertainty about the stability of companies who had bought lots of potentially bad mortgage loans further increased, but more importantly the stability of companies who had lent money to or insured the value of those companies, through now increasingly famous credit default swaps, came into question.  (Indeed, the news that AIG was in trouble might have been the turning point:  AIG did invest in risky mortgages, but it appears that what really pushed the company beyond the point of no return was its liability as an issuer of credit default guarantees.)  Fear spread quickly among big lenders.  The LIBOR, a key interest rate that big banks charge on loans they make to each other, literally doubled overnight.  For the first time in decades, a major money-market fund reported that the value of its commercial paper holdings had sunk below purchase value.  Money-market funds stopped buying commercial paper.  General trading of commercial paper and other debt instruments between even the biggest banks slowed as banks became afraid to make even short-term loans to each other.  The credit markets were freezing up, and in just a few days the capital freeze would have spread to consumer and small business lending.  Large companies, and then smaller companies, might have had to make widespread layoffs.  Simply put, the economy was heading into cardiac arrest.

In the wake of the announcement of the federal government’s plan to buy up to $700 billion worth of distressed securities from financial institutions, the credit markets have drawn back from the edge a bit.  But as the decline in the stock market this week has shown, the continuing inability of elected officials in Washington to come to agreement over the terms of the rescue plan is driving continued uncertainty and instability in the U.S. financial system.  The message coming from Treasury, the Federal Reserve, and Wall Street is clear: the financial system needs the bailout to pass, and it needs the bailout to pass now.

But just because Secretary Paulson, Chairman Bernanke, and various titans in the private sector say a bailout is the only way forward doesn’t inevitably require the conclusion that it is. Indeed, in the last few days a somewhat surprising (at least to me) number of strong dissenters, both policymakers and commentators, have emerged.  The arguments from the left --which mostly seem to boil down to the idea that bailing out irresponsible borrowers is fine, but bailing out financial companies is horrible-- don’t much interest me, but some of the ones on the right call for answering, especially from those (like me) who often bemoan government interference in the markets.

George Will has a fine column in today’s Washington Post making (explicitly and implicitly) what I consider to be the four of the most trenchant free-market arguments against the rescue plan.  They are: (1) the bailouts the federal government has already tried (from Bear Stearns onward) in this situation haven’t averted the current crisis, (2) as a matter of constitutional law, the bailout plan proposed by Secretary Paulson gives the Executive too much discretion, (3) as a practical matter, the Treasury Department could not make all the many, many decisions of the bailout plan with anything like the efficiency we expect from our decentralized, free-market credit system, and (4) a more general objection that the plan would, at least temporarily, greatly expand government control over the “commanding heights” in our economy (our credit markets), a quasi-socialist move.

All these objections have considerable merit.

Though the bailouts the federal government has committed to so far may well (as Secretary Paulson claimed yesterday) have staved off a real financial collapse up to this point, they haven’t prevented the current crisis.  On the legally of the proposed plan, under Supreme Court precedent as it currently stands the Treasury’s bailout plan is probably on pretty solid ground; the non-delegation doctrine (which prohibits Congress from just giving the Executive completely unfettered discretion over a subject) still has some bite, but not much. However, were it tested by the “true meaning” of the Constitution, with a narrower reading of Congress’s delegation abilities, I agree that the Treasury's plan might well not pass muster.  Furthermore, though Secretary Paulson and those experts charged with deciding which securities get purchased and at what price are undoubtedly financial wizards, centralized governmental decision-making is by nature considerably less efficient than markets in allocating economic resources. Finally, a $700 billion plan to enlarge (even temporarily) the federal government’s role in markets that hold a vital place in the American capitalist scheme should always raise very important economic and philosophical questions about the role of government.  All in all, the Treasury's bailout proposal is a bad option indeed.

But with all that said, Congress should still pass it. The only realistic alternative to doing so is doing nothing (or passing a plan that is so limited in scope that it amounts to nothing).  If it becomes clear that there won’t be a bailout, the credit markets could move from a state of fragility to a state of collapse.  If that happens, we’re not just talking about a recession, at least not of the kind America has experienced in the modern economic age.  We’re talking about a quasi-depression. And, aside from the short-term human trauma that would cause, measures that federal and state governments would impose to deal with the downturn would likely dwarf the intrusiveness and the expense of the current bailout proposal.

Situations where one must choose between two bad choices are never desirable, but actually making the choice is often simple: you choose the least-worst alternative and deal with the consequences as best you can.  Congress must now do the same.


Update:  Changed the title to make it more reflective of the content of the post.

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