Letter by Economists Against the Bailout

John Cochrane at the University of Chicago has this letter up on his website:

To the Speaker of the House of Representatives and the President pro tempore of the Senate:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.



Anonymous Anonymous said...

You and the other economists noted that not every failure causes systemic crisis, but it only takes a few--as the history of the Great Depression showed us. So when does the fairness argument give way to old fashion pragmatism? After the tenth major bank failure? After the one hundredth?

Also, what is the alternative plan being offered by you and the other economists who signed this letter? The credit markets are frozen and other markets will cease to function without confidence. Surely, you do not believe that there is no proper role for the government. Must we repeat the mistakes of the 1930s?

9/29/2008 3:27 PM  
Blogger John Lott said...

Thanks, Anonymous. I actually have several op-eds on this, but I put up another post earlier here:


9/29/2008 3:54 PM  
Anonymous Anonymous said...

Thanks for the link, but where are the answers to my questions?

You wrote at that link:

"1) No reform -- the bailout bill refuses to address any of the government regulations that caused the problem to begin with. The "private profits, socialized losses" issue will still be there."

But which regulations are you talking about that caused the problem? The deregulation of commodities and futures trading allowed exotic securities (e.g., mortgage backed securities, collateralized debt obligations and credit default swaps) to be created and traded with any regulation, and Warren Buffett warned against this in 2002. Additionally, the ultra-low interest rates maintained by the fed caused the bubble in housing that triggered all of this. And Christopher Cox came out admitting that the SEC contributed by not regulating enough. Please don't tell me that you believe that the GSE's or CRA loans are mostly responsible, since the default rates on those loans are running at one-half the private market side. So what regulations were more to blame than the factors I cite?

You also wrote:

"2) Assume for a moment that the claims of panic driving down the value of assets are right, this bill isn't the right way to solve the problem. Other more direct reforms would be to get rid of the government accounting regulations. Or providing temporary bridge loans as opposed to having the government have to buy all these assets."

But why do we need to assume this? If you model out a given MBS or CDO what you find is that the current prices are assuming default rates of 35% or more and recovery rates of 50%. This is worse than the great depression and even Schiller, the biggest real estate bear on the planet, does not believe we will see this. This is what the market is pricing, however.

And how does changing the accounting rules now cause everyone to forget what they say? This is like putting the genie back in the bottle and will not work unless market participants tend to forget everything that happens after a week--very dubious.

Also, you mention bridge loans but do not say to whom they should go. The banks already have a credit window to access from the Fed. How is this a new solution? Also, the banks are scared they will be the next to collapse, so they won't lend out money lended to them unless other steps are taken.

You wrote:

"3) Not clear that it is needed. The claim about panic driving down the value of assets doesn't make a lot of sense. We keep on hearing that these assets are actually below their real value and that the government will make money buying these assets now and reselling them later. If so, why won't private parties around the world see the same profit opportunities?"

So a record point drop did happen in the equity markets yesterday. Do you still think it won't happen? Money supply continues to drop, just as it did when the government failed to supply liquidity and boost confidence in the 30's. As I wrote above, the market is assuming default rates well in excess of what bears are calling for, which is a result of opaque, complex securities that require very much time and information to value (lemon problem). These toxic securities need to come off banks' balance sheets before they can again lend money and restart the liquidity cycle, and no private parties (including sovereign funds) will have the confidence to enter the US markets if they cannot show that they are well functioning and well regulated. Other markets with housing boom-bust cycles (e.g., UK, Ireland and Australia) are not coming as unhinged because they had more regulation, as Ozzie PM Kevin Rudd (and former accounting firm exec and financial expert) noted this morning.

You wrote:

"4) Why would we be bailing out foreign financial institutions?"

Because they also supply liquidity to US businesses and employ a lot of Americans. But let's just do something to get the US institutions stabilized, since the frightfully ignorant ideologues in Congress cannot even accomplish that!

I've read serious alternative solutions or suggestions from well-regarded economists (e.g., Lucian Bebchuk, Lawrence Summers, etc.), but I haven't seen much from the signatories of that letter, yourself included. Please tell me that you have more to say than the four-point blog you linked me to--you referenced "several op-eds" so perhaps there is more cogent analysis elsewhere. It seems to me anyway that this really is a very serious crisis requiring more than theological-like blind faith in unregulated markets being the best solution all of the time rather than just most of the time.

9/30/2008 10:27 AM  

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