Can I bring myself to utter THOSE words?

| Peter Boettke |

Tyler Cowen argues that in hindsight, we should consider the bailout to have been successful in averting a financial meltdown of the US economy.  He specifically asks me whether I can bring myself to admitting this.

I cannot. 

But that is not because of what I would term first principles libertarianism.  I am a consequentialist libertarian, not a natural rights theorist.  Nor is my hesitation due to what I would term simple-minded economics.  No, my hesitation is due to an empirically grounded and theoretically consistent political economy that looks at both the direct and indirect effect of public policies.  The basic analytical framework derives from my reading of economic arguments from Hume and Smith, Say and Bastiat, and Mises and Hayek.  And, yes, it is also influenced by Friedman and Buchanan (and several other modern economists that have contributed to our understanding of "the economic way of thinking").  As I have said multiple times throughout the discussion on the current crisis, a close reading of both Hayek's Tiger by the Tail and Buchanan and Wagner's Democracy in Deficit should be manditory for all interested laymen, journalists and policy makers.

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.

Tyler's argument rests upon claims that if factually true, I would have to agree to Tyler's point, and utter the words he fears I cannot bring myself to speak.  Tyler's argument is a subtle one (and important one for consequentialist libertarians to seriously consider), but I believe it does rely on both faulty empirical claims and theoretical differences in perspective.

1. World of the Second, or Third, or N-th Best

I agree with Tyler that we do not live in the ideal institutional environment for a free market economist and many of the propositions of economics are worked out against the backdrop of a free market system.  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.  I have argued on the blog and in a number of papers is that due to Milton Friedman's explanation of the Great Depression, economists have fought inflation in theory but feared deflation in practice and did so to such an extent that any downward market correction was met by easy monetary policy to prevent "deflation".  The Greenspan years in this interpretation were far from the "perfected practice of a maestro" but instead inflationary practice which produced malinvestment and coordination failures.  I am persuaded by John Taylor's Getting Off Track, and the consequences of devitations from the "Taylor Rule" and how that easy credit fueled the artificial booms we saw in the decade prior to last fall.

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.  I have taken a more traditional free market stance due to my concern with long-run inflation and the need to have immediate market adjustments guided by relative prices not distorted by continued inflation. I am all for easing of pain and suffering provided it doesn't cause even more pain and suffering down the road.

I am even more resistant to Tyler's argument about Fed and Treasury and Congressional decisions over the last year because I am not convinced by the facts used to justify the policy steps.  As Anna Schwartz has repeatedly argued, Bernanke sees similarities between our current situation and the 1930s when in fact those similarities were (are) not there.  Bernanke has an intellectual hammer forged through years of thorough research on the Great Depression, and thus in his position of policy decision making he sees a giant nail he cannot help but hit (with a bigger hammer than any Fed chairman ever used).  Basic data presented by the Minn Fed, as well as discussed by Bob Higgs as well as Jeff Miron, Casey Mulligan and John Cochrane on issues related to liquidity, regime uncertainty, unemplyment composition, problems of moral hazard, effectiveness of fiscal policy, etc. have all at various times seemed to call into question the entire policy rationale used by economists and government officials.  I am willing to be convinced that these empirical points are indeed wrong, but I have not been presented with such counter-claims on the data.  Instead of critical engagement of the contending positions, we often just get in the blogosphere the separate claims presented.  And in the instances where "debate" has in fact been encouraged --- such as the discussion between Brad de Long and Luigi Zingales, I found Zingales the more convincing presentation of economic argument.

Bottom-line, I don't believe we have seen a crisis of confidence, but instead a crisis of insolvency compounded by regime uncertainty caused by government's activism.  In other words, we didn't have a credit lock-up a year ago due to liquidity issues, we had a credit lock-up due to regime uncertainty brought on by government decisions on who to bailout and who not to bailout for their bad decisions.  Resources needed to be reallocated guided by price adjustment to bring production plans into alignment with consumption demands.  Bailouts prevent the needed adjustments.

So not only am I dubious that the monetary policy the Fed has engaged in over the past year has been productive, I am extremely dubious that its expanded role beyond monetary policy in the economy.  In fact, the dangers for the economy are significant, and as even discussed recently on both Tyler and my blog, the lack of a credible exit strategy makes it even more troublesome (remember those long-run consequences).

