Economaton

The Bear Stearns bailout has set off a wave of posts complaining of the moral hazard involved. Why should the taxpayers rescue an investment bank from its own greed and stupidity? Why should they not be allowed to fail? This is corporate welfare for the wealthy and powerful. Profits are kept private, and losses are socialized.

A bailout is, unfortunately, the lesser of two evils. I’m pretty sick of bailing large companies out with my tax money, but in this case, the alternative would be an economic collapse 100 times worse than the Great Depression. Bear Stearns indeed occupies a special position in the economy; they are indeed “too big to be allowed to fail”. What is lacking in the present equation is the great responsibility that ought to be required to hold such a special privilege and position.

If Bear is taking public money, then there needs to be a thorough and public investigation into the innards of their business and why they need public money to save them. Air out all their dirty laundry. The managers of Bear Stearns need to be held materially accountable for the actions that led to this point. I don’t mean a slap on the wrist for a few scapegoat “rogue traders”, I mean major public scrutiny of every single manager and department there, and major jail time for those who deserve it. The government needs to delve deep and look hard, and any wrongdoing uncovered needs to be used as an opportunity to set a severe example for other investment banks in the future. Such ought to be the price for their privileged status above the free market.

Credit — Economic Grease

Would you Prefer a Cash-Only Agrarian Economy?

The economy runs on credit. I don’t think most people really realize how critical the availability of credit is to keep all modern businesses functioning smoothly. As a basic example, vendors (of anything) routinely ship products on “net 30″ or “net 45″ terms, meaning that their cost must be paid in full in 30 or 45 days. But the vendor’s own employees still need to be paid at regular intervals rather than when the invoice is settled; the vendor’s electric bill and phone bill and insurance premiums need to be paid regularly, the vendor’s raw materials (purchased a month before on similar terms) must be paid for, etc. This is not a problem, because the business can establish a credit history and get a line of credit with a bank. The bank issues them a loan for a short period of time so that they can meet their recurring financial obligations, and they pay it back plus interest when their customers pay their invoices, which happens irregularly. This system works quite well in practice, and allows far greater flexibility and efficiency in moving products and services through the economy than would be possible in a cash-only economy.

Many people have a problem with the notion of debt per se. Such a company, they say, should simply build up cash reserves over time so that it can pay its regular bills out of its pocket, even when the customers still haven’t settled their outstanding invoices. But consider the competitive landscape — consider two companies that are otherwise identical. One pays for expenses out of its cash position, the other has the same amount of cash, but also establishes a line of credit. If the cash position is large enough (i.e. huge relative to the monthly expenses), there won’t be much difference. But most companies don’t have a huge amount of cash to fall back on like that, especially small and medium sized ones. In such a company, if a customer is a week late paying, or any one of a hundred other things goes wrong, the cash-only company will be out of business, while the credit-using company will not suffer major ill effects. In other words, in an environment where most of your competition is using credit to leverage their cash, you have to do it, too, or you’ll be out-competed and put out of business.

The same thing happens at a more abstract level between banks themselves. They are required to keep some percentage of their deposits on hand, and can lend the rest out. This increases the money supply and allows value to flow through the economy faster. Of course, they want to loan the most possible so that they can make more on interest. But when dealing with millions or billions of dollars worth of loans each day, and the unpredictability of customer withdrawals, it is impossible to map out exactly how many dollars can be loaned out each day while still meeting the regulatory reserve requirements. Some banks wind up with an amount in excess of their required reserves; others wind up with less than what they are required to have. So, the ones with more money than they need lend it to the others overnight.

Bear’s Blowup

Or, “Value at Risk” Doesn’t Work With Complex Derivatives

This brings us back to Bear Stearns. Extend that concept even further — in the real world, banks, hedge funds, pension funds, and other financial institutions have all kinds of (often extremely complex) positions beyond simple deposits and loans. Bear Stearns is one of the major investment banks in the world, and had the highest possible credit rating until very recently, when they were bailed out. If they are allowed to default on their obligations to other institutions, nobody will trust the credit ratings of anyone. The entire financial system will freeze up.

The effect will be that nobody will trust anyone else anymore. Interbank lending will dry up, or only be available at extremely high interest rates. If banks can’t use that to cushion their unpredictable reserve requirements, they’ll vastly reduce the amount of money they loan out. Businesses that had nothing to do with the subprime scandal or any other Wall Street malfeasance will be either completely unable to obtain credit, or only able to obtain it at prohibitively high interest rates (depending on their size and credit history.) They’ll be forced to do less business because of the lack of credit. Many will default on their prior obligations due to lack of available credit and go bankrupt. Most will lay off workers, who will then spend less money themselves. This will cause a second wave of failures in service-oriented businesses that cater to those workers, and so on. It will ripple throughout the entire economy, and everyone will suffer.

The downside is the moral hazard involved. If banks know that they’re too important to be allowed to collapse, then they’ll take on stupid risks. This is a serious problem, and it’s exactly what led to the current financial market crisis. In 1929, the federal government decided to avoid the moral hazard and simply allow large banks central to the economy who had gotten themselves into bad situations to fail. Secretary of the Treasury Andrew Mellon recommended that they be allowed to collapse: “It will purge the rottenness out of the system… High costs of living… will come down. People will work harder, live a moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.” The Great Depression and a world war resulted.

The problem is, adopting a utilitarian tone, the bad effects upon society from the moral hazard are not as severe for most people as the bad effects that would result from a complete seizure of the financial markets and a resultant depression. Bailing Bear out is the lesser of the two evils.

Avoiding Moral Hazard and Staying Solvent

So are we then doomed to periodically bail out big banks forever? Corporate welfare, the government rescuing the fat cats who deliberately make bets they can’t cover, keep the profits for themselves when they win, and stick the taxpayers with the losses when they lose? I don’t think so. The Fed acted appropriately in rescuing Bear Stearns in this case. It’s true that they are too intertwined in the fabric of our economy to be allowed to fail.

However, that is a very unusual privilege in our system, and it has hitherto been given with very little concomitant responsibility. In order to receive such a privilege, these banks ought to be forced to accept responsibility for their actions, both at a corporate level and at a personal level. The executives and managers must be held to account for their situation and for the necessity of invoking this extraordinary measure of a taxpayer bailout.

This move should have severe repercussions for the executives. At the very least, any Fed bailout should include mandatory and retroactive forfeiture of all bonuses by management personnel. Very likely, some of them should wind up in prison, and not a country club prison with tennis courts. If proven to have had a hand in the situation that led to this, they ought to all do hard time in a real jail. The entire internal operations of the bank should be thrown open to public scrutiny, since they now require public money. The FBI and the SEC should have their offices and computer systems locked down; home offices should be raided.

The managers of this and other banks must be made to realize the gravity of their situation, and the taking of public funds the benefit of a private institution, to cover its losses, should be viewed by all as an extraordinary event that will carry severe repercussions for those who put the bank into such a situation. Only in this way can their privileged status of being effectively above the free market and market consequences of their actions be reconciled with the moral hazards involved and the danger to the entire economy risked with their failure.