Thursday, 27 August 2009

Boettke v. Cowen (updated)

Over at Marginal Revolution Tyler Cowen asks Were the bailouts a good idea? Cowen argues that in hindsight, we should consider the bailout to have been successful in averting a financial meltdown of the US economy. Specifically he asks whether Peter Boettke, of the Austrian Economists blog, can bring myself to admit this. Boettke has now replied. Boettke writes,
The basic point I would like to make is that those long-run negative consequences that Tyler admits in his post might cause problems (perhaps even serious ones) are in fact problems. The cycle of deficits, debt, debasement doesn't just cause economic disturbances against a long-term growth trend, it has historically destroyed the economies of nations. If what the bailout and shift in both the traditional role of the Fed and Treasury perform have done is unleash this cycle of deficits, debt and debasement rather than constrain it (as it obviously has done!), then we have sent our national economic policies on a path of ruin that may well set us back for decades.

But there is more to my hesitation than just this issue of short-run and long-run consequences as can be gleaned by following the commentary I have made throughout the history of the debates over the financial crisis. I have been consistently against the bailout, and critical of Fed and Treasury behavior in general. Government activism isn't the cure for the crisis, it is the cause.
He ends by saying
But expediency tends to defeat principle in political discourse, because of the focus on direct and immediate effects whereas principle tends to focus on indirect and long-run effects. Was it expedient to pursue the bailout? Of course. But was it a policy move that followed a working principle of public policy? Of course not. And once we include those indirect and long-run negative consequences the assessment of the effectivenss of the bailout on averting disaster is not as easy as Tyler suggests.
In the comments to the Boettke post Steve Horwitz writes
[...] but I've never, ever suggested that "bailing out" the banks was even the right second-best policy. Banks should have been allowed to fail if they made bad investments. Adding reserves into the system to prevent the money supply from falling and leading to more, economically unjustified, bank failures is a different matter.

So I have no problem at all saying "banks shouldn't have been bailed out," but I think that's a different idea from "the Fed should have done nothing."
I feel Horwitz is right, there is a difference between saying the Fed should have done nothing and saying bank shouldn't have been bailed out. The bailouts were not a good idea, just think of the moral hazard problem this has created, while there may have been more justification for the Fed acting to prevent the money supply from falling.

Update: Matt Nolan writes on Bailouts, moral hazard, and the money supply.


Julian said...


You state "...there may have been more justification for the Fed acting to prevent the money supply from falling."

I struggle to see what justification there could be. Why was/is it necessary to see the money supply fall? The decrease in money supply was reflecting the loss of fiduciary media, the part of the money supply which grew rapidly in the past decade and drove significant malinvestment. Why attempt to replace the loss of fiduciary media?


Paul Walker said...

Julian. The basic argument is that in the Steve Horwitz quote:

"Banks should have been allowed to fail if they made bad investments. Adding reserves into the system to prevent the money supply from falling and leading to more, economically unjustified, bank failures is a different matter."

So it would depend on the effects of the reduction in the money supply.

Julian said...

I would say that a decrease in the money supply which subsequently caused a bank failure would *be* a case of an economically justifiable bank failure. Banks grow (and continued to operate) following a model (i.e. fractional reserve banking) which would one day result in their demise. Is this not an example of their chickens coming home to roost? Why would we/you wish to impede banks facing the consequences of their decisions?


Paul Walker said...

I'm not sure the issue is fractional reserve banking, after all you can have free banking and fractional reserve banking together. I think the issue is to do with having a Central Bank.

As Peter Boettke writes

"In the world of Central Banks, the policy analysis cannot be pursued as if we were existing in an ideal free banking system where decentralized banks could respond to market signals to adjust money supply to meet money demand in the most effective way possible. Instead, central bank monetary policy relies on clunky and inefficient mechanisms to try to accomplish this task of matching money supply with money demand. In this central banking world, it is much more difficult to distinguish between "good" deflation and "bad" deflation. A "good" deflation corresponds to declining prices due to productivity increases, a "bad" deflation corresponds to falling prices that can be attributed to mismanagement of money supply relative to money demand. It is the "bad" deflation that causes fear due to its association with a cummulative rot theory of economic crises."

and later

"Steve Horwitz and Bill Woolsey have repeatedly argued on this blog about the fine points in monetary theory associated with central bank policy, and admitted that in such a world quantitative easing of some sort or another might make sense at various times."

In a world with Central Banks, other bank may well fall victim to the "clunky and inefficient mechanisms". In a world of bad deflation CB action could help prevent Horwitz's "economically unjustified, bank failures".

Mark said...

The bailouts were not a good idea, just think of the moral hazard problem this has created

Maybe you can explain this. While I don't necessarily think the bailouts were a good idea, I don't follow the argument that it created a moral hazard.

My (limited) understanding of the moral hazard argument is that by shielding a party from the negative consequences of their actions, you affect their behaviour.

I just fail to see how the bank bailout achieved this, unless you:

a) take the line that the banks themselves and not the individuals running them, are the key parties in question


b) equate the bailout with not prosecuting corporate malfeasance

It's individuals who make the decisions and operate the banks. They had already collected their bonuses. Their main downside risk in many cases was a little moral opprobrium (which is probably worse due to the bailout), a year or two without a decent bonus and maybe the need to go job hunting (although it seems there were plenty of cases of top guys just taking a signing bonus to move to a still-solvent bank).

It appears to me that the moral hazard was always there in the way banks' top executives and dealers are remunerated. Bailing out banks to save our financial system (if it did that) doesn't change this.

Paul Walker said...

Mark: My quick reply is that without the bailout some banks would have gone under imposing costs on the management of those banks, eg unemployment. Due to the bailout the management of banks now know they will not face such costs in the future because if they stuff up again they will be bailed out, again. Thus they are more likely to take risks that they otherwise would not take. Which makes the probability of needing a bailout that much greater. This is the moral hazard issue.

Mark said...

Thanks Paul.

My argument is that the moral hazard created is almost negligible because:

a) the downside cost to the managers is small. As, their employer's collapse, their unemployment probability remains very low (I was in London when JP Morgan collapsed and the word on the street was that many of their top guys were being head-hunted even before they'd been made redundant)

b) the risk-reward ratio is very uneven. Massive bonuses when it doesn't go pear-shaped more than compensate for as few months' unemployment every 10 years.

If I was a top investment banker and firmly convinced that my bank would NOT be bailed out in the event of failure, I'd still act the same way in the face of a similar bubble (assuming I was both rational and amoral). The possibility that my bank could get bailed out really would have little impact.

Paul Walker said...

Mark. I take your point but I think most economist are worried by the effect of the bailout on the probability of bad future behaviour. If the bank's management don't suffer (for whatever reason) then bad decisions are not punished and thus we will get more bad behaviour in the future.

Mark said...

But that is my point. Not bailing out the banks would not have made much difference to the suffering of management. If lack of negative consequences to bank management is really distressing economists, then I think they should be advocating market reforms (like that found here) which give investors (who ARE suffering) real control over their employees.