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Home Publications Blogs Beat the Press The Cost of the Bailout As Calculated by Allan Sloan

The Cost of the Bailout As Calculated by Allan Sloan

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Thursday, 21 July 2011 05:49

Allan Sloan had a lengthy piece in the Post business section last week examining the cost of the bailout. He showed that the vast majority of the money was repaid with interest, with Fannie and Freddie being the big exceptions. He followed this up with an explanatory piece today. This analysis is worth a bit of additional explanation.

Sloan did exactly what he said, he did a straight cash-out, cash-in analysis. How much money the government lent to financial institutions and how much it got back. By this measure he is absolutely right, the government made money on the vast majority of its loans.

However, this is a very incomplete analysis. Suppose the government announced a new mortgage program in which it would give every homeowner who meets a minimal standard a mortgage at 1.0 percent interest. Presumably the vast majority of homeowners would repay the loan. In the methodology used by Sloan, the government would make money on this deal.

If the government can make money by making low cost mortgages available, why shouldn't it do this? Well, this move would actually carry an enormous cost to the government and the economy. The government typically borrows at interest rates well above 1.0 percent. The gap between the interest rate that the government pays on its borrowing and the 1.0 percent it gets back on the mortgage loans is a direct cost to the Treasury.

Even more important are the costs to the economy. By making a vast amount of capital available to homeowners at very low cost, the government is diverting capital from other uses. (This is less of an issue in a period in which we have 9.2 percent unemployment and vast amounts of excess capacity.) This means that money that might have been used developing new software, better medical technology, or cleaner forms of energy production will instead go into home construction because the government is allowing people to borrow money so cheaply. 

In fact, the government can cause this diversion of money without even lending at a below-market rate. Suppose it just guaranteed all mortgages at 100 percent value. This would have the same effect on the economy as lending to homeowners at below-market rates since it would divert capital from other uses into housing.

This is what happened with the bailouts. The government lent money at interest rates that were far below market levels and also provided guarantees so that private lenders would make loans at much lower rates than would otherwise have been the case. We don't know the exact financial situation of the banks in the immediate aftermath of the crisis, but there can be little doubt that Bank of America and Citigroup would have quickly gone under if left to the mercies of the market. The same is true of Goldman Sachs and Morgan Stanley who were the victims of a classic bank-run that was only stopped when the Fed let them become commercial banks, granting them its protection as well as that of the FDIC.

Left to the market, the shareholders of these companies would have been wiped out, their executives put out on the street and their creditors forced to take substantial haircuts. Instead, the bailouts kept them in business and allowed them to return to their pre-crash profitability.

While this was arguably a desirable policy for the economy as a whole, there is no reason that the Fed and Treasury could not have extracted a much larger price for rescuing these institutions. It could have put an end permanently to the multi-million dollar Wall Street compensation packages. It could have required that the too-big-to-fail banks commit themselves to breaking up once the markets stabilized. It could have wiped out shareholders.

Instead, the bailouts made a vast amount of capital available to Wall Street at a time when capital was scare and therefore valuable. In this sense the bailouts were a enormous gift from average people to some of the richest people in the country, even if the money did not flow directly through the Treasury.

Comments (13)Add Comment
too kind and long winded
written by frankenduf, July 21, 2011 8:47
the 'bailout' was a looting of public funds by private financial corporations- how else to explain the post-bailout 'bonuses' that banks 'paid' their executives?- it certainly was not a gift- it was stolen via political corruption- remember paulson's 3 page protocol?- give the banks the money with no strings attached (or else...)- more the style of gangsters than economists
...
written by skeptonomist, July 21, 2011 9:38
The Fed's purchase of about $1T in Fanny/Freddie MBS's is not technically part of the bailout, but it was a gift to banks and other big investors. It appears that the Fed will hold these forever, absorbing any loss from defaults. The "cost" of this is difficult to calculate, since the Fed has deliberately obscured the market value, but it was another huge action whose primary purpose was to keep financial institutions afloat, partly at taxpayer expense. Most of the "money" created by this action is still sitting in bank reserves.

This is another example, by the way, of the fact that any benefit the Fed might do has to go through banks. The Fed does not have the power to give money or offer credit to anyone else.
Sloan Approximately Right, Baker Exactly Wrong
written by izzatzo, July 21, 2011 10:31
Baker doesn't get it. It wasn't a bailout as much as it was an all out rescue move to save the economy.

