Thursday, October 9, 2008

What Should be Done?

An earlier post provided a multitude of reasons why the Treasury should not spend any of the $700 billion it was authorized by Congress. I keenly appreciate that the financial crisis is very disturbing, and that it would feel better to do something. But does that mean feeling better by doing something harmful? I assume that the answer is "no". With that in mind, here are two action principles:
  1. Rely on the market as much as possible. In my view, it is even more important to rely on the market in a crisis than it is in the calm. When things are calm and prosperous, we can afford anti-market policy mistakes. Arguably, now is not one of those times.
  2. Play to your comparative advantage. Don't try to wrestle an elephant when you're a mouse! The money market is a very big place, even from the U.S. Treasury's perspective. Washington has a couple of comparative advantages: (a) the markets love its debt, and (b) it proposes, writes, interprets, and enforces the law.
These principles bring a couple of possible policy actions to mind (I'm sure you can think of more):
  • Improve the law to encourage (or at least reduce the amount of discouragement of) exit and entry into the financial industry. We need the weak players to exit, and new players to enter. Expedite bankruptcy for the weak banks. Lower capital requirements for new banks. Allow new and expanding banks to hire talented leaders (that means no ceilings on executive compensation). If people value access to insured, well-capitalized and heavily regulated banks, than have some banks of that type but do not erect barriers for new and innovative entrants by imposing those standards for all institutions. If insured, well-capitalized and heavily regulated banks cannot coexist in a market with the unregulated, then listen to what the market is saying.
  • Cut taxes and sell Treasury bills. Taxpayers will be happy and, judging from the very high prices paid for Treasury bills these days, the money market will like it too.
  • Perhaps one way to do both of these is to give a corporate tax credit to banks that raise capital or merge with another institution. Or a personal tax credit to persons who purchase new bank shares. To the extent that there be a temporally coordinated private sector supply (i.e., that capital is worth more in bank ABC when bank XYZ is also raising capital), this tax credit could apply to a limited time window, for example between now and March 31, 2009. Whether that tax credit is refundable or not depends on how you want to treat old versus new banks. The law of one price suggests making it refundable, although maybe there is some public benefit to having banks absorbed by existing institutions that are already profitable.

2 comments:

Don said...

"Rely on the market as much as possible. In my view, it is even more important to rely on the market in a crisis than it is in the calm. When things are calm and prosperous, we can afford anti-market policy mistakes. Arguably, now is not one of those times."

In spirit I'm with you, but this is what I believe.We need to settle this crisis with the cards that we have been dealt, i.e., the government had implicitly, for sure, and obviously, I think, guaranteed that it would intervene in a crisis such as this. So, for this time, game over.

Now we need to develop a long term strategy to reduce the risk of such crises with some regulation, minimal, but effective, and slowly move away from the need and risk of government intervention. But, here's the thing: if governments not going to intervene,that needs to be made perfectly clear from the beginning, i.e., agreed to as a matter of clear policy. Otherwise, the government will be expected to intervene in crises such as this.

Arguing these kinds of issues during a crisis is not going to favor government not being involved. That must come in less troubled and more thoughtful times.

Don the libertarian Democrat

Will said...

The government should have been tightening lending standards and perhaps raising interest rates when we first knew we were in a housing bubble. That was some years ago. Instead they made it much worse.