Proper Market Bailouts

Last week U.S. capital markets were in unprecedented distress and were on the verge of locking up, imperiling both the U.S. economy and world markets.  Over the past year excessive leverage throughout the markets began to unwind as market participants realized that many assets were worth less than they had previously believed.  This gradual unwind became critical last week when it began to happen too fast for market participants to react in an orderly fashion.

In the normal course events capital markets are like a nuclear reactor, pooling capital and risk to create heat that powers the economy.  Without the concentration and free exchange of capital and risk no heat is generated and economic development is stagnant.  However, the same leverage and risk exchange that fuel the economy can produce critical conditions that can spiral into a system meltdown.  Meltdowns can be provoked by systemic frauds and bad government regulation, of which the massive government-sponsored mortgage debacle was a prime example.

Whatever the root causes, the U.S. markets were undergoing a protracted delevering that began to look like a meltdown.  Until recently private sources of capital have always stepped up to halt such crises by buying distressed assets and institutions at deep discounts.  But last week the unwind became so fast and widespread that no private entity could intervene: So many market entities and normally low-risk assets were caught in the unwind that there was simply not enough leverage and liquidity in private hands to put a stop to it.

This is a painful and difficult thing for us free-market adherents to acknowledge.  We may very well be able to pin some of the blame on past government interference in the markets.  But we can now see how large-scale fraud and mismanagement can cause markets to fail in a catastrophically contagious way: i.e., one that threatens the ability of regular people and companies that depend on modest debt financing or the lowest-risk assets to go about their daily business.

Is a government-sponsored bailout justified in such circumstances?  I am inclined to believe so, just as the government should have the ability to issue gobs of debt to jump-start a defensive war for our survival (as in WWII, for example).  When assets cannot find buyers even at distressed levels, and when this market failure will trigger a meltdown, the government should be able to buy distressed assets at a discount.  When contracts and their counterparties that are essential to the operation of the capital markets are in danger, and when their failure will exacerbate a meltdown, the government should be able to backstop those contracts.

Many conservative writers are appalled at the bailout proposed by the U.S. Treasury, and for many good reasons.  It is fraught with moral hazard, and it risks increasing the ongoing involvement of government in markets.  Therefore, a proper government-sponsored market bailout should adhere to the following principles:

  1. Anyone who stood to gain from a risky position should ultimately bear the maximum possible loss if that position is bailed out.  For example, equity holders in bailed out GSEs and banks should lose all their equity.  Debt holders should also be charged for losses that are not recouped.  Even money market investors know that their investments are at risk and should take losses where they occurred.  Bailouts can provide liquidity to halt the vicious cycle of selling, but ultimately losses need to be born by the market, not the taxpayers.
  2. Anyone who participated in fraud should be prosecuted.  This would include mortgage brokers and debtors who lied, and brokers and underwriters who misrepresented the liquidity of auction-rate securities.
  3. The government intervention should be strictly temporary.
  4. Government liquidity should ultimately make a profit for the taxpayers.  Liquidity should always be able to earn excess returns in free markets.  When the government steps in to buy assets and contracts in a crisis, it should do so at a steep discount.  It can afford to hold those assets for as long as necessary, but its ultimate goal should be to cash out those assets or return them to the market — at a profit.

Is Obama a Socialist?

Today I had an inquiry from a journalist.  I don’t know whether she will use my response, but since I’m always eager to share my opinion here are the questions, followed by my answer.

Some have criticized Barack Obama’s tax plan, which includes income redistribution — taking income from the top 5% and giving it to the bottom 95% — as a socialist proposition. In your opinion, is it? And in your opinion, would it be effective?

Is Barack Obama a socialist? If so, why? If not, why not?

It is fair to characterize the Obama tax reforms as socialist, in that they both increase wealth redistribution and increase the proportion of wealth allocated by government.  The Obama campaign claims that its plan would reduce tax revenue as a fraction of GDP, but this is misleading: A significant amount of the Obama tax plan consists of new “refundable tax credits,” which are effectively welfare payments handled by the IRS.  To illustrate why this is a socialist practice, consider the extreme case in which the tax code did nothing but take property from the top 5% of earners and distribute it as “tax refunds” to everyone else.  The Obama campaign would argue that in this case the government has no (net) tax revenue, but this arrangement meets every definition of classical socialism since the government controls the distribution of a majority of wealth.

Would the Obama wealth transfers be effective?  That depends upon one’s objectives.  Such a plan could be very effective in getting him elected if three conditions were satisfied:

  1. Voters believe that they have no probability of ending up in the top 5%.
  2. Voters cast their votes entirely out of selfish interests.
  3. Voters believe that this wealth distribution will not reduce their long-term well-being.

In that case why wouldn’t they vote to line their pockets with the assets of the most wealthy?  I hope and believe that none of these criteria are satisfied.  I.e.,

  1. Voters believe that they have upward mobility, and that they have an opportunity during their life to be among to top earners.
  2. Voters believe that principles like freedom and the integrity of private property are worth preserving, even if it involves sacrificing opportunities to profit at the expense of a fellow citizen.
  3. Voters realize that taxing the best producers will tend to suppress production.  I.e., even though they may end up with a greater portion of “the pie,” the pie will get smaller rather than larger.

Is Obama a socialist?  Clearly his tax proposals are more socialist than the current system.  I think it’s fair to apply the label to someone advocating socialist policies.

Classroom Lectures are Very Obsolete!

My previous discussion of this topic wondered why live course lectures persist in a day when modern media can give students a recorded version that is both cheaper and better.  Brad DeLong suggests that the lecture course is far more obsolete: It dates to the epoch before movable type, and the innovation of relatively cheap books made the lecture (literally, “reading out loud”) method of pedagogy obsolete.

Indeed, other than the potential for ancillary entertainment what educational substance can a professor present in a lecture that he can’t just as well put in writing?  And if he’s not a good enough writer to get his lecture printed, or a good enough showman to get his lecture recorded, wouldn’t the students be better off reading or watching somebody who is?