Summers: Taxpayers Can Still Benefit from a Bail-Out

This is an argument I've been making too, i.e. that "we don't have to give up our aspirations for the future." So I'm in full agreement with the points made below that the expected cost of the bailout is far less than $700 billion and hence not as constraining in terms of out ability to address other problems as many pundits have implied, that countercycical measures are needed immediately, and that fiscal policy dominates monetary policy as a stimulus tool. (And with fiscal policy, I prefer government spending to tax cuts as a means of stimulating the economy since the effect on aggregate demand is more certain, and spending can be directed toward particular, high employment, high economic return projects such as rebuilding infrastructure and addressing environmental concerns). I also agree with the final point made below that as fiscal policy measures are undertaken to stimulate the economy in the short-run, it is best if they also help with long-run problems. But right now, the short-run is the biggest concern:

Taxpayers can still benefit from a bail-out, by Lawrence Summers, Commentary, Financial Times: Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. ...

The idea seems to have taken hold in recent days that because of the ... bail out..., the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. ...[T]he events of the last weeks suggest that for the near term, government should do more, not less.

First,.... No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. ... It is impossible to predict the ultimate cost to the Treasury of the bail-out... But it is very unlikely to approach $700bn and will be spread over a number of years.

Second, the usual concern about government budget deficits is that ... government bonds ... will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. ...[T]he US made a serious error in allowing deficits to rise over the last eight years. But it would be compounding this error to override ... “automatic stabilisers” by seeking to reduce deficits in the near term.

Indeed, in the current circumstances the case for fiscal stimulus ... is stronger than at any time in my professional lifetime. Unemployment is now almost certain to increase – probably to the highest levels observed in a generation. Monetary policy has very little scope to stimulate the economy... And ... economic downturns caused by financial distress ... ... are almost always of long duration. ...

The more people who are unemployed the more desirable it is that government ... put them back to work by investing in infrastructure, energy or simply through tax cuts that allow families to avoid cutting back on their spending.

Fourth, it must be emphasised that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the US is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.

From this perspective the ... best measures would be those that represent short-run investments that ... over time ... improve the budget. Examples would include investments in healthcare restructuring or steps to enable states and localities to accelerate, or at least not slow down, their investments.

A time when confidence is lagging in the household, financial and business sectors is not a time for government to step back. ...

Comments

[Organic George]

Everyone knows that this deal stinks however it's the only deal the WH and Republicans will allow. The Dems are betting that they will take the WH in Nov and reach a 60 Dems in the Senate. Then they can rewrite the bill so that it makes economic sense and really punish the Wall St criminals.

[Bruce Wilder]

LS: "No one is contemplating that the $700bn will simply be given away."

B.S. That's exactly what Henry Paulson was proposing.

Now, we have a "compromise" proposal, that no one understands. This is not good.

MT: "the expected cost of the bailout is far less than $700 billion"

This is where Mark Thoma has a serious difference opinion, or, at least, a serious difference of rhetorical discretion.

There's something seriously wrong with a discussion, in which there's so much handwaving and so few numbers.

The losses, which are still ahead for banks and investors, may well total $700 billion.

In principle, there's no good reason for the government to take on any of those losses. The government may be needed to replace bank capital, after those losses have been absorbed by private parties, including shareholders, but also, possibly bondholders and other investors. That's what I, personally, believe should be a fundamental principle of policy.

And, if that were the fundamental principle guiding policy, then an expectation that government bank rescues would have a minimal fiscal impact on the government would be sensible.

It is just not clear what principle will guide the neo-modified-semi-Paulson Plan, as executed by Paulson. This plan is a messy kludge.

Will it work as a general policy? No, almost certainly not. It has been re-worked into a probably costly political punt.

Maybe that's the best we can do, at this moment in time: a political punt.

The electoral politics worry me, more than the economics, since there's so little economics left in the proposal.

If the Democrats have snatched defeat from the jaws of victory, by giving the House and Senate Republicans something to run on, I will be sorely disappointed in my country.

If the question is, whether the country needs a large-scale fiscal stimulus, I agree with Larry Summers and Mark Thoma that the country needs it. But, the vote on that will not come until after the November election.

