'Bailouts' Are Misunderstood

The trillions of dollars in various "bailout" and stimulation initiatives are not intended to bail out wrong-headed investors or executives. In the case of Bear Stearns, notwithstanding the "bailout," shareholders still lost 90% of their investment. It is true that some lousy executives got away with undeserved golden handshakes and I agree this is wrong. Avoiding moral hazard, however, requires placing responsibility where it is due, and that means holding the decision makers responsible and accountable for their mistakes. I had been disappointed with the decision of Paulson not to "bail out" Lehman Brothers (LEHMQ.PK) on that fateful September weekend, and that is not because I wanted Paulson to bail out the wrong-headed decision makers who brought Lehman to its knees. I was wary of the effects of the fallout of the bankruptcy of Lehman on innocent people, and events that unfolded proved me right.

It is easy to say that we should let businesses fail if they cannot survive on their own. But policy makers have to worry about the chain effects each business failure brings about. If the cost of a business failure proves bigger than the cost of a "bailout," the bailout makes sense. I must repeat: such "bailout" is not intended and should not be misused to bail out or reward wrong-headed executives. The latter should still be held accountable.

Some commentators say that Americans need to save more. I said that more than ten years ago. Exactly because this is so important, we need to spend the trillions of dollars of "bailout" money. If they helped save jobs, Americans will then have the income from which they can save. Without jobs, Americans cannot save.

Some commentators also are "sure" hyperinflation is inevitable. I can assure them that hyperinflation is not going to happen. Hyperinflation is always caused by too much spending. During all episodes of hyperinflation such excessive spending is indeed financed by the printing of money. But printing money in itself does not imply excessive spending. Right now any printing of money earmarked for "bailout" or "stimulation" serves only to make up for inadequate spending. Because anemic spending is going to continue for quite a while because of the collapse in asset prices worldwide, how can hyperinflation take place?

Finally, some commentators worry that the "bailout" money will create another bubble. Again, the various bailout packages serve only to fight deflation and to re-establish full employment. Can anyone find any sign that a bubble is forming because of a bailout?

Comments

[Moon Kil Woong:]

You are wrong on hyper-inflation. Germany was not due to too much spending. Hyper-inflation occurs when there is too much money comparable to goods or when supply does not increase enough to offset increases in money. In this case, if we keep adding money and cutting supply due to a recession what do we get. We get the supply of money not falling in line with a drop in supply leading to more money for the limited supply.

It is true increases in money supply usually spurs comparable supply and decreases in demand decreases money supply. When this fails we call it a market dislocation. That is what the bailouts cause. This is the worry. How much increase of money supply can you add until you get a dislocation where supply does not increase enough if at all leading to inflation. And continuing to panic and hyper-inflation.

I am not saying this will happen. But running a socialist style economy like the Bush Jr. Administration is undertaking risks the same problems the USSR had. A total disconnect of the fundamental capitalist pricing signals people rely upon to make rational market decisions.

If the fed dumps $10 trillion in the banks will you as a steel maker increase steel in anticipation of new demand? Probably not. So if everyone does the same you get 0 new supply since they except a market contraction and loads of fresh cash. This is the dilemma.

2008 Dec 03 04:00 AM

[Steven Hansen:]

at some point, this massive liquidity will cause hyperinflation.

Mr. Lok, you argument against hyperinflation relates to velocity of money - money not spent cannot cause inflation. but let me introduce a new theory. velocity of money is not a constant - the more liquidity you have the less velocity it takes to cause inflation.

everyone seems to forget we are not saying the economy is stopping dead, it is only contracting a little bit. it does not take much contraction to cause disruption. so money is still flowing but just at a reduced rate.

at no time has a major currency thrown as much liquidity into the economy as the US has just done. i hope you do not think there is no negative consequences for their actions.

2008 Dec 03 05:32 AM

[socrateazz:]

I may be wrong but i think::Excess money will cause hyperinflation. but not immediately. The greater the deflation the more production due to lack of money will reduce. As production decreases prices start to raise due to more demand for the lower quantity of goods. As prices raise more folk think they are worth more pushing the prices higher..Fair value is somewhere between the peak high price and the bottom low price. Finacial traders should keep the swings from being as drastic. Most financial traders of today are trend traders and not value traders. Thus the true value is actually exasperated by their actions. They should be better stabilized by their existence. Anyhow, if deflation becomes great a swing toward greater inflation will take place. I expect deflation will cause shortages. Those shortages will cause prices to increase which causes folk to use more wealth to get goods. I think food shortages are very possible. Balance is the goal. The attempts by government to fix imbalances will probably create more imbalances. .

