Why Banks Want the Old Bailout Back

In my last article I stated that the current crisis is now largely contained as the Fed goes about buying MBS. The argument is that the damage to the financials will then be capped. Although the housing market may continue to slip, if the problematic MBS had been taken over by the Fed, the balance sheets of the financials would not deteriorate further.

The Fed's plan to purchase mortgage-backed securities was targeted at those guaranteed by the mortgage-financing companies Fannie Mae (FNM) and Freddie Mac (FRE) There was also additional money for the purchase of mortgages directly held by Fannie, Freddie and the Federal Home Loan Banks. These programs have already effectively helped drive down mortgage rates noticeably and is making home loans more affordable.

My earlier statement that this means that the exposure to risks posed by further defaults on home mortgages will be shifted from the lending institutions to the Fed is, however, not entirely accurate, because banks that hold sub-prime related mortgages or securities would not benefit from these Fed programs directly. For this reason, they would continue to see greater pain as the housing market declines. This is what prompts them to push the government to bring back the original bailout plan, which would have the government purchase their toxic assets.

Some readers worry about the government debt resulting from such purchases. Some readers also worry about the moral hazard problem of helping banks that had made bad decisions in the first place.

The debt problem is not a serious problem if the economy starts growing again. Particularly because the yield is low and given the fact that under normal circumstances there will be normal inflation of 2 to 3%, even very large government debt will prove less onerous than may be thought. I do not see hyperinflation a threat under the current circumstances because hyperinflation occurs when there is more aggregate spending than aggregate output. Such a scenario is out of the question over the foreseeable time horizon.

The moral hazard problem is real, but acceptably small relative to the potential benefit, because the MBS purchase plan does not mean that the banks are not taking losses. They have already taken huge losses, though they are protected from further difficult-to-pin-down losses. Protecting them from such further losses is important at this juncture because the benefit is huge: if banks have the uncertain loss overhanging, they will not lend and the systematic risk to the economy would be much higher.

The current task at hand for the policy makers is not to bail out or not to bail out one commercial entity as distinct from another commercial entity. Economists, myself included, would generally not condone such bailouts. However, many economists, myself included, consider systematic risks too huge for the economy to swallow. The stakes are just too high. The economic cost is just too great. The central banks and the governments in many countries are working hard to stave off an avoidable depression.

Some say a depression is unavoidable. If it had to happen, it would be no use trying to prevent it from happening. Some say a depression is "creative destruction." But where is the scientific proof of such diagnosis?

Take a look at past history: until this very crisis, we have had fewer and shallower recessions over time. This did not happen fortuitously. The quality of monetary policy has improved over the years. No depression is inevitable. From my study of this and past recessions, most recessions are traceable to bad policy. Inadequate regulation, poor corporate governance, fraud, remedies that came "too little too late": all have contributed to the severity of the current crisis. We need circuit-breakers in the system. If a circuit breaker could prevent a house from being engulfed in flames, why do we keep saying that the fire is inevitable?

Comments

[Steven Hansen:]

"Take a look at past history: until this very crisis, we have had fewer and shallower recessions over time."

this is my argument too. we have been able to paper over the systemic problems, and time shift their unwinding. specifically, i am referring to the 2001 / 2002 recession. if you look at gdp, back out inflation and the costs of iraq, the economy has not grown since 2000. now look at employment - and you get the same result.

at some point, you must deflate the bubble. bubbles have negative economic consequences. we are again trying to coverup the problem and prevent the unwinding. why?? it is only limiting growth in the future.

Jan 12 03:52 AM

[Jubilee Year:]

Your arguments read like a series of fallacies and fantasies:
-the debt problem of buying toxic assets is not a serious problem if the economy starts growing again. [Yeah, that is a mighty important “if” there, isn’t it?]
--hyperinflation is a not threat because hyperinflation occurs when there is more aggregate spending than aggregate output, which you cannot foresee [And worldwide gov’t quantitative easing in worldwide economic contraction is what, exactly?]
-- Protecting banks from further losses is important because if banks have the uncertain loss overhanging, they will not lend [Banks won’t lend because of the certainty of deflation, making all loans guaranteed losers. Buying their bad assets won’t stop the deflation.]
-Depression is avoidable, because we have had fewer and shallower recessions over time because the quality of monetary policy has improved over the years [Hmmm, where have I heard this: “Past performance is no guarantee of future results”? And what about the role of that monetary policy in creating this problem, fashioned by the very people still in charge?]
--We need circuit-breakers in the system. If a circuit breaker could prevent a house from being engulfed in flames, why do we keep saying that the fire is inevitable. [Agreed, but a little late for short circuits when the house is already on fire, isn’t it? The short circuits were there, but were removed years ago.]

Jan 12 11:38 AM

[monday1929:]

The "quality of monetary policy has improved" so much that we stand at the edgge of the biggest bust in history, caused by the largest credit bubble in history. If economists studied history they would not be so wrong so often.

Jan 14 08:11 AM

[Lok Sang Ho:]

The main problem as I see it is a regulatory lapse that allowed excessive leveraging and that allowed people who cannot afford it take on mortgage loans. This is not an aspect of monetary policy though arguably remains the responsibility of the Fed, as well as that of several other regulatory agencies. Monetary policy by and large tightened and loosened to maintain sustainable growth.

Jan 14 11:59 AM