Daily Archives: September 29, 2008

by Ricardo Caballero and Pablo Kurlat

Hank Paulson’s $700bn “bailout” plan unleashed a flurry of alternative proposals, as most people recognize that time is running out. There is an urgent need for a significant intervention to break an accelerating downward spiral that is threatening the very survival of the financial core of the world economy.

Most proposals, including the one just agreed to by Congress, have in common a few general principles. First, they recognize the need to recapitalize the financial system and to improve the liquidity of several key asset and insurance markets. Second, there is agreement on the need to protect taxpayers by giving the government a share of the upside as well. Third, most see moral hazard as a reason to limit the extent of intervention and, in particular, to punish shareholders. Not doing so, the argument goes, would make future crises more likely as it would encourage the financial sector to repeat the excesses that caused the crisis in the first place.

We share the first two “principles” but are less persuaded by the third one. The main problem of the standard moral hazard view is its disregard for the incentive problems it generates within crises. In real life, unlike in many of our models, crises are not an instant but a time period. This time dimension creates ample opportunity for all sort of strategic decisions within a crisis. Distressed agents have to decide when and if to let go of their assets, knowing that a miscalculation on the right timing can be very costly. Speculators and strategic players have to decide when to reinforce a downward spiral, and when to stabilize it. Governments have to decide how long to wait before intervening, fully aware that delaying can be counterproductive, but that the political tempo may require that a full-blown crisis becomes observable for bickering to be put aside. Each of these agents is in the game of predicting what others are likely to do. In particular, the likelihood of a bailout and the form this is expected to take, change the incentives for both distressed firms and speculators within the crisis. These incentives are central, both to the resolution of the current crisis as well as for the severity of the next crises. Read more

By Lawrence Summers

Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. There are hugely important tactical issues regarding the deployment of these funds that the authorities will need to consider in the weeks and months ahead if the chance of containing the damage is to be maximised. I expect to return to these issues once the legislation is passed.

In the meantime, it is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs. Read more