Is the Butcher's Finger on the Scale?

by Ron Daly

(For more on the bailout, read the October 6 issue of the CU Journal; for the online version, click here.)

Wall Street versus Main Street. I'm not exactly up to speed on the minute details of the government bailout but something seems amiss. I've been thinking way, way back to my one and only Economics class in college on this whole "rescue" thing. While that Economics class was indeed my lowest grade ever received (C+), and the reason I became an Accountant 30 years ago, there is one principle that sticks in my mind. The principle that free markets eventually balance themselves. They might be bumpy and uncomfortable for a while, but they will eventually come back into balance when left alone. 

There is always risk and reward in any free market and I understand that. Take a risk and win, you win. Take a risk and lose, you lose. But come on... take a major risk and do something stupid with other peoples' money and we'll cover you? I understand the Government's move to restore confidence in the market. But is the plan tipping the scale so that it will take even longer for the free market principles to come back into balance? Maybe that was covered in Economics II?

 

There is now a line for the "free" money and temptation for some credit unions to get in line to get their share of the $800 billion being allocated. In the plan, the government is taking preferred stock positions in public companies in hopes of recovering the money somewhere down the road on the sale of that stock. We all know that credit unions do not have preferred stock and there is no such thing as a free lunch. So what are they going to ask for in exchange for the "rescue?"

  

Chip Filson recently expressed his thoughts and the danger to the cooperative system in a three article series called "Taking the King's Schilling" on just that. Chip's main point..."This economic crisis can once again be a demonstration of the power of the cooperative model, but not if we take the King's schilling. At that point, we lose both the moral and political authority to differentiate our solutions from those who did create the problem." (find the article series here). 

Right now, I'm just wondering if the butcher has more than his finger on the scale and perhaps making the cost worse on Main Street that it might have been. Maybe some of our readers with Economic backgrounds, or at least took more classes than I did, can shed some light on this for the rest of us?

Comments

[Elliott]

Well, I was able to actually pull off a B- in Economics, so maybe I can help out Ron here.

As Ron points out, the free market goes through cycles, periods of rapid growth tapered by periods of recession / reassessment.

We get over-excited when we see a boom and over-fearful when we see a bust. What has been happening (and what the bailout represents) is an effort to fill in the valleys without chopping the tops off mountains.

And the question is "Why do we do this?" and the answer has nothing to do with economics. We now expect the government to let the economy alone when times are good, and step in when times are bad.

So here's the really scary thing. What happens when people EXPECT the government to step in. We'll start facing a HUGE moral hazard problem, where we will be encouraging firms (read CEOs) to take outlandish risks for the promise of huge profits because we've taken out the risk. The only caveat is that if you fail, you have to be so big that you become "to big to fail."

The final lesson to the market: if you are going to fail, fail BIG (read "Go for broke").

[Greg]

As someone who watched the S&L industry failure and subequent bail-out in the 1980s, I can say without hesitation that the financial industry has been in the "too big to fail" model for 25 years, and that moral hazard has been built into our financial system because we have chosen to allow massive consolidation, and limited regulation of those massive companies. I participated in a comprehensive study of the S&L debacle, its reasons and outcomes, in 1990-91, and the problems understood then remain unresolved now.

As for the notion the government is back-filling these institutions with the monies they are pouring in, I'm afraid they are indeed capitalizing large institutions, but doing nothing to make those institutions monetize the investment and put it back into the market via loans to businesses to drive the economy forward. It may well turn out to be just another government bail-out, absent even better regulation to forestall the next financial snafu born of moral hazard.

[Elliott]

My question in regards to the bailout is why there was no effort made to pay the bank through "Main Street." Rather than buying toxic securities from FIs, why didn't the government have the mortgage holders identify delinquent loans least likely to pay, and then work out a subsidized payment plan for those mortgages. We see banks attempting to restructure mortgages to prevent foreclosure, but they lack the resources necessary to restructure all of the mortgages in a timely fashion.

I would imagine this would also help protect the real estate market. While real estate has been overpriced, subsidizing the mortgage payers would stem the tide of foreclosures, and stop the frantic sell off of real estate by banks who don't want them. This would give the real estate market a softer landing, and maybe a faster turn around.

The question here is still one of moral hazard, however. Would this encourage more people to take out loans they can't pay? I would say probably not, since the average mortgage borrower isn't in the "too big to fail" category.

Greg- I think there would be interest to see this study. Is it publicly available?