If this political hodge-podge, though, allows the Republicans to maintain large enough numbers in Congress to veto all sensible policy, such a fiscal stimulus is a pipe dream. Democrats will have achieved office, and responsibility, without actual power. The Republicans will go on wrecking the country. People, who see the banking system destroyed by their own stupidity, and then recommend cutting the capital gains tax rate, will be vetoing every sensible proposal, forever. And, come 2012, a Republican Dictator will emerge to rescue us all from the failures of Obama and a Democratic Congress, which didn't have the votes.

[A. Mercer]

On the issue of entitlements, wasn't it expected that baby boomers would be starting to retire in droves? With 401(k)s and IRAs getting hit hard, will that lead to many trying to stay in the work force, further constricting the availability of jobs?

http://indexed.blogspot.com/2008/09/retirement-is-so-last-year.html

[dd]

"So I'm in full agreement with the points made below that the expected cost of the bailout is far less than $700 billion..." and Larry: "No one is contemplating that the $700bn will simply be given away."

Not me; it will be given away to protect the derivatives debacle. The Troubled Asset definition is broad enough to bailout the CDS, interest rate swaps and "any other instrument the Secretary in consultation with the Chairman of the Board of Governors of the Federal Reserve System determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination in writing to the appropriate committees of Congress." (Section 9B).

[Winslow R.]

"Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. ...[T]he US made a serious error in allowing deficits to rise over the last eight years."

Summers joins Bernanke, Delong on my list of financial bunglers.

Given the current monetary mechanism (not counting Ben's fiscal acrobatics), I don't believe Keynes would have desired a surplus. Ever.

[Winslow R.]

"...[T]he US made a serious error in allowing deficits to rise over the last eight years."

The U.S. made a serious error in how they spent the deficits of the last eight years. The U.S. made a serious error or who they elected President for the last eight years.

[Laocoon]

Let's not overlook that the current administration has ignored fiscal stimulus and instead relied on monetary policy. There are limits to what monetary policy can accomplish and we have tested those limits in the absence of administration and Congressional leadership. I agree wholeheartedly that it is time to try fiscal policy, if the Congress hasn't forgotten how, and with this dead duck president the leadership must come from Congress or the next administration.

[a]

"First,.... No one is contemplating that the $700bn will simply be given away."

Except Wall Street? Any law passed of this magnitude will involve corruption and other operational errors. Congress never seems to plan for this kind of thing and just supposes that fraud and mistakes will not occur.

[wjd123]

On Sept 23, Martin Wolf wrote a column entitled, "Paulson's plan was not a true solution to the crisis." He recommends three criterion be used for intervention. From what I can understand of the bill his criterion were not used.

There is no social justice in the bill, conservative Republicans saw to that by killing bankruptcy reform.

What the taxpayer is likely to end up holding a bunch of worthless over-leveraged paper rather than paper backed by real assets. Taxpayers are going to end up bailing out the system that caused this mess.

This isn't a help for Main Street but congresses way of putting the wants of financial services above that of taxpayers.

Look at the makeup of the Financial Stability Oversight Board, every one is a Bush appointee.

If emergency measures have to be taken Democrats should see to in that measures don't come with a "snow job" for the American public on how to price this worthless paper.

Here is what Wolf said about Paulson's plan:

....Given the recent explosion in leverage, the challenge is unlikely to be one of mispricing of the toxic mortgage-backed securities alone. Many people and institutions made leveraged bets that have since gone sour. Their debt cannot be repaid. Creditors are responding accordingly.

Now turn to the [Wolf's] criteria to be used in judging the intervention. First, it would deal with the systemic threat. Second, it would minimise damage to incentives. Third, it would come at minimum cost and risk to the taxpayer. Not least, it would be consistent with ideas of social justice.

The fundamental problem with the Paulson scheme, as proposed, is then that it is neither a necessary nor an efficient solution. It is not necessary, because the Federal Reserve is able to manage illiquidity through its many lender-of-last resort operations. It is not efficient, because it can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors.

Furthermore, these assets are illiquid precisely because they are so hard to value. The government risks finding its coffers stuffed with huge amounts of overpriced junk even if it tries not to do so....

Yet, above all, a scheme for dealing with the crisis must be able to remedy the looming decapitalisation of the financial system in as targeted a manner as possible....

