Monday, October 6, 2008

Mr. Paulson, There’s Still Time to Return Your Grinch Costume

Although the law “Emergency Economic Stabilization Act of 2008” now authorizes U.S. Treasury Secretary to use taxpayer funds to accumulate a portfolio of “troubled assets” unwanted by the private sector, it does not obligate him to do so. Thus, it is not too late for the Treasury Secretary to determine that he will not use taxpayer funds in this way, or for President Bush to replace Secretary Paulson with a new Secretary who has made that determination.

There are a multitude of good reasons for keeping taxpayer funds with the taxpayers. Any one of these reasons by itself justifies my proposal, even if the others did not have merit:

(a) The Treasury’s plan for acquiring “troubled assets” may not avert a financial industry crisis because the $700 billion authorization is small relative to aggregate financial market activity, even while it is large from U.S. taxpayers’ perspective. Bloomberg reports “There are lots of reasons to think the Paulson plan won't succeed in cleaning up banks' balance sheets any time soon,” [Edmund] Phelps, an economics professor at Columbia University, said ….

(b) The Treasury’s plan for acquiring “troubled assets” may not avert a crisis because it is not designed to stop the reduction in the prices of houses and other real capital that collateralize many of the assets of trouble banks. See Professor Feldstein’s recent article in the Wall Street Journal.

(c) Even if the crisis could be averted by a one-time realignment of the assets and liabilities of financial institutions, bankruptcy proceedings could serve this purpose – at financial institution owner expense rather than taxpayer expense. If averting the crisis requires that such a realignment happens quickly, then expedited bankruptcy proceedings could be used – again at financial institution owner expense – see Professor Zingales’ article.

This has been criticized because expedited bankruptcy may be inconsistent with the law, but I am baffled as to why we need to pass a $700 billion law in order to avoid changing whatever laws supposedly get in the way of expediting bankruptcy proceedings for banks whose liabilities now exceed their assets.

(d) Even if a financial market crisis could only be averted with taxpayer dollars, this aversion is not worth what it costs. Each dollar brought into the Treasury costs taxpayers about two dollars, because the actions taxpayers take to reduce the tax liabilities. These are known as the “deadweight costs of taxes.” Economists may argue about the magnitude of deadweights costs, but all admit that they are real.

Some have claimed that the Treasury will make a profit on its transactions pursuant to the bailout plan. This is the "profitable government enterprise" myth. Government enterprises LOSE MONEY unless they enjoy a legal monopoly, and even in the latter case a government profit is no guarantee. Are you familiar with Amtrak? The U.S. Post Office?

Others have claimed that the Treasury will not lose the full $700 billion, because it will receive assets in return. I agree (at least if we do not aggregate this bailout's $700 billion with the funds used for past and future bailouts) that the net Treasury subsidy from this $700 billion will be less than $700 billion. But that does not mean that the cost to taxpayers is less than $700 billion. Because of the deadweight costs of taxes, a subsidy in the amount of, say, $400 billion, costs taxpayers about $800 billion.

Furthermore, the smaller is the Treasury subsidy, the more powerful are the arguments (a) and (b) above! You cannot have it both ways -- either the Treasury subsidy is large enough to dramatically impact financial markets, or the Treasury subsidy is small, or neither.

Professor Mankiw's related proposal is to have the Treasury co-invest with private investors. This is a (significantly) watered down version of the profitable government enterprise myth, and thereby dilutes -- but does not eliminate -- the fundamental problems with government enterprises. Furthermore, it does not eliminate the deadweight cost of taxes because the Treasury funds are collected from involuntary taxpayers by the IRS. Quite simply, the fact that private investors cannot find their own partners proves that the taxpayer is not a voluntary participant.

(e) Even if a financial market crisis could only be averted with taxpayer dollars, and these taxpayer dollars did not have deadweight costs, each dollar spent on trouble assets likely creates additional deadweight costs by increasing the supply of troubled assets. If the Treasury pays for troubled assets, the market will oblige!

(f) Even if a financial market crisis could only be averted with taxpayer dollars, and the various deadweights costs of the Treasury’s activities taxes were sufficiently small, averting the crisis would not be worth what it costs because financial market performance has little correlation with the real economy. Don’t let bank advocates let you think that banks are an indispensable part of capital formation. For more on likely non-financial sector responses to a financial market crisis, see my earlier blog post, and a forthcoming post that elaborates further on these issues.

(g) Even -- especially -- if banks were an indispensable part of capital formation, a banking crisis cab be resolved by new entry into the banking industry. Any time existing producers in an industry fail to supply their eager customers, there are profits to be made by new entrants. The banking industry is no exception, at least if it were sufficient deregulated. Indeed, I expect that the prospect of additional government bailouts (reinforced by the Bernanke/Bush/Paulson plan) hinders this powerful margin of market response because potential entrants see even greater profits after the government pays its subsidies, rather than before.

(h) In the past, we economists have not analyzed the marketplace the way epidemiologists analyze contagious diseases. I see no reason to start now. Rather, the marketplace has shown time and time again that it absorbs and dissipates shocks, rather than magnifying them. The process of entry cited above is one important mechanism achieving this end.

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