Saturday, September 27, 2008

Why the Wall Street bailout plan is wrong

Is the Wall Street bailout plan a good idea? To answer this question it would be useful to get an international perspective on the problem.

Fortunately, Russian Jotman reader Sanjuro -- who has a lot of international business experience -- has surveyed some of the relevant literature and shares his findings. Sanjuro writes in an email:
A number of facts suggest to me that the the present bailout plan is wrong-headed. One comparison that is increasingly mentioned in business publications is the famous "lost decade" of Japan. Although the business establishment argues that the combined effect of the Japan's bailout of "zombie" banks was rather positive, many have argued otherwise; it's still a complicated issue, but there sound arguments suggest that the bail out doesn't maximize the value for everyone. Some articles to check out include:
Researching the question, here are the two main arguments against the bailout that I could find:

1) It is innefficient. Patrick Honohan and Daniela Klingebiel wrote a detailed study for the World Bank (2002) covering over a hundred (!) system-wide bank crises and regulatory responses to them:
  • 'If the countries in our sample had not pursued any such [supportive or bail-out] policies, fiscal costs [borne in the end by the tax payer] would have averaged about 1% of GDP – little more than one-tenth of what was actually spent." (MoneyWeek)
It was mentioned in the yesterday's version of the electronic Economist that the proposed $700 bln bailout would greatly benefit the moguls like GoldmanSachs. The article was titled "And then there were none". There was a cartoon showing a US dollar bill with "In Goldman Sachs We Trust" and the language in the article was "We heard rumours before that Goldman Sachs is ruling America. Now we know it does." I checked the same article today - that language and the cartoon are gone.

2) It is unfair … That man from the Catholics United that you interviewed may not be an economist, but perhaps instinctively he mentioned one crucial thing: "dollar for dollar". He meant that for a dollar of additional investment, the companies must return to the public a dollar of their value in stock without any discount. That's only fair, but that's not what the US government is aiming to do:
  • "banks who sell their debts to the Treasury would receive cash equivalent to something like twice the value in their books of these poisonous assets," … "It would represent a massive injection of new capital into the US banking system - for which taxpayers would receive nothing in return, except for the assurances from Mr Paulson and Chairman Bernanke that their banking system would not collapse." (BBC Business)
With "dollar for dollar" principle there's one more implication. An economist friend told me that when measuring net social benefits and efficiency of economic solutions to problems, we should: "treat all individuals as equal in our measure, so that one dollar to a poor person is counted the same as one dollar to a rich person. Consequently, if we have pure redistribution within the society, this has no effect on our measure, even if we are taking money from the poorest and giving it to the richest". That's a direct quote from my economist friend. It's one of the crucial conditions to achieve the Pareto equilibrium. Of course, this is just a pure economic model, and reality may be different. Still, the amount of distortion with the current bailout plan seems to be high.

And of course, the moral issue here intensified by sending the wrong message to large financial institutions that they are sort of immune in their gambling, implying that if they win, they win, and if they lose, someone else gets to pay the bill... The Japanese regulators bailed out their banks in 1996, and what was the risk management lesson? Japanese banks had the largest exposure to the Lehman's fallout: Aozora, Shinsei, Mizuho...

To sum it up… I believe it is delusion to think the bailout will save the economy as a whole. Some larger players, closer to policymakers, will benefit, and the rest will take battering… I even suspect the $700 bln do not exist simply because nobody produced any additional effort to make this money. What Paulson et al are trying to do is called printing money and taxing average person - practice common among governments worldwide, except the US govt. is also able to tax people overseas.*
* I assume Sanjuro is referring not to taxation of US citizens living abroad, but the taxation-by-another-name of foreigners everywhere that happens simply because 1) the US dollar remains the world's reserve currency; and 2) this means that foreigners holding a lot of savings in dollars "pay" when more US dollars need to be printed and the currency suffers a loss in value.

Photo credit: Jotman. Shows a spokesperson for Catholics United whom I interviewed Thursday. He was protesting the Wall Street bailout plan.

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