The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system.

The advantage of these schemes is that they would require not a penny of public money. Their drawback is that they would be disruptive and highly unpopular: banking institutions would have to be valued, whereupon undercapitalised entities would have to adopt one of the ways to improve their capital positions.

If, as seems plausible, a scheme that imposes such pain on the financial sector would be rejected out of hand, the next best alternative would be injection of preference shares by the government into decapitalised institutions, on the lines proposed by Charles Calomiris of Columbia University. This would be a bail-out, but one that constrained the behaviour of beneficiaries, not least on payment of dividends. That would make it far better than dropping benefits on the unworthy, via mass purchases of overpriced toxic paper.

What then do I conclude? Yes, there may well be a place for intervention in the market for toxic securities. But this is a costly and ineffective way of meeting today’s deepest challenge. What is needed, still more, is a clear and effective way of deleveraging and recapitalising the financial sector, ideally without using taxpayer funds. If such funds are to be used, they must also be injected in as carefully targeted and controlled a way as possible. Comprehensive action is essential, as Mr Paulson has decided. But let the US take the time to make that comprehensive action right.

[BJ Feng]

Federal spending via needed infrastructure construction could be beneficial both short-term and long-term. The problem is that there is no glitz, we know that Congressmen want to announce some grand project so they can show how concerned they are. The actual good derived is secondary to showing they care, so it's unlikely any fiscal stimulus will be well spent. More than likely we'll get a bunch of pork instead of advantageous spending on infrastructure that will last for decades. Spending money on what the government should be spending money on just isn't sexy enough I'm afraid.

[BJ Feng]

There is absolutely no way a bankruptcy judge can be given that much leeway. As a person who's been to small claims several times, there's no telling what a judge will decide to do. It would create a morass of uncertainty if judges were allowed to unilaterally change the mortgage terms to prevent foreclosure.

This crisis has nothing to do with bankruptcy laws, by the way, I was against the changes made to the bankruptcy laws earlier this decade. But allowing a judge to stop a foreclosure has nothing to do with the previous change. It would do far far more harm than good. We want laws that are predictable and consistently applied. The foreclosure process is very simple and transparent, if you can't make your payments, the bank forecloses on that property. This does not need to be changed.

[paine]

"Summers joins Bernanke, Delong on my list of financial bunglers"

no win

these chaps are efending he system

the system of private profiteering

limitless full employment is a taboo zone for the system
and with good reason
reasons well digested by 1949

[paine]

"As a person who's been to small claims several times"

one way or other
this seems a key
to
the raisin like soul
of count fengula

[ken melvin]

Oh the paine of the silver bullet.

[don]

So, Mark, do you agree with McCain's plan to build nuclear power facilities? That might be a better WPA plan than expanding medicare.
Larry makes some rather large, unsupported claims here:
(1) The bailout can succeed with less than $700 billion cost. As that will account for about another 5% drop in housing prices, I sincerely doubt this. The bailout is not aimed at any one bank and the U.s. financial sector as a whole is much too big for Treasury to save under very reasonable estimates of true asset values.
(2) Although I agree that a downturn is no time to be stingy with federal spending, spending way beyond its means to prevent even a modest downturn will not convince anyone that the U.S. will ever stop its profligate ways.

[baileyman]

"that the expected cost of the bailout is far less than $700 billion"

By whom?

You know, there are $14 trillion in mortgages out there. Housing will bottom, hopefully, at near 30% down from peak. What LTV would you like to use? 80%? then that's $1.4 trillion below water. That loss is sitting on some financial company's balance sheet.

And this does not include foreclosure and sales costs. That could be another 20%, $2.8 trillion.

[Sharon Schmidt]

Why not take a look at the massive spending put on Medicare by the Politics of Medicine - especially regarding overuse of medical radiation imaging procedures? There is very very little research done on damage to dose, yet the public listens to M.D.s on the necessity of having yearly mammo's, etc. They tell you the dose is perfectly safe, as they run out of the rooom, and that the benefits outweight the risks. However, if you ask them what the dose is, as in millisieverts, they don't know. When is the mainstream media going to get on this so the public can make an informed decision? Maybe whistleblowers need body guards. Nothing would surprise me anymore!