Wednesday, October 1, 2008

Wall Street Bailout, or Main Street Rescue?

I was surprised Monday to hear that the House of Representatives rejected the “bailout” bill. The 777 point decline in the Dow suggests a few other people were surprised as well. On balance, I was in favor of the bill. How could 228 smart representatives disagree? What were these representatives thinking? As best I can tell, their reasons for voting against the bill fell into two broad categories, philosophical and political.

Philosophical Reasons for Voting Against the “Bailout “

The philosophical arguments against the bill seem to be based loosely on the belief that “bailing out Wall Street” somehow goes against the basic tenets of capitalism. Many people believe strongly that poorly run companies should be allowed to fail. Similarly, the “moral hazard” argument argues that those who have made poor decisions should suffer the consequences of those decisions.

Much of the economic theory that we think of as the “basic tenets” of capitalism is based on the concept of “perfect competition.” Among other things, perfect competition is characterized by many independent buyers and sellers of approximately equal size. In such an environment, it is constructive to allow poorly run companies to fall by the wayside. Allowing these companies to fail does not jeopardize their industry, and in fact makes their industry stronger since stronger, more efficient companies will assume the market share of the failed companies. However, the investment and insurance industries are oligopolies, and highly interdependent ones at that. Allowing major companies in these industries to fail is far more detrimental than it would be in an environment of perfect competition.

In addition, I would argue that buying illiquid debt from these companies at garage sale prices hardly qualifies as bailing them out. Even if it did, risking bringing the economy to its knees in order to penalize the wrongdoers strikes me as biting off your nose to spite your face. I want THEM to suffer, not us.

Political Reasons for Voting Against the “Bailout”

The political reasons are based on representatives’ desire to keep their jobs in the face of a perceived outcry against the “bailout.” However:
1. I think constituents were perceived to be more vehemently opposed to the bill than they actually were. Phone calls and e-mails to Congress are not a random sample; they are skewed toward those who have a complaint. (Note: my understanding is a recent random poll shows public opinion more evenly split.)
2. Describing the bill as a “bailout” was an unfortunate choice -- it artificially skews results. If you ask the public if we should bail out Wall Street, of course they will say no. If instead the question is, should we try to stave off the worst recession since the great depression and try to avoid the loss of millions of jobs, I think the public will be much more supportive.
3. Many of the comments that I read from the public seem to me to be ill founded – based on jealousy, wanting vengeance, and an insufficient understanding of the financial realities. To the extent that this is true, I believe Congress has an obligation to provide leadership and not to simply reflect the possibly misguided opinions of their constituents.

The idealist in me thinks that members of Congress have an obligation to lead. However, in addition, I think there is a chance that voting for the bill could actually improve their chances of re-election. If Congress does nothing, by election time the clamor in favor of taking action could exceed the call volume they received last week.

What Should Congress Do?

I think it is critical that Congress take constructive action as soon as possible. I can’t argue that this bill was the perfect solution. In fact, I believe that the chance of arriving at a near perfect solution to such a complex problem on such short notice is remote. There are likely to be many unintended consequences. However, I do believe that extraordinary action is required to stem the tide, and restore confidence. Doing nothing is likely to result in the worst economic disaster in this country since the great depression, and, given the increased global interdependence, the worst worldwide recession in an even longer period.

As mentioned in my post on the Fed’s proposal to insure money market funds, there is little money available for short-term loans. A clear indication of the severity of this situation is the recent yield on 3 month T-bills; recently it was 0.65%, versus over 2% a couple of months ago. This suggests that nobody wants to lend money to anyone except the government. If “Main Street” companies cannot borrow at somewhat reasonable rates they cannot fund short-term working capital needs, and they cannot rollover maturing short and medium term debt. Initially it may only mean slowed growth. However, as short-term debt matures that cannot be re-funded I think it means widespread, though possibly small-scale, layoffs. Slightly longer term, it means bankruptcies in the “real economy” accompanied by even more significant layoffs. This clearly would become a vicious cycle of people buying less, falling further behind on debt payments, and losing still more homes to foreclosure – resulting in still more “Main Street” bankruptcies…. This could get REALLY ugly.

I don’t mean to be an alarmist, but if government’s first obligation is to protect and defend the country, I think this qualifies. Our priority needs to be restoring enough confidence so that the economy can function. Sound companies need to be able to function more or less normally – at least they need to be able to fund their inventories, payrolls and other working capital needs. Ideally, they need to be able to fund investments also – though it is probably unrealistic to expect they will be able to do so at “normal” interest rates. Then we can worry about lower priorities such as punishing the guilty.

No matter what happens, capitalism will “never be the same” (at least, not in my lifetime). We are headed toward an era of dramatically increased oversight and regulation – which is clearly appropriate. The worse we allow the current situation to become, the further overboard we are likely to go with regulations.

Related Reading:
Just Say No, a completely different point of view from Fractals of Change
Politicians gamble like Wall Street CEOs, Loren Steffy

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