The future damage avoided represented a huge benefit for which the discount rate was very high which in turn justified the low lending rates to banks.

To claim that the loans were 'below market' denies that the market itself was in turmoil and concurrent indicators were of no value in representing its health, which is also why forcing banks to mark assets at market value is just one more regulation that backfires.

It wasn't just the banks that were saved. It was all Americans as part of the greatest economy in the world. It's no different than spending money on wars to save the country while building nations for the world.

As Boy Monarch Bush and Hank Paulson said about the rescue - Whatever it takes. Even if not paid back it was a bargain. Baker needs to stop whining like a libertarian about government interference in the market.

Stupid liberals.
izzatzo just doesn't get it
written by Paul, July 21, 2011 10:56
We would all be much better off living in cardboard boxes now. Life would be much simpler and we would all be equal. Society would return to a much more interesting tribal state such as the Tea Party is trying to establish. Added bonus - no need to increase the debt ceiling!
...
written by kharris, July 21, 2011 11:12
I haven't reviewed all of Baker's earlier posts to see if he has ever based an argument on the notion of a liquidity trap. If he has, then today's post is out of line.

The standard liquidity trap argument regarding government spending is that since real resources are fallow and there is excess private demand for safe assets, there is no crowding out when government spends in a liquidity trap. Now, assuming Baker has never made the liquidity trap argument, he isn't being hypocritical here. He's simply wrong. If he has made the liquidity trap argument...
...
written by liberal, July 21, 2011 12:09
kharris
The standard liquidity trap argument regarding government spending is that since real resources are fallow and there is excess private demand for safe assets, there is no crowding out when government spends in a liquidity trap.


That's a very interesting and reasonable point to make. However, I'm not sure it's that simple.

Usually liquidity trap arguments re crowding out concern real, productive resources. The FIRe sector is different. The most charitable way of looking at it is that it attempts to allocate capital in an efficient fashion.

The uncharitable way of looking at it (which has considerable empirical evidence behind it) is that much or even most of the activities engaged in by FIRE is simply rent collection. If that's the case, it's not clear to me how the liquidity trap/crowding out reasoning goes.

At the very minimum, backstopping bondholders etc must have distributional implications.
Liquidity Trap
written by Dean, July 21, 2011 1:21
Kevin,

I have made the argument about liquidity trap endlessly but I don't generally use the term, since I don't think it is helpful. In this case, that was the reference of the parenthetical sentence "This is less of an issue in a period in which we have 9.2 percent unemployment and vast amounts of excess capacity."

However, the point remains that we gave the banks a huge claim to future income that had no special justification. To understand this, support that we handed you $1 trillion. We could do this at a time of high unemployment and it creates no issues of excess demand and crowded out of investment. However, unless the $1 trillion magically disappears, then at some future point you are likely to spending this money, pulling resources away from other uses.

This is the situation of the Wall Street boys. At this point, the handout to them is not pulling anything away from anyone since we have idle capacity and easily increase production if the demand existing. However if we are not in this slump forever, the fact that we effected handed hundreds of billions worth of subsidies to the Wall Street boys will mean that there is less for everyone else.
...
written by K. Williams, July 21, 2011 2:55
"This is the situation of the Wall Street boys. At this point, the handout to them is not pulling anything away from anyone since we have idle capacity and easily increase production if the demand existing. However if we are not in this slump forever, the fact that we effected handed hundreds of billions worth of subsidies to the Wall Street boys will mean that there is less for everyone else."


Dean, you've made this argument numerous times, and I still don't understand it. If I'm a VC and I invest in Google and after a year they're strong enough to stand on their own and pay me back, and then they go on to make tons of money, in what sense does this mean there's "less for everyone else." In their absence, the value they create just wouldn't have existed. They're not taking resources away from anyone else.

Now, you could argue in the case of Wall Street that in the absence of Citi and BoA, some other bank would have stepped in and claimed the income that otherwise went to them -- in effect, you'd be saying that individual banks add no real value. And I can sort of see this, but I still don't see how this means that there's less for "everyone else," rather than less for their competitors. You seem to be assuming that there's a finite amount of resources, rather than that successful (that is, profitable) companies increase overall product by adding value to the economy.

