Finance

President Bush’s speech tonight urged Americans to side with the Bush-Bernanke-Paulson worldview that a bailout is the only option.  Is it the only option?

Luigi Zingales believes Henry Paulson’s decision to bail out Wall Street is a mistake.  Most economists agree that the government won’t get a “deal” when negotiating the price of risky assets.

“In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price?  The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich–at the taxpayers expense.”  

Zingales continues: “Do we want to live in a system where profits are private, but losses are socialized?”

In an attempt to stabilize the economy, the U.S. government has taken some significant actions.  Let’s recount.  The government has taken over Fannie Mae and Freddie Mac.  Combined assets: $5 trillion.  The government has “rescued” Bear Stearns by backstopping questionable assets valued at $29 billion.  The government has given a loan to AIG for $85 billion.  Further, Lehman Brothers–a firm with $600 billion of assets–is bankrupt.  The SEC has banned short selling on 800 financial stocks.

Are these government actions warranted?  Looking just at the stock market, we see that despite the doom and gloom, the S&P 500 is down less than 1% over the past month and the Dow is actually up 0.4%. [Although year to date, both are down around 15%].  Conservatives claim that the stock market’s resiliency is a sign that the government does not need to bail out these firms.  Liberals believe that bailouts caused the market recovery.  Was the bail-out needed?

The Economist writes that “Officials worried that the collapse of AIG, with its $1 trillion balance sheet and operations in 130 countries, could send the financial system into a tailspin.”  On the other hand, Joseph Stiglitz claims that the bail-outs amount to corporate welfare: “It’s one thing for, to have some safety net for very poor people. It’s a different thing to have safety net for some of the biggest corporations in America.”  Menzie Chinn notes that these bailouts certainly will do nothing to help the U.S. government pay off their debt.  

Who is to blame for this mess?  Maybe Alan Greenspan:

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

A more important question is what should be done now.  If we wish to have a more deregulated financial sector, this will likely lead to higher average economic growth accompanied by a higher probability of financial crisis.  If we wish to live in a less regulated world, investors must face the consequences of their asset allocation decisions.  More regulation may slow economic growth over the long run, but–if the regulation is effective and wisely implemented–will reduce the probability of financial crisis.  If the federal government is liable to bail out failing financial institutions, regulations must be tighter; otherwise financial institutions will suffer from moral hazard and invest in overly risky asset.  

Now we are in the worst of both worlds.  Government regulation was lax, but instead of letting investors eat their losses, the government is bailing them out.  

What would happen if we did not bail out Fannie, Freddie, Bear Sterns and AIG?  The truth is, no one knows.  Financial markets could have stabilized; or financial markets could have gone into a tailspin.  The one thing we do know:  Joe Taxpayer has a large bill coming in the mail.