Why spending 2 trillion to defy the laws of financial gravity is wrong

by Peter

The new rescue package being put together by Treasury Secretary Timothy F. Geithner is fundamentally flawed. Essentially, it may be viewed as an attempt to defy the laws of financial gravity at a cost of $ 2 trillion. Why is it flawed?

There are two main reasons why it is flawed. The first has to do with how the market for bad debt works, and with two problems with the functioning of this market currently. The second has to do with the stage the crisis of the American economy is in now.

Let’s start by looking at how the market for bad debt works. For the moment it is difficult for banks to unload this debt. The primary reason for this is that the pricing of it is difficult. There is a risk that the value of the debt may deteriorate even further if the crisis deepens. And currently sellers are not willing to sell at a price that reflects that possible downside and want a higher price than buyers are willing to pay.

But why do they not want to sell at the price where the market would clear? In other words, why is the market for bad debt not functioning as it normally does? There are two reasons, I think. The first is government intervention, the second is balance sheets.

The government intervention argument is, simply put, that as long as there is a chance of the government being the first to “chicken out” (due to the political pressures resulting from the crisis) of “the game” of conflicting interests that the crisis also is, there is also a possibility that banks may be able to shore up their balance sheets with government subsidies or capital infusions that allow them to ride out the storm. Thus the debt is worth more to them as sellers – as there is a potential upside in terms of subsidies – than it is to potential buyers lacking this potential upside. So the market will not clear due to a history of government intervention and expectation of more interventions that creates an asymmetric situation. This is perfectly rational.

The balance sheet argument is pretty straightforward too: It is likely that some banks, possibly a lot, are not willing to sell bad debt at market prices because if they do the balance sheets will be red or so bad that it will threaten their survival. And survival is a goal with higher priority than stock price or customer confidence.

So, in essence, these lines of reasoning on the functioning of the market imply that putting in $ 2 trillion to subsidize buyers is government intervention to repair flaws in the market caused by government intervention. Signaling instead that no more intervention is forthcoming would be a significantly cheaper alternative that would have the effect of reducing the sellers’ valuation of the bad debt and increase chances of market clearing. But it would not fix the second problem, the balance sheet problem. To fix the balance sheet problem, government would also need to say that they will go in and shore up banks by, for example, buying stock (possibly at market price).

Morally speaking the $ 2 trillion intervention is pretty problematic too. It is an intervention that allows banks to sell bad debt at a price higher than the current market value. As such it is an indirect subsidy to the banks using taxpayers’ money. Also, the plan is to do this in a fashion where FDIC picks up some of the risk for the buyers of bad debt. And this, of course, represents a direct subsidy of investors – rich people not needing subsidies, and probably not deserving of taxpayers’ money.

And this leads me to the stage of crisis problem. In order to be willing to put up 2 trillion dollars – a fairly big sum – one ought to be extremely certain that the money goes into the economic system at the point where it will be the most effective. And, frankly, for the moment I don’t think this is that point. The crisis started with the credit crunch, but for the moment it is not lack of credit that escalates the crisis. Rather it is lack of demand. The reason banks are not lending, is not that they do not have money to lend, it is that the crisis is still deepening and that they therefore in a lot of cases think it is too risky to lend out their money. More money to the banks will not make them lend significantly more if the crisis continues to deepen – it will only make them richer. Elsewhere, I have argued that redistribution in order to increase effective demand is called for, and I think that is still the case.

So the point where the impact is likely to be the biggest as of now is with stimulating the economy rather than with relieving the problems of the banks. In short – the wealth effect is reversed, times are uncertain, jobs are lost and people are not spending. As well, the crisis internationally means foreign demand is reduced too. So public spending, income redistribution, job creation, reduced taxes and similar measures are likely to have much more positive effects than more subsidies to the banks.

So, concluding, I think there is every reason to discuss and most likely rethink the so called TARP 2.0. I think it is very likely that it is not the most effective possible policy measure, and I also think it is wrong morally speaking. There has been too much subsidizing already – it should end.

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