05 Sep 2009

Rizzo Joins the Fray

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Mario Rizzo comes late to the fight, and sees Tyler Cowen bloodied and beaten on the ground, surrounded by Pete Boettke, Steve Horwitz, David Henderson, Arnold Kling, and me. (Henderson and I are high-fiving while Horwitz gives a chest-bump to Boettke.) Mario asks what all the fuss is about, and we explain that Tyler still thinks the bailouts were a good idea. Mario says, “That’s impossible. I know back in November he still supported TARP, but back in June Tyler wrote in the NYT: ‘The sooner banks can get out of TARP the better. People have differing opinions on which of the bailouts were good ideas and which not, but we can all agree that the entire episode has been a national nightmare. We should not turn down a chance to put parts of that nightmare behind us.’

“We hear you, Mario,” we all explain. “But he quite clearly said on his blog recently that the bank bailouts were a good idea.”

“Yes, but we’re talking about Tyler after all,” Mario says. “Maybe he is making a distinction between the Treasury bailouts versus the Fed bailouts. Or maybe he thinks nightmares are sometimes a good idea. After all, he just read 8 books on what psychologists think about the function of dreams. In any event, you guys shouldn’t have hit him,” Mario concludes.

“Hang on a second,” David interjects. “Tyler also said that Milton Friedman would have supported the bank bailouts.”

“He said that? Wow. Still…” Mario is squeamish, as Tyler lifts his (broken) hand briefly before it falls back to the ground.

“And he said that any libertarian who thinks otherwise is just ‘pretending,'” I add.

A fuse blows and Rizzo puts on a headband that reads, “Extreme Unction.” Then he declares:

[A]n interesting dispute has arisen among friends Tyler Cowen, David Henderson, Arnold Kling, Peter Boettke, Bob Murphy, Steve Horwitz and others over whether Ben Bernanke was right to bail out specific banks. (Some of this has gotten mixed up with the issue of what Brian Boitano would have done — oops, I should say Milton Friedman.)

I think the question could be simply stated in two parts. First, is it possible to prevent general deflation and not bail out big banks? Second, if so, what would be the effect on the economy of bringing the banks to bankruptcy court while preventing outright deflation?

1. The answer to the first question is yes. Even if the Fed ran out of short-term Treasuries to buy it could have bought longer-term Treasury obligations sooner. Unfortunately, in 2008 the Fed rescued Bear Stearns and AIG with Treasury securities. This then was a sterilized bailout. The bailout protected the banks but reduced the Fed’s balance sheet an equal amount. Thus, the bailout preserved certain sources of credit but did nothing to prevent deflation. The Fed’s own actions separated the two.

Therefore, I can see no reason why the Fed could not have prevented deflation without bailing out particular banks.

2. The answer to the second question is more complicated. If the Fed had not bailed banks out they would have had to go into traditional bankruptcy proceedings. This would have taken longer…But this is not altogether bad since excessive credit was the problem in the first place…Total spending need not have declined, with deflation averted, but its composition would have been altered.

…The bailout solution produces long-term moral hazard. The bankruptcy path does not eliminate that problem but reduces it substantially. It also allows the market more of a say in the composition and firm-size of a restructured banking industry. (Why should we have such large banks?)

In addition, the bailout method opens the system to rent-seeking. In the absence of a clear-cut definition (or even conceptualization) of systemic risk, there is too much room for arbitrariness or political favoritism. The expansion of government power in the direction of saving particular firms is a seriously problematic precedent.

The danger is that we continue the process of getting out of one recession by creating the basis for another recession or, at the least, further significant financial difficulties. The long run begins sooner than many people think.

After Rizzo walks away from the lifeless Cowen, I turn to Boettke and ask, “Did you know Rizzo watches South Park?”

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