Government response to financial panics
Jonathan Wilde initiated a discussion about forecasts of future economic growth and the prospects for deflation rather than inflation. This prompted a debate about appropriate government policies in the face of a fiscal collapse:
Is the price [of bailing out Wall Street] worth the cost? Should AIG, the institution that stupidly wrote credit default swaps on CDOs backed by shitty bonds based on even shittier mortgages, exist at all? We've perpetuated the shittiness in the system. I think we'd have been better off if the USG had let AIG and the banking institutions go bust. The information cloud encapsulating AIG and big Wall Street institutions needs to evaporate or else better, smarter information can't take its place.
To which Steve Ingram responded:
Hoover allowed the banks to fail; believed the deleverage had to occur and the market will get it right. Guess what? It didn't get it right. It spilled over to other healthy areas of the economy and basically took everything down, including the little main street guy that lost his savings.
To this I added three thoughts for consideration:
1. Today the little main street guy wouldn’t lose his savings. The little guy’s savings are backed up by the Federal Deposit Insurance Corporation. And his income is protected to some extent by unemployment insurance and Social Security Disability Insurance. And his pension is backed up to some extent by the Federal Pension Guarantee Corporation, and supplemented by Social Security. Etc.
So maybe we don't need government to engage in new interventions today -- not because intervention is always wrong, but because we already have sufficient interventions in place to keep the little guy from panicking.
2. How about this alternative scenario: Instead of bailing out the big guys the US focused on bailing out the little guys?
Imagine that while debating the bailout of Wall Street and the auto industry in 1998, the US sells gobs of bonds in anticipation. Then the US announces, “We’ve decided not to bail out any firms; you’ll have to stand or fall on your own. Yes, some firms will fail, and unemployment will rise. In anticipation, we’ve stockpiled enough cash to provide unemployment insurance until 2020 without debasing the currency. Thus the American consumer can be reasonably confident of his income, and can continue consuming, albeit at a slower rate. Firms that can sell to that consumer can feel reasonably confident of having sales, albeit at a slower rate. And everybody else – well, best of luck to you.”
3. Of course, if the US did this, lots of investors would end up burned, and would henceforth be more reluctant to lend/invest. This "friction" in the system would create a drag on the economy -- at least, relative to the go-go days of the mid-2000s.
So here's the big question: Should government try to make people feel confident in the face of uncertainty? Many aspects of government intervention, both during the current crisis and more generally, seemed to be designed to reduce people’s fear of loss, and increase people’s willingness to take risks. Is that sound public policy?
The FDIC helps people feel comfortable depositing money in financial institutions. I suspect the FDIC is sound policy. We could expect every consumer to incur the cost of investigating the soundness of every financial institution he invests in, but this would be pretty inefficient. Moreover, the fear of a bank failure can trigger a run on a bank, causing the very event that is feared. Deposit insurance seems to defuse this self-defeating fear, producing social benefits that arguably justify the social intervention.
Government blesses certain ratings agencies -- Moody's, Fitches, Standard & Poors (S&P) -- and gives certificates to "Certified" Public Accountants, all in an effort to provide people with greater assurance about data. Is this just a fool's errand?
Is there sound public policy in, for example, keeping interest rates low, thereby encouraging greater investment (and correspondingly less savings) than would otherwise occur? I’m iffier about this. The Austrians clearly don’t think so. Yet if we live in a world in which positive externalities exceed negative ones then society may well have an incentive to induce you to take risks beyond those that you would choose to take based solely on self-interest. Because classical economics suggests that positive externalities (consumer surpluses) are part of most typical voluntary transaction, leaving people to act only on the basis of self-interest (producer surplus) may result in a level of economic activity that is sub-optimal from the perspective of society.
Finally, is it desirable for a president to appear at the scenes of disasters and offer reassurance? Perhaps, in the short run. But these reassuring words arguably make it harder to remind people that we live in a world of risk, that we can console ourselves that this generation faces a lower risk of imminent death or injury than any generation preceding it, and that we might benefit from stoically acknowledging and facing risk. I suspect we’d all be better off if we could acknowledge that the risk of harm from most types of terrorism is not worth the cost of trying to thwart terrorism. I suspect we’d all be better off if we concluded that the benefits from capital punishment are not worth the cost of implementing capital punishment. And I suspect we’d all be better off if we concluded that the cost of protecting various industries is not worth the cost. But I’m not sure how to create a system that rewards leaders for this type of INaction.