2. Counter-factual and Post Hoc Ergo Propter Hoc

I argued early on the discussion concerning the financial crisis that free market economists are going to confront a serious challenge and Tyler's post hits on the core issue.  Markets are amazingly robust and resilient entities -- gains from trade and gains from innovation can off-set a lot of government stupidity.  So wealth creation and economic growth can take place even in the face of government obstructions -- as Adam Smith argued:

The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security is so powerful a principle that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations; though the effect of these obstructions is always more or less either to encroach upon its freedom, or to diminish its security.

Finally, let me conclude by pointing to Hayek's discussion of expediency versus principle in Law, Legislation and Liberty, Vol. 1.  A consequentialist libertarian can, indeed must, address the general rules that are guided by principle.  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.

Comments

[Steve Horwitz]

I will only note, Pete, that there's a difference between "bailouts" and "quantitative easing." One could believe that an increase in reserves was justified last fall but that's not the same thing as saying that banks shouldn't have been allowed to fail when they faced negative net worth or other problems.

I can't speak for Bill (or Larry White, who I've also heard make the case for some increase in reserves last fall, though not to the degree we saw), 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."

[Don Lloyd]

Peter,

"So not only am I dubious that the monetary policy the Fed has engaged in over the past year has been productive, I am extremely dubious that its expanded role beyond monetary policy in the economy...."

TYPO -- something has been omitted from the above.

Regards, Don

[James H]

Peter,

I understand that you're concerned with the theoretical difficulties posed by Cowen's argument, but don't utter THOSE words until he considers the bank bondholders. Cowen presents the bailout option here as if it were binary -- but he doesn't treat it this way in his April 9 article "Why Creditors Should Suffer, Too." In that article, he points out -- correctly -- that the biggest beneficiaries of the bailouts, at least in total dollar terms, are the bondholders and other creditors and counterparties. They should take a hit, too, he argues, and not just shareholders and taxpayers.

On the other hand, even as he argues for having creditors take their losses, Cowen says that we must avoid another Lehman-style bankruptcy (sudden, unexpected). And yet, on the third hand, now that the Fed and Treasury have bailed out the bondholders and given them a govt. guarantee, they mustn't do anything that might "panic" the bondholders.

In other words, even by his own reckoning, Cowen doesn't have a very strong argument for the benefits of the bailouts -- either near-term or long-term.

Moreover, just as "bailout" isn't a binary option, neither is bankruptcy. The failure of Lehman, was traumatic because it was sudden and unexpected (the market expected a bailout). The Fed, Treasury and FDIC (and OCC and OTS) should have been working the last few months on the orderly resolution of many of these institutions under FDIC receivership instead of continuing to keep unpayable debts alive with taxpayer money and guarantees. Admittedly, this would be a difficult process, especially with the larger banks (C, BAC), but it's a process made all the more difficult precisely because of the regime uncertainty brought on from the bailouts, particularly Geithner's explicit promise to give the TARP banks all the "support" (read: our children's money) that they need.

Finally, debt-for-equity swaps or simple haircuts for the bondholders would allow for the rapid destruction of bad debt, something that is economically beneficial. Instead, we've put that debt onto the public ledger and have effectively reduced future standards of living thereby -- at least to some degree. Cowen's arguments would have some plausibility if he were to restrict himself to talking only about the Fed's provision of (short-term)liquidity, but if he's making arguments about "the bailouts" as such, he's left far too many questions unanswered.

[DG Lesvic]

We just had this discussion a short while ago, under A Little Inflation Now Might Help --- Really?

Here were Prof. Horwitz' last words there:

"What Bill (Woolsey) said. I will just note that the productivity norm idea does implies that a good banking system is one that ensures that M moves opposite to changes in V, which has the consequence of effectively "targeting" nominal income. So as factor productivity and output rise, prices should fall."

I noted that I couldn't understand what he was saying, and another participant, Greg, or razerfish, said he couldn't understand it either.

And there it was left.

Perhaps Prof. Horwitz might clarify that for us now.

[James H]

One more thing about the bailouts and regime uncertainty.

