Avoiding Deflation Without Bailouts

by Mario Rizzo  

I have not posted in a while since I have been on vacation. During that time an interesting dispute has arisen among friends Tyler Cowen, David Henderson, Arnold Kling, Peter Boettke, Bob Murphy, Steve Horwitz and others over whether Ben Bernanke was right to bail out specific banks. (Some of this has gotten mixed up with the issue of what Brian Boitano would have done — oops, I should say Milton Friedman.)  

I think the question could be simply stated in two parts. First, is it possible to prevent general deflation and not bail out big banks? Second, if so, what would be the effect on the economy of bringing the banks to bankruptcy court while preventing outright deflation?  

1. The answer to the first question is yes. Even if the Fed ran out of short-term Treasuries to buy it could have bought longer-term Treasury obligations sooner.  Unfortunately, in 2008 the Fed rescued Bear Stearns and AIG with Treasury securities. This then was a sterilized bailout. The bailout protected the banks but reduced the Fed’s balance sheet an equal amount. Thus, the bailout preserved certain sources of credit but did nothing to prevent deflation. The Fed’s own actions separated the two. 

Then, of course, it could, and did, buy other obligations like mortgage-backed securities. (This of course is not a problem-free option since it injects funds into particular sectors.)  

Therefore, I can see no reason why the Fed could not have prevented deflation without bailing out particular banks.  

2. The answer to the second question is more complicated. If the Fed had not bailed banks out they would have had to go into traditional bankruptcy proceedings. This would have taken longer. Credit availability would have been impaired. But this is not altogether bad since excessive credit was the problem in the first place. The structure of production would have been shortened, perhaps by too much for the new equilibrium. Total spending need not have declined, with deflation averted, but its composition would have been altered.   

Let us say for the sake of argument that the reduction of investment spending would have been greater relative to the bailout solution. Is that good or bad? First, any method of adjustment would have had transitional over/under shooting. Second, it is not clear what the socially optimal reduction in investment spending is. Third, it depends on what one’s time horizon is. The bailout solution produces long-term moral hazard. The bankruptcy path does not eliminate that problem but reduces it substantially. It also allows the market more of a say in the composition and firm-size of a restructured banking industry. (Why should we have such large banks?)  

 In addition, the bailout method opens the system to rent-seeking. In the absence of a clear-cut definition (or even conceptualization) of systemic risk, there is too much room for arbitrariness or political favoritism. The expansion of government power in the direction of saving particular firms is a seriously problematic precedent. 

On the other hand, the difficulty is that markets may not have gotten the signal that the Fed was committed to prevent deflation even if it allowed particular insolvent banks to go into bankruptcy. But the Fed could have made that clear. In fact, this is the traditional role of the Fed so it would not have been too complicated to explain.  

The danger is that we continue the process of getting out of one recession by creating the basis for another recession or, at the least, further significant financial difficulties. The long run begins sooner than many people think. 








7 thoughts on “Avoiding Deflation Without Bailouts

  1. I don’t understand how dispersing the losses from the bondholders, shareholders and FDIC to the general public can possibly mitigate systemic risk. Why is it a systemic risk when losses are concentrated but not a systemic risk when dispersed? It seems to me that the bailouts are what cause the systemic risk. Bailing out a particular institution to preserve its ability to lend while simultaneously reducing the capacity of everyone else to borrow (because they will have to pay for the bailout through either higher taxes or inflation) seems to me a zero sum game. The bailouts accomplished nothing but the alleged preservation of confidence which I think is a dubious claim at best.

  2. Mario said: “Credit availability would have been impaired. But this is not altogether bad since excessive credit was the problem in the first place.”

    Really? Perhaps I don’t understand.

    The credit was “excessive” relative to savings rates. Once the bust was underway, money demand spiked and people started saving. What was excessive before the bust might be correct after the bust, because it’s the *relative* quantity of credit and saving that is important.

    If credit markets were impaired, then a sudden spike in savings would not be met with more lending, and a shortage of money would follow — leading to a glut of “idle resources.” There would be both relative price adjustments and absolute price falls threatening a secondary recession.

    So it seems to me that impairing credit markets just when people begin saving might be applying good policy applied too late — and doing more harm for it. A relevent question is what the proper rate of lending should have been in the first place, but without a free market to discover these things we’re just groping in the dark.

  3. Great post.

    Is it even clear that credit availability was significantly impaired? I remember a debate at Marginal Revolution during the crisis in which Alex convincingly showed that there was no reduction in credit and perhaps there was even an increase. Perhaps Bernanke and Paulson had more/better information on the subject, though.

    In any case, how bad do you think the extent of bankruptcy in the “real” sector would have been had no bailout been attempted?

  4. Jake said: “Is it even clear that credit availability was significantly impaired?”

    I don’t think credit was significantly impaired. But the important issue is surely the counterfactual: would it have been significantly impaired without the bailouts?

    My gut says that a moderate increase in the money supply was appropriate. The Fed completely overcompensated and the bailouts were unnecessary — and both are harmful in the long run.

  5. Another excellent post. We must have historical perspective going back to the savings and loan, and banking crises of the 1980s. More recently, the failure of LTCM in 1998 and the Fed’s “unoffical” involvement evolved the idea of a “Greenspan Put”: the Fed will bailout the markets when asset bubbles collapse. That produces moral hazard: greater risk taking and greater losses. Each bailout leads to another, greater bailout. Or as Hayek analyzed it in the Road to Serfdom, each intervention leads to another. Classical liberals must never accede to this statist dynamic.

  6. Mario,
    the attitude with the bailouts seems to have been – if we make the banks balance sheets look healthy, they will behave like healthy banks and increase lending. Bingo, problem solved. I don’t believe this proxy has legs.

    I look at it like this – did the affect of the bailouts leave the banks in an equilibrium or disequilibrium position?

    Banks, like all businesses, have as a central goal a specified rate of return on investment. Achieving that rate is the firms equilibrium position.

    Now prior to the bailouts, profitability would have been compromised for obvious reasons. So prior to the bailouts there is general disequilibrium in the banking sector, with regards to their desired rates of return.

    If the bailout artificially improves the capital position of the banks such that their rate of return is restored, then there is equilibrium. But equilibrium implies no tendency to change. Banks after the bailout have got what they want, they are profitable again, and assets exceed liabilities.

    The increased lending due to recapitalization theory can only work if the recapitalized state is regarded by the bank as a disequilibrium condition, and one that increased lending will ‘resolve’.

    There is every reason to believe that the reverse is true – that the bailouts sorted out the banks, but in the process dragged the rest of the economy down to pay for it.

    Consequently i believe that the bailouts had the exact opposite effect to what was intedended. The empirical evidence would be the still low and declining levels of lending/investment.

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