And the fact that there were so many idle resources at the time of the bailout isn't an aside -- it's central to why Sloan's analysis made sense. Private capital was scarce, but public capital was enormously cheap. So it made perfect sense for the government to borrow and lend -- just as it made/makes perfect sense to borrow and spend -- because we could both get good economic results (avoiding a cascade of failing banks, which would have been disastrous) and in most cases get a reasonable return on our investment.
Forget the liquidity trap: think "moral hazard".
written by Jose, July 21, 2011 6:17
The government should have lent at below market rates, yes - but to mortgage holders. Indirectly, this would also have helped the financial sector.

Instead, it provided huge low-rate loans to banks. Now the financial sector in again in great shape but guess what - mortgage holders aren't.

Even in a so-called liquidity trap with unused resources etc. choices still count. Banks or common citizens? Who is government going to help?

Unfortunately, the unwritten rule here is that market discipline only applies to individuals. Corporations - especially financial corporations - can always count on the helping hand of the public sector actively promoting moral hazard.

This is the point that Allan Sloan failed to write about in his analysis.


We Didn't Have to Give the Money to the Banks to Keep the Economy Going
written by Dean, July 21, 2011 6:18
K. Williams,

Let me try again. Suppose that we have two options in the wake of the 2008 crash. Option #1 is that we give you a trillion to support the economy. Option #2 is we do nothing.

In this story, option #1 is undoubtedly better. You will spend some portion of this trillion on consumption. You may also use some to finance business investment. Both will add to output, making the rest of us richer.

However, this will also make you richer, so come 2015, or 2020, or whatever point the economy gets back to something resembling normal, you will be commanding resources that you would not able to absent our trillion dollar gift to you. That means that your consumption will be pulling away goods and services that others could have consumed.

Now if the alternative was doing nothing, the goods and services would not be there if we hadn't handed you the trillion dollars. However, we did not have to hand you $1 trillion, we could have given it to anyone. Better yet, we could have given it to state and local governments so they didn't have to cut back spending and raise taxes. Or, we could have used it as a wage subsidies to support work sharing. All of these measures would have kept the economy going at least as well as handing you $1 trillion and they would have led to a situation where your consumption would not be pulling resources away from the rest of the country in future years.

This is the deal with the bank bailout. We kept the people who wrecked the economy hugely rich just as handing your $1 trillion would make you hugely rich. It was better than sitting here and doing absolutely nothing, but I don't really think anyone supports doing nothing as a serious policy.
"doing nothing as a serious policy"
written by Paul, July 21, 2011 10:25
Is exactly what the Chicago School advocates. In fact, they want to do less than nothing: decrease government regulations so business has a completely free market.

However, we did not have to hand you $1 trillion, we could have given it . . . to state and local governments so they didn't have to cut back spending and raise taxes. Or, we could have used it as a wage subsidies to support work sharing.
Yes, we could have done those things and still given the banks $1 trillion dollars (which they paid us back with interest). There is no real limit to what we could have done or what we could still be doing. It is not a zero sum game, unless you are a Tea Bagger.
...
written by K. Williams, July 22, 2011 3:12
"All of these measures would have kept the economy going at least as well as handing you $1 trillion and they would have led to a situation where your consumption would not be pulling resources away from the rest of the country in future years."


Well, I think this gets to the heart of the disagreement, which is that I think letting the big banks fail, which in turn would have led many smaller banks to fail (since they held a good chunk of the big banks' debt), would have been disastrous for the economy, and you don't. But we already knew that, so I guess what I'm saying is that I don't understand how your formulation is any different from saying "TARP kept the big banks in business."

Having said that, what I don't understand about your formulation is that the banks paid all the money back. So the government isn't out $1 trillion (or whatever). It's actually got the trillion dollars + the interest, so if it wanted to it could go out and do all the things you suggest (give it to homeowners, whatever), and also have the big banks be in business. This is what I don't understand about the notion that the banks are pulling resources away from everyone -- if the bailout made the government richer, how could it make anyone else worse off (as you imply it did)?

(I'm explicitly not dealing here, of course, with issues of moral hazard, etc. I'm just focusing on this economic claim you're making.)
So the cost really is...
written by McDruid, July 29, 2011 4:24
So, at a lower bound of $3T and a spread of 5% difference between what the Federal government charged and what they could have gotten on the open market, we are looking at some $350 Billion dollars a year?

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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