If Neel Kashkari is to be believed, Paulson and Bernanke knew in "early 2008" that they would have to go to Congress for a massive pile of bailout cash, and instead they decided to wait until conditions were more favorable. Forgetting the political implications of that fact, it's worth pointing out that in the meantime none of the major financial institutions significantly reduced leverage, wound down risky trades or built sufficient capital cushions in order to withstand a severe liquidity crisis brought on by fears of counterparty insolvency. Instead, they thought they could rely on regime CERTAINTY -- i.e. that the Fed would bail them out. Lehman, in particular, was extremely vulnerable, but it is reported that Fuld thought the Fed would bail the firm out.

The "bailout" as such (what became TARP) happened in October of 2008, but the wink-and-nod promise of a bailout was implicitly there for months. This further weakens Cowen's argument as the October bailout wasn't the sudden exigency that it seemed to be at the time. Instead, we have to regard it as the result of a deliberate decision by the Fed and Treasury to avoid the problems in the financial system until it was deemed too late to wind things down in a more orderly fashion.

[TGGP]

Scott Sumner argues against Schwartz using Schwartz' work with Friedman. His posts mentioning her are here:
http://blogsandwikis.bentley.edu/themoneyillusion/index.php?s=%22anna+schwartz%22

Regarding the distinction between targeted bailouts and easing, check out David Henderson's response to Tyler Cowen, especially the comments. Bill Woolsey does a good job (including some quotes of Leland Yeager) and Jeff Hummel links to his own response:
http://econlog.econlib.org/archives/2009/08/tyler_cowen_on_2.html

[Greg Ransom]

Arnold Kling consistently asks the deep and nagging question about 2008 -- were we looking at an insolvency crisis on the part of a few big players and a lot of little home owners (many of them targeted by the government and its corporate friends in the "ownership society" scheme) -- or a liquidity crisis?

Deepak Lal and Nick Gillespie ask the other deep and nagging question -- is the most fundamental fact about the bailout at bottom nothing else than the simple fact that the government is robbing Peter to pay Goldman Sachs et al (and shift over control of many of the "commanding heights of the economy" to the President and his union financiers).

Tyler in his "brilliance" manages to pretend that none of these issues exit.

[Greg Ransom]

Tyler is worse than a sophomore when it comes to thinking through the politics of this.

If Nancy Pelosi and the Democrat Congress had gone it along after the people's money in order to give it to Goldman Sachs et al against the direct and vocal opposition of McCain and President Bush, Obama would never have been elected President, and Pelosi and the Democrat Congress would have been put in a permanently crippled -- and increasingly hemorraging -- position.

Tyler's "worse case" would have been a _non-starter_ if the Bush-Obama-Pelosi-McCain bailout had not gone through, because of Bush and McCain opposition to the robbing of the people in order to pay Goldman Sachs.

[Greg Ransom]

Make that:

"If Nancy Pelosi and the Democrat Congress had gone it _alone_"

[DG Lesvic]

This is a debate between Misesian and Keynesian Austrians, those following Mises and those following Keynes.

While, to the Keynesians, the recession is a malady, to be treated by a shot of Vitamin S, for stimulus, to the Misesians, it is the cure and must be allowed to run its course. The real malady is the inflationary boom. It’s like drug addiction. It cannot go on forever. The pleasure of the artificial boom today must be paid for by the pain of depression tomorrow, and the sooner the depression the lesser the pain. Withdrawal from the squandering malinvestments and overconsumption of the boom period is an essential step on the road to recovery, and, the more delay, the longer and more difficult the cure.

The pure and the Austrian Keynesians differ over the form of the stimulus, with the pure Keynesians favoring the fiscal and the Austrian Keynesians the monetary approach, the fiscal being direct spending by the government itself, and, the monetary, merely pumping up the money supply in order to stimulate private spending. But both aimed at more spending, whether public or private, and reflected the fundamentally Keynesian bias for spending over saving.

But saving is precisely what is needed. Capital has been squandered on unproductive enterprises. Trying to keep them afloat is wasteful and futile. What is needed is not more “spending” on them but more saving and investment in new and more productive and viable enterprises.

The Keynesians are afraid of “systemic failure, a cold turning into pneumonia, the recession into a depression. But, if there could really be such a thing in the market itself, it would occur every time a donut shop went out of business, setting off an endless cascade of falling businesses. In fact, the market has withstood the failure of a great many donut shops and banks, for, no matter how many fail, there are still eager buyers and sellers.

If something is keeping them apart, it isn’t the market. For, it is nothing but buyers and sellers. The only thing that could come between them was the so-called government. Get it out of their way, and they will surely come together again.

