Spend in haste, repent at leisure: America’s latest bailout plan
Kenneth Rogoff
Cambridge – With minds concentrated by fears of another 1930’s-style Great Depression, America’s politicians have adopted, virtually overnight, a $700 billon bailout plan to resuscitate the country’s rapidly deflating financial sector. 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 that this will be the panacea that credit markets are (literally) banking on.
The plan’s central conceit is that government ingenuity can disentangle the trillion-dollar “sub-prime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so. To boot, we are told that government is so clever that it might even make money on the whole affair. Perhaps, but let’s not forget that a lot of very smart people in the financial industry thought the same thing until quite recently.
Just a year ago, the United States had five major freestanding investment banks that stood atop its mighty financial sector. Collectively, their employees shared more than $36 billion dollars in bonuses last year, thanks to the huge profits these institutions “earned” on their risky and aggressive business strategies. These strategies typically involve far more risk – and sophistication – than the activities of traditional commercial banks.
In mid-August, I had the temerity to predict that risks had come home to roost, and that a large US investment bank might soon fail or be forced into a highly distressed merger. Little did I imagine that today, there would be no freestanding investment bank left on Wall Street. Indeed, after years of attracting many of the world’s best and brightest into ultra-high paying jobs, collapsing investment banks are now throwing them out left and right. One such victim, a former student, called me the other day and asked, “What am I supposed to do now, get a real job?”
This brings us back to the US Treasury’s plan to spend hundreds of billions of dollars to unclog the sub-prime 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!
Let’s ponder this. Investment bankers have been losing their cushy jobs because they could not figure out any convincing way to price distressed mortgage debt. Otherwise, their firms would have been able to tap the trillions of dollars now sitting on the sidelines, held by sovereign wealth funds, private equity groups, hedge funds, and others. Now, working for the taxpayer, these same investment bankers will suddenly come up with the magic pricing formula that has eluded them until now.
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 around the Treasury’s apparent intention to pay more than double the current market price (20-30 cents on the dollar) on the premise that 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. Thus, unlike in the 1930’s, the US faces a hypertrophied financial system. 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 during this time of turmoil, so that there are no more Northern Rock-style bank runs. That was a big lesson of the 1930’s. 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 homeowners and their lenders work out efficient bankruptcy proceedings. It makes no sense for banks to foreclose on homes when there are workout options whereby people could stay in their homes and banks could recover far more money.
Eventually, after further twists, turns, and huge expenditures, 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.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.
Copyright: Project Syndicate, 2008.
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