2008 Dec 03 07:19 AM

[Lok Sang Ho:]

The comment about velocity at least makes sense. MV is spending. And if MV is greater than P(0)y then P(0) becomes P(1) and it is much higher. Then you will indeed have inflation and even hyperinflation.

However, if MV is no bigger than P(0)y even as M rises there will be no inflation. Aggregate spending as a flow as to be bigger than aggregate supply as a flow before you will have inflation.

Economists understand that V is not a constant. Indeed V is now falling. That is why there is an imperative for stimulation.

2008 Dec 03 08:07 AM

[Smarty_Pants:]

"If the cost of a business failure proves bigger than the cost of a "bailout," the bailout makes sense."

Cost to whom?

In the case of the business failure the cost is borne by the business and its shareholders/bondholde...

In the case of the bailout, the cost is borne by taxpayers.

Is this the sign of a free market? That I, as a taxpayer, am financially responsible for the mistakes of others, including their debts? Did any of these irresponsible businesses seek my opinion on undertaking their risky ventures? No. Nor do I recall receiving my cut of the leveraged profits they enjoyed for several years while they speculated with borrowed money.

What moral principle do you advance that places the burden of rescue on me while denying me any input into operations or receipt of the profits that were generated?

What you advocate is theft of my property for the benefit of others against my will.

Why not just end free markets and let the gub'mint decide who will succeed or fail?

Hint: It didn't work very well in the former Soviet Union, it's not likely to work very well here.

2008 Dec 03 11:00 AM

[moonbat1775:]

"Indeed V is now falling. That is why there is an imperative for stimulation." Lok Sang Ho

The proper way to increase V is new lending from real savings resulting from previous increases in aggregate output resulting from previous lending etc. Note however that the lending should result in increased aggregate output. How does one know if aggregate output has increased or just the price level for a given P*Y? Just see if Y is falling as determined by measurement of the price level. True economic growth should be characterized by rising V, lowering P, and increasing Y. M can be increased sustainably by the proper use of commodities and assets in succession to ethically distribute new money by selling new money for a commodity at greater than par value and using the "profit" to compensate existing money holders for the dilution of their money stock. After distribution, the now bigger commodity backing should be swapped out for appreciating assets in the money till the next issue of new money. A virtuous circle? If not, I would like to know why not.

2008 Dec 03 11:27 AM

[Econ 101:]

The congress of the United States authorized this disaster over several years. Now they are paying off their contributers with your money and the money of your children & grandchildren.

In a few months the velocity of the money being pumped into the economy will increase and we will see inflation. Probably Hyperinflation, stock up on groceries NOW! When gold reaches $1500 the government will start thinking about confiscating gold from the citizens, ala FDR. They will say it is being held by greeedy businessmen. When it reches $2000 it will be confiscated "for the good of the country". When there are riots they will confiscate guns, "for the good of the country."

Welcome to Orwells 1984, 1789 France and 1930's Germany all rolled into one nightmare scinerio, a real "Black Swan".

2008 Dec 03 11:29 AM

[zorkfin:]

The role of a free market is to alocate a scarce resource, money, to the places where it is most needed and where it is best spent. All government interventions, like bailouts distorts this mechanism and ends up in malinvestments and bubbles, Money which should not be available ends up in investments which should not be funded. That's why you had the internet bubble, the housing bubble, the commodities bubble and the massive interventions now will create the next bubble. Speaking of interventions also the state gets to decide that AIG leaves while Lehman dissapears which should not be their decision. The state can decide to print money but it has no control where the money ends. This is why eventually we will have other bubbles, hyperinflation and a debased currency, even if this does not start tomorrow,

2008 Dec 03 11:48 AM

[regeya:]

"Cost to whom?"

Cost to shareholders who lose their investment, cost to "consumers" in the form of lost jobs, cost to retail when "consumers" no longer have jobs...

This isn't rocket science. When big companies fail, there's a domino effect.

