Monday, September 22, 2008

Republican vs. Democratic Bailouts

As I pointed out before, the plan favored by Hank Paulson is simply terrible. It will grant dictatorial powers to the Justice department, and transfer hundreds of billions of dollars of wealth from the American taxpayers to incompetent Wall Street bankers.

Does that mean that the Democrat's bailout plan is better? Yes and no, is the answer to that. In some aspects, it will clearly be better, or more accurately, it will not be fully as bad.

There are three main differences between the version favored by Paulson and the version that Democratic congressional leaders favor. One is that the Democrats want some form of accountability for the Treasury department so that they can't get away with doing anything. A second is that the Democrats want executive pay to be curbed at companies that receive this subsidy. A third is that the Democrats want to insert other forms of spending into this legislative bill, such as extended unemployment insurance and subsidies to prevent foreclosures. Some left-liberal pundits, such as Paul Krugman, also wants the government to receive shares in the companies the government help, and now it appears that some Democratic congressional leaders are adopting this idea too.

With regard to the demand for accountability, the Democrats have the better proposal, clearly. Giving a government agency a blank check to do whatever it wants without any overview is not just a bad idea, it's creepy.

With regard to the demand for curbs on executive pay, that seems reasonable too given that these companies receive government aid. However, what would really be needed would be some retroactive curbs. Curbing pay now won't do much about the moral hazard created by the massive bonuses and severance packages awarded to executives whose decisions created multi billion dollar losses. Since these curbs will likely be gone by the time of the next boom, the lesson for executives is that they can earn enormous sums by making risky and stupid investment decisions. Had the banks gone bankrupt, it would have been possible under current bankruptcy law to take back at least the bonuses of executives, but now that they are bailed out that will be very difficult.

On the spending proposal, the Democrats are worse than the Republicans. While it may seem just that more than just Wall Street bankers should receive government aid, this implies a further damaging increase in the already too high government spending and deficit level.

With regard to the proposal that the government should receive ownership in the bailed out firms, just like in the cases of Fannie Mae,Freddie Mac and AIG, this has both good and bad sides. The good part is that this will reduce the redistributive effect and for that reason also limit the moral hazard effect. Still, it will not come even close to eliminating any of them because not only will creditors and former executives be bailed out, but shareholders will still benefit, only somewhat less so than under Paulson plan. The bad part is that further increasing government ownership in the economy will unless the stakes are later privatized further increase government control of the economy, which would be bad for both liberty and long-term economic efficency.

To summarize, both the Republican and Democratic bailout plans stink and should be discarded. While the Democratic plan is in some aspects less bad, they are in other aspects worse.

As usual, the only politician with a sound approach is Ron Paul.


Anonymous Anonymous said...

Stefan, just want to let you know that this is by far my favorite blog on economics. You have been the most consistently correct economist out all of the economists' blogs that I have read.

11:48 PM  
Blogger Celal Birader said...

Hello Stefan,

People keep talking about how Sweden dealt with its banking crisis in the early 1990s. Can you say a few words about this ? How does it compare with the Paulson plan ?

Thank you

6:14 AM  
Blogger stefankarlsson said...

Celal, the Swedish solution was quite different from Paulson's plan. The banks that had lost so much money that they would have gone bankrupt without government intervention were taken over by the government without any compensation to shareholders.

These harsh terms made the banks extremely reluctant to seek aid, so most banks did everything they could to avoid it. In the end, apart from a smaller regional savings bank, only Gota bank and Nordbanken were taken over. The other large banks, SE-Banken and Handelsbanken, as well as the main savings bank (what is now known as Swedbank) was not bailed out. SE-Banken was close to collapsing, but the main owner, the Wallenberg family chose to recapitalize the bank themselves rather than turning it over to the government.

The gross cost for the government for the banks that were taken over was roughly 4% of GDP, although some (but certainly not all) of that was recouped in the form of profits in the state owned banks.

9:57 AM  
Anonymous Anonymous said...


What is your opinion on Swedbank - in case if NPLs in Baltic States (Swedbank has granted a lot of money to Baltic people via mortgage and commercial loans) are higher than expected, can that lead to potential capital problems, as Swedbank liabilities exceed assets?
Just by looking at how share price plummeted 7.5% due to the collapse of Lehman Brothers, it seems rather realistic that share price could diminish much more than that, if situation in Baltic States turns really nasty (due to global crisis, deflation or devaluation, miscalculated risks - pick your favourite)...

Also, why could Swedbank be so ignorant about warning report issued by IMF? Are they hoping, that EU will bail out any of Baltic countries, if it fails, as otherwise it would make all Union look rather pathetic? Or are they hoping on Swedish government (although that seems rather unlikely, given their stance on bailouts).

Thanks a lot,
Your loyal reader from Latvia

P.S. I will agree to anonymous1, this is by far the best blog about global economocs. Keep up the good work!

6:48 PM  
Blogger Celal Birader said...

"The gross cost for the [Swedish] government for the banks that were taken over was roughly 4% of GDP"

If the U.S. GDP is $13.8 trillion then 4% of that would be $560billion. Sounds like the Swedes did on the cheap compared with Paulson who wants $700B

11:23 PM  
Blogger stefankarlsson said...

Latvian reader: thanks for your supporting comments. I'll probably return to the issue about the baltic state exposure that Swedbank and other Swedish banks once I've studied the issue more, so stay tuned.

11:40 PM  
Anonymous Anonymous said...

I don't like to get in the middle of the blame game, but let's keep in mind that, in addition to supporting Acorn, Obama was one of the highest beneficiaries of Freddie and Fannie, and those at the top of the food chain that enjoyed those:

This song is going out to all of the big winners in the bailout contest:

Golden Parachutes
words and music by Dr BLT copyright 2008

From the CD-in-the-making, Shadow of the Man

8:23 PM  

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