The Bailout Will Not Impoverish America

The Bailout will not Impoverish America Can a bailout impoverish a nation? Perhaps. Will this bailout (I speak not of GMChrysler, that was a political payoff to union supporters, and chump change anyway)? Not likely. This does not mean it will not be costly. We will build up more debt. But we must compare the costs of action with the costs of inaction. Recall that the bailouts we speak about were designed to prevent a financial crisis from materializing. What happened a year ago? Lehman Brothers collapsed  Reserve Primary Fund broke the buck  meanwhile AIG much bigger than Lehman Brothers could not cover its rising collateral requirements a run on money markets led to a flight for the safety of Treasury debt  the commercial paper market froze  credit spreads exploded (TED spread went from under 50 basis points to 400 basis points). The TARP was designed to prevent a financial collapse. The bailout was necessary to prevent a full-blown financial crisis. Some argue that we should have let the banks liquidate, like Lehman. New credit worthy institutions would arise to take their place. It is true, but it ignores the cost of liquidating a large financial institution, as the Lehman case indicated. Moreover, it ignores the consequences of a large financial crisis. Financial crises are very costly. Reinhart and Rogoff show that in such full-blown financial crises real public debt increases 86% over the subsequent three year period. Now what is most important about that is the fact that this is primarily due not to the fiscal cost of bailouts, but rather to the fall in revenues from the crisis,1 as incomes and asset prices fall. Now, Gross US federal debt in 2007 was roughly $10 trillion. So a financial crisis would, based on experience, cause it to rise to about $18.6 billion by 2011. So we are comparing a bailout expenditure of $750 billion or even $2 trillion, against a potential increase in the debt of $8.6 trillion. Which is more likely to impoverish us? And that does not include output losses and unemployment effects of financial crises. Our best estimates are that in postwar financial crises, output takes 4.4 years to reach the pre-crisis level, and in Great Depressions, 10 years. We have not had a worldwide serious financial crisis since the Depression, so not clear which experience is more relevant. And, regarding unemployment, between 1929 and 1932, the unweighted average increase in the unemployment rate was 16.8%. In July 2008 the unemployment rate was 5.8%, so we could expect unemployment to rise to 22% based on previous experience. So with the chance to prevent a full-blown financial crisis was it worthwhile to bail out the financial institutions? I say certainly yes. Recall the magnitudes. Taking the TARP and the fiscal stimulus program together we get about $1.6 trillion. Let’s double that to cover other commitments, so $3.2 trillion. US GDP is about $14.2 trillion, and US Net wealth is about $57 trillion. The current yield on 3-year Treasuries is about 1.5%, 4.5% on 30 year Treasuries, so if we split the difference and take 3%, the extra interest burden is then $96 billion, 1

That is the average, not the highest, over many countries financial crises.

which is less than one percent of GDP. And the rise in the debt is about 5.7% of net wealth, roughly 30% of gross federal debt, which is a lot less than 86%. These are manageable magnitudes (the same may not be said for future spending programs but that is a subject for a different debate) given the size of our economy, and given the costs of inaction. Interest rates are low, so a good time to borrow, if the use is worthy. The use was to prevent a recurrence of the Great Depression. Clearly the bank bailouts were necessary to prevent an even worse catastrophe. Stimulus package of $787 billion less crucial, but the cost of this spending in a recession is less than in normal times. Our opponents will argue that bailouts cause moral hazard, and indeed they are correct. But so do firemen and ambulances. If we had no firemen or ambulances, people would take more precautions in their homes and in their driving. Perhaps they would have water hoses in their living rooms and never drive above 20 mph. This would prevent accidents, but it would not be efficient. That is why we have firemen and ambulances. The question then is should we use their services when an emergency arises. The answer is obviously yes, despite the resulting moral hazard. Then why should we not try to prevent a full-scale financial crisis when we have the chance? Finally, one could argue that we are just creating the seeds of future crises. No doubt true. But suppose we did not have a bailout and instead had a rebirth of the depression. What type of policies do you think the government might enact then?