Rogoff: Significant Reasons to Doubt Wisdom of Bail-Out

Kenneth Rogoff thinks that the bailout plan "might end up doing more for profits and bonuses in the financial sector than for the rest of the economy":

Significant reasons to doubt wisdom of bail-out, by Kenneth Rogoff, Project Syndicate: With minds concentrated by fears of another 1930s-style Great Depression, America’s politicians have adopted, virtually overnight, a $700bn bail-out plan...

The final deal is an elaborate piece of financial and political engineering whose ultimate effect is almost impossible to predict. There are good reasons, however, to be skeptical...

The plan’s central conceit is that government ingenuity can disentangle the trillion-dollar “subprime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so. To boot, we are told that the government is so clever it might even make money... Perhaps, but ... a lot of very smart people in the financial industry thought the same thing until quite recently. ...

This brings us back to the US treasury’s plan to spend hundreds of billions of dollars to unclog the subprime mortgage market. The idea is that the US government will serve as buyer of last resort for the junk debt that the private sector has not been able to price. Who, exactly, does the treasury plan to employ to figure all this out? Why, unemployed investment bankers, of course! ...

Little wonder that academics across the political spectrum have expressed considerable skepticism. True, the treasury will take equity stakes in some firms, so there is some upside potential. But the main concern centers on the treasury’s apparent intention to pay more than double the current market price (20c-30c on the dollar) on the premise that the treasury’s success in untangling the mortgage market will make any discount seem like a bargain.

Does such nitpicking fail to recognize the urgency of fixing the financial system? Isn’t any plan better than none? I, for one, am not convinced. Efficient financial systems are supposed to promote growth in the real economy, not impose a huge tax burden. And the US financial sector, in greasing the wheels of the real economy, has been soaking up an astounding 30% of corporate profits and 10% of wages. ... Isn’t it possible, then, that rather than causing a Great Depression, significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?

I am not suggesting that the government should sit on its hands. It needs to provide an expanded form of deposit insurance... That was a big lesson of the 1930s. The government may also need to consider injecting funds more directly into the mortgage sector while the private sector reconstitutes itself. Certainly, the government must also find better ways to help home owners and their lenders work out efficient bankruptcy proceedings. ...

Eventually, ... the US will emerge from its epic financial crisis. But there is a significant risk that this latest step, however grand, might end up doing more for profits and bonuses in the financial sector than for the rest of the economy.