Notes made for remarks to the Federalist Society on November 13, 2009
It’s an honor to be on this panel with all these distinguished people. But I’m afraid I was invited because I’m considered soft on bailouts. That’s a terrible reputation to have. What is it they say about poker? “If you look around the table and you can’t tell who the sucker is, it’s you.”
The case for bailouts is usually systemic risk. You do it, not for the bailout-ee, but to limit the collateral damage, damage to the whole “system.” The case against bailouts is that by saving management and owners from the consequences of their excessive risk-taking or bad decisions, you create moral hazard and encourage similar behavior by others.
In most of the so-called bailouts during the Panic of 2008—bunched together in September 2008—the decision-makers were not saved or rescued. Top management, directors and stockholders generally lost their jobs and much of their wealth, and were maligned in Congress and by the press.
They didn’t benefit from a “heads I win, tails you lose” proposition. They had won for a while; then they lost.
Future decision makers under similar circumstances will remember both sides of that coin and not want to go there. Public humiliation is not something you want to emulate.
Mr. Paulson, in fact, seemed eager to fire people at the top who had done no wrong specifically so that he could not be accused of creating moral hazard. The CEOs of Fannie and Freddie were following policies mandated by Congress and were not the same CEOs in place during the earlier accounting scandals. I believe the fired CEO of AIG had been on the job only a few months. And Ken Lewis of Bank of America has learned that no good deeds go unpunished.
Moral hazard did get us into this mess. The making and securitizing of subprime mortgage loans and selling those mortgage bonds all over the world was the mother of moral hazards, since mostly independent unregulated mortgage brokers made the credit decisions and unsuspecting owners of the bonds—misled by their AAA ratings—bore the risk.
Many pundits who were saying “let ‘em fail,” “let ‘em fail” later said letting Lehman Brothers fail was the biggest mistake of the crisis. I tend to agree.
There were a lot of tall dominoes, standing close together. I’m not sure the system could have survived many other failures like Lehman’s, which cost me about 40 percent of my little portfolio.
Given time, I’m sure the Treasury’s TARP program could have been better designed and executed, but under the circumstances I think it’s working pretty well for almost 700 banks caught holding mortgage-backed securities and other assets no longer trading. We only hear of the top nine or the top 19.
I won’t try to defend TARP’s use outside the financial system or the way Congress has used it to fan and pander to our worst populist instincts, to demonize bankers, and as a pretext to expand government power, violate contracts and private property rights. It has been shameful.
The public, egged on by politicians, regards TARP as the Government spending their money to support “evil doers.” Most people have no idea that the Treasury will be able to sell its preferred stock and warrants received from banks, likely at a profit.
There will be losses here and there, on individual transactions and banks, but, overall, I won’t be surprised if taxpayers come out ahead net. The Treasury has earned about 18 percent on the banks that left the program early.
The Federal Reserve’s extraordinary lending last year and security purchases this year are even more likely to earn a net profit for taxpayers. The Fed generally turns over about 90 percent of its earnings to the Treasury’s general fund. Those earnings are rising significantly with the expansion of the Fed’s balance sheet, and those earnings will benefit taxpayers. Even the individual losses here and there, to the extent there will be any, would not be a loss of existing money, but only a loss of the new money created by the transaction—an opportunity cost loss.
Skeptics make much of the Fed’s expansion of bank reserves and money and take it for granted that it will be highly inflationary. Possibly, but I doubt it.
New money must be spent before it can cause inflation. Banks are holding most of their new reserves idle as excess reserves because they are scared to death. And the public has similarly reduced the velocity, or turnover, of money sharply. With the velocity of money collapsing, and credit shrinking, rapid money expansion has not been inflationary. So far, rapid money growth has been needed to forestall deflation.
Despite some pick-up lately, both the Consumer Price Index and the Producer Price Index remain below year-ago levels. Prices for the year are down, not up.
The trick for the Fed will be to adjust money growth as velocity returns toward normal—the exit strategy.
Chairman Bernanke’s study of the Depression has convinced him that tightening monetary policy prematurely is a greater danger than tightening too late. Most pundits on financial TV seem to assume the opposite.
During the Depression the Federal Reserve increased reserve requirements on banks to “mop up” banks’ excess reserves. The banks reacted by contracting credit further. It turned out that the reserves were not considered excess by the banks themselves. They wanted an extra cushion against uncertainty.
Today, the pundits are urging the Fed to make the same mistake—to “mop up’ excess bank reserves before they are used for loans and investments that might create inflation. But the banks are holding those excess reserves voluntarily—for the same reasons they did during the depression, as precautionary balances. Just because they may be excess reserves in a regulatory sense doesn’t make them excess in a more real sense.
While I give passing marks to the Treasury’s capital injections into banks and to the Fed’s direct and indirect lending, I put the massive stimulus program on the other end of the spectrum. It reminds me of hunting wild hogs with a shotgun rather than a rifle. There is a lot of firepower, but it’s diffused–not focused enough. It has probably prevented some layoffs at the state and local levels, but at a huge cost in money, deficits, and debt.
The Fed made loans and the Treasury made investments. The stimulus program, however, was old-fashioned spending. Money spent, money gone.
The deficit as a percent of GDP has tripled and outstanding debt is headed above its recent level of about 40 percent of GDP.
Instead of targeted marginal tax-rate cuts to stimulate the private sector, we face the prospects of repeating a huge mistake made during the depression—raising taxes in a weak economy. Not only the expiration of the Bush tax-rate cuts, but also additional taxes to finance new government programs.
In the 1937-38 period during the depression, the government raised taxes to finance new government programs already put in place. They wanted to balance the budget. We face the prospect of new taxes for existing programs and new programs yet to come.
Another negative feature of the Depression that we seem to be copying is class warfare against business leaders. How that is supposed to help anything is a mystery to me. But, to my knowledge, even Roosevelt didn’t think to have a pay czar.
Another depression-era mistake we’re in danger of repeating is protectionism. We haven’t gone as far as the Smoot-Hawley tariff increase yet, but we are on a slippery slope in that direction, with the violation of the NAFTA agreement on Mexican trucks, tariffs on Chinese tires, and buy-American policies spread all over the stimulus bill.
Will we ever learn?