The Economic Consensus

Alex Tabarrok at Marginal Revolution argues there is now a consensus among economists that the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization. He notes that economists as diverse as Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan, along with Tabarrok and Tyler Cowen, and many others, are of this view. Tabarrok goes on to say

Krugman would prefer a recapitalization in the form of nationalization. In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.) In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.

The consensus policy of economists would put most of the burden of adjustment on politically powerful holders of equity and bonds.

Importantly Tabarrok also notes that economists have arrived at a consensus that the bailout bill is not the right policy. Looking at the economists noted above, none is enthusiastic about the bailout. Most would properly think that the bailout has a good chance of failing. But as Tabarrok also points out

Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.

Lynne Kiesling at the Knowledge Problem blog notes

Fast recapitalization, removing the signaling penalty by having the government require banks to stop giving dividends in the short run ... those are the kind of policies that economists have been discussing, fleshing out, and encouraging over the past two weeks. Of course, the challenge to those proposals is that the parties who end up paying are precisely those firms and industries that are politically powerful.

The public choice economics lesson in this? Mancur Olson was right about concentrated benefits and diffuse costs:

... large groups will face relatively high costs when attempting to organize for collective action while small groups will face relatively low costs. Furthermore, individuals in large groups will gain relatively less per capita of successful collective action; individuals in small groups will gain relatively more per capita through successful collective action. Hence, in the absence of collective incentives, the incentive for group action diminishes as group size increases, so that large groups are less able to act in their common interest than small ones.

The book concludes that, not only will collective action by large groups be difficult to achieve even when they have interests in common, but situations could also occur where the minority (bound together by concentrated selective incentives) can dominate the majority.

Sadly, if not unexpectedly, politics trumps economics yet again. But this time it could be very costly. Steve Horwitz points out, over at the Austrian Economists blog, that this is The Triumph of Politics over Economics. He writes

Not much more to be said about the bailout bill going into law. Load it up with lots of goodies and you can buy lots of votes. Keep stoking the fires of "crisis" while you do to make sure the public is sufficiently confused. End result? De facto nationalization of a huge hunk of the credit markets. To use Pete's terms, this was a major victory for the "forces of stupidity." Let's hope the "forces of innovation" can make a comeback.