2008 Dec 03 04:40 PM

[axelrod608:]

"If the cost of a business failure proves bigger than the cost of a "bailout," the bailout makes sense."

What are the underlying assumptions ? That the bailout wil work. And what does REALITY tell us ?

World Bank economists studied all national financial disasters over a 30 year period. Their conclusion was that in EVERY case, without exception, the length and depth of the following recession was directly proportional to the amount of money thrown at the problem to try to fix it.
Why indeed has Japan never recovered from its bank meltdown ? They threw trillions at the problem and made it permanent. Zombie banks with no prospects of recovery.

Hank, Ben, George,II, and the "fools on the hill" all believe this time is different. Keep your seatbelts fastened.

2008 Dec 03 05:56 PM

[growser7:]

I am just asking a general question of all of you, because I don't get some of the fundamental issues involved---sadly I am no economist so forgive my innocence. Question: With the government bailing out the financial institutions, didn't it more or less buy up privately held debt, so maybe total debt stays constant, but only a greater percentage is now public? Because isn't the government borrowing money, competing with the private sector for capital? Does that increase money supply? I thought it would have to be printing new $$s to do that.. It seems it's just moving capital from the private sector to the public side. I just dont' get it----help! Can someone walk me through this?

2008 Dec 04 12:11 AM

[Moon Kil Woong:]

Growser7 It is a bit complicated as to what the government is doing. They are increasing the deficit allowing the Treasury to dump $700 billion to whomever they want. this is essentially new money based on debt coming into the market. In addition, the Fed is buying or backing all sorts of debt from banks which lets them loan that amount of money back into the market which is increasing the money multiplier. Also lowering interest rates alows people to borrow at lower interest rates spurring people to borrow also increasing the money multiplier. The more banks loan and the more people borrow the more money there is in the system. And the faster rate they do it increases the money multiplier.

Unfortunately, if the banks have a lot of cash but no one borrows more money doesn't enter the system no matter how much $ the government gives banks. Also if the banks refuse to lend the money no increased money occurs. And if there is a lot more money entering the system without corresponding goods and services this creates inflation since there is more money per goods and service unit.

Right now, there is a de-leveraging or people are trying to clear their debt or banks are not lending as much. This makes the money multiplier shrink and there is less money. So the government is trying to get people to borrow again to stop the deleveraging and economic slowdown. However, this is not occurring. Also its clear businesses are cutting back goods and services and prices are starting to fall.

Unfortunately, if only inefficient users of money get the government funds this money will be squandered and adequate goods and services are not produced leading to inflation. Also if government keeps making money and counters deflation, with less goods and services and the same or more money inflation will occur.

So money basically is not a fixed sum, a scare resource, etc. It can be made. The government can make infinite amounts of it. The issue is, if you make infinite amounts of it it would have no worth because there are not enough resources to correspond to the money supply.

This is just a basic summary. The Treasury and Fed always should walk a tight line of making sure there is not a shortage of money which may lead to contraction and not too much that leads to inflation. And also they should not interfere with the market dynamics or you get a dislocation where their interference creates bubbles and pockets of inefficiencies. You may want to read an economics book or watch Commanding Heights or something. I suggest Paulson and Helecopter Bernake do so too since they seem clueless about economics.

2008 Dec 04 03:20 AM

[Invisible Hand:]

Deflation is the current concern not inflation. GDP is falling, unemployment rising, and CPI is falling; this creates deflation not inflation. The combination of the Fed funds rate at virtually zero and CPI falling is another tell tale sign of deflation. I'm not as concerned that we will mimic Japan's deflationary economy because they had and still do have a current account surplus--nation of savers. In contrast we are a current account deficity country, and thus, have no problem with encouraging people to spend as witnessed by our low marginal propensity to save--nation of spenders.

Inflation is a major concern going forward because the Fed always overshoots on the easy money side. Most likely they will start reigning in money supply too late, and this will cause the type of inflation we saw during the late 70's early 80's. I would start dollar cost averaging into tips and gold. You may want to hedge this position with U.S. treasuries. If you have an appetite for risk start building positions in oil and steel in the middle of the year. I figure the fiscal stimuli from around the world should show up in future GDP expectations by then. Moreover, all the pumping of money should start stimulating the world economy.

Jan 03 09:51 AM