But, since they need capital to do so, what is needed is not spending but saving, and to halt all intervention and let the market find its own way back.

[Matt]

I'm thinking outloud:
Has anyone ever theorized about a magic number; a percentage the government should be involved in. I don't think I've heard any credible people say zero but I could be wrong. Is there a way to quantify how many times in 100 the government "gets it wrong?" And based on that number bracket the government into a percentage of GDP it has access to? Maybe we could even calculate some crude number for the desire of power. For example, every fiscal year we would give the Congress 4% of our GDP and let them fight over who can spend it the most wisely(I use this term loosely).

I only mention this because to me the argument seems to be more about how the government uses its power and less about how much power the government should have. This contradiction seems to be a main theme in many economists' blogs.

[Lee Kelly]

"Instead, central bank monetary policy relies on clunky and inefficient mechanisms to try to accomplish this task of matching money supply with money demand." - Peter Boettke

A free banking system would have a propensity to better match the supply of money with changes in demand, but it would also target its monetary expansion away from any malinvestments responsible for a preceeding boom and bust.

It seems to me that the Federal Reserve's task is far greater than just matching the supply of money with changes in demand, because it must also target the right banks, businesses, and industries to receive the new money -- or else risk maintaining or creating new malinvestments.

Unfortunately, the Federal Reserve and the Treasury have actually targetted the malinvestments. It has succeeded in averting a crash, but at what cost? The economy still has a broken leg, but has just been pumped full of so much aenesthetic the pain has yet to be fully felt. Meanwhile, the Obama administration is planning to break an arm with its massive expansion of government, all in the name of saving the economy from collapse.

But since when do Austrian economists deny that bailouts and reinflating bubbles don't work? It is precisely because they work so well in the short-term that we have such a big problem; an important part of the Austrian story of this business cycle is that the Fed's response to the dot-com bubble was such a success -- in the short-term.

We can't live in delusion forever; eventually no amount of aenesthetic will be enough when every bone in the economy is shattered.

[Greg Ransom]

Is the Fed lending freely at a penalty rate or is it transfering wealth at no penalty?

Tyler, Tyler. Come in please.

[DG Lesvic]

Mises Rides Again!

[Roger Koppl]

Tyler says, "in reality Friedman blames the Fed for having let the money supply fall by one-third and not having run a bank bailout." Is that exactly right? Friedman and Schwartz say that bank failures were causing the money supply to contract. But the problem was the money supply, not the viability of the banks. Indeed, that's why Bernanke says he was taking a non-monetarist position in an old AER article on the Great Depression. Bernanke says it was not just money, but the spike in transaction costs in credit markets. If F&S are right, we can have "quantitative easing" without bailing out the banks. If Bernanke is right, we need to save the banks too.

[Steve Horwitz]

Roger - I made the same argument about F&S over at Marginal Revolution.

[Roger Koppl]

You said the same thing? Then it's gotta be right! :-) I see that Larry White made pretty much the same point as well. I think he's right. The FOMC should have bought up assets to keep the bottom from falling out and we should have let the big houses crash and burn if that was their fate.

[Steve Horwitz]

Was going to mention Larry's comments as well. http://econlog.econlib.org/archives/2009/08/tyler_cowen_on_2.html

If Larry, Bill, David Henderson and you and I all agree....we must be right! I think Tyler's wrong and I think Bruce Bartlett is really wrong.

[DG Lesvic]

And, Mises wrong?

[James H]

There's a great description of the regime uncertainty produced by the bailouts -- and by the uncertain possibility of further bailouts -- on page 3 of Philip Swagel's account of the crisis. This would seem to support your argument, Peter. But at what point do expectations of a bailout actually arise? In our present context (or in the summer 2008 context) aren't market participants already pre-programmed to expect some sort of intervention/bailout in a major crisis? In some sense, the October bailout is already affecting markets before the bailout legislation has even been proposed -- and in order for there NOT to have been an October bailout, market participants would have already had to have behaved differently, based on expectations very different from the sort of expectations they in fact had.

Barry Ritholtz's very interesting (and fun to read) "Bailout Nation" blames a whole series of bailouts, including the 1998 LTCM "bailout," for creating a culture that priced in govt intervention, particularly on the part of the Fed. I think Swagel's description of the Paulson Treasury and its inability to communicate to the market the rationales for its various interventions is a real smoking gun for the kind of argument you are making. But I think the question of time -- when expectations arise -- presents its own difficulties.

[Wilmot]

One of the worst things I thinke to come of this recent recession is the surge of "behavioral economics" as a justification for all of the economy's ills.

Now, instead of actually relying on facts or at the very least logic, we're going to get guys telling us that we can't do this or that or we must do that and this because otherwise the world will panic and the children - because that's all we really are, apparently - in the stock market will all just run around like chickens with our heads cut off leaving the economy to rot away as we cry in our bedrooms and forget all we knew about arbitrage and venture capital.

Panic is only a very short term feeling. One would expect that once it subsides, the economy will go back to normal - if it really is panic caused and not REALITY caused, in the first place.

Of course, though, the media likes to inflate it's own importance. So all we'll hear about for the next 25 years is how panic and behavior are the only causes of economic fluctuations, because we can change psychology and feel all gooy inside if only we think magical thoughts - then we'll all be rich, rich, RICH!

[Roger Koppl]

@ Steve: Yeah, pretty much! And I don't see how it keeps transactions cost low in credit markets to prop up politically important houses that have failed the market test. Maybe Tyler or Bruce Bartlett can help me out with that one.

[amv]

@Koppl & Horwitz

I also agree with you (if that is of any interest). However, even if we can analytically distinguish between quantitative adjustments of money supply and bank bailouts (that is, we can have one without having the other), it remains unresolved if we should separate these problems in practice. Bernanke's transaction cost argument does not rest on the assumption that to hold money constant we have to hold the number of banks constant, but that reducing the number of banks leads to the additional and distinct problem that banking services become more costly. In light of such an argument, perhaps it seems appropriate to bail out even if you know that you can keep money in circulation constant by other means. I do not think that this is legitimate however. Such an argument does not consider that transaction costs associated with the banking industry is not determined necessarily by the number of firm/banks. the insolvency of some banks may lead to mergers and increase the size of the remaining banks while keeping the industry size constant, thus reducing the number of firms. Of course, bail-out promises hinder such market-based solutions.

[Roger Koppl]

I think Bernanke's argument was that bank's were good at distinguishing good from bad credit risks among borrowers with low collateral. I'm willing to spot him the idea that making such distinctions is a team production process. I just don't think we get a better array of such teams out there by bailing out the ones who did a bad job of it in the recent past and are politically important. In other words, as I think you are saying amv, the market is a system of profit *and loss*.

[amv]

yap. I agree. my clumsy English attempted to say that in purchasing the assets of failed banks, competitors can gain (if these assets are of value) and the industry do not need to reduce its average level of human capital (bankers with the comparative advantage of identfying good and bad risks). In eliminating 'bad banks', the cost-minimizing activity of the banking sector even improves on average and therefore transaction costs for mainstreet falls.

[Mark Brady]

"But that is not because of what I would term first principles libertarianism."

One could have consequentialist reasons for always preferring a consistent private property libertarianism over any other set of political beliefs.

"I am a consequentialist libertarian, not a natural rights theorist."

A false dichotomy.

[Aron]

Austrian Keynsians? WTF?

[Chris Bolts Sr.]

This is my first time reading this blog thanks to Veronique De Rugy @ National Review, but I am glad she pointed me in the direction of someone who is so deeply knowledgeable about the principles of Hayek and von Mises. This is a blog that I will now regularly visit.

[vimothy]

I guess I have become pretty estranged from this viewpoint over the last couple of years, but...

"Government activism isn't the cure for the crisis, it is the cause."

Really -- it's that simple? Don't you want to look at underwriting practices, or the 2/28 structure that places mortgage lender long house price appreciation, or the subprime RMBS overcollateralization structure that places holders of subprime RMBS securities long house price appreciation, or the byzantine CDO and SIV architecture of the shadow banking system that makes locating the risk so difficult, or the way that CDO expected values are so sensitive to parameter error, or the way that financial intermediaries became over reliant on models, or, indeed, any number of things? (I could go on, but you get the point).

Maybe you could even say "government activism is one cause of the crisis", but to explain away the whole thing with a pat explanation that lines up suspiciously well with what must be libertarian priors suggests to me someone who is sticking their head in the sand. Oh that crisis thing? Yeah, we figured that out – it was big government. Cheese and Mises dip, anyone?