Saturday, July 23, 2011

The Complexity of Making a Very Simple Calculation

I've been told you should never make an argument by analogy because people will fail to understand the analogy. Here's Dean Baker trying to explain why Allan Sloan doesn't really understand the cost of the TARP bailout. Baker explains how the banks were subsidized by using a hypothetical analogy where he assumes that the government subsidizes mortgages. It is an excellent argument and a fine analogy, but I'm afraid most people won't understand it. I constantly get blank stares when I try to argue by analogy.

From Dean Baker's Beat the Press blog:
The Cost of the Bailout As Calculated by Allan Sloan

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 did the government lend to financial institutions and how much did it get 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.
The simple fact is that the real cost wasn't the money lent and paid back. The real cost was the foregone use of the money, the taxpayer's money. The taxpayer's subsidized the banks in two ways:
  1. Dean Baker points out that the interest rate the government charged the banks was below market rate, so the foregone interest that the government could have gotten was taken out of the taxpayer's pocket since those are government funds that the taxpayer had to make up.

  2. Baker doesn't point out that when the Federal Reserve lowered rates to zero, this meant that savers all through society saw their income plummet. This was an involuntary and secret tax on the saver portion of the taxpayer base. If you were living off interest on your bank account (investments) then you lost money because the Federal Reserve moved the cost of money down in order to save the banks. This social policy favoured borrowers (the banks) at the expense of creditors (the savers).
The Wall Street bankers made out like bandits. Instead of losing their money and their jobs, they were saved by the taxpayers. Then these Wall Street bankers spit in the eye of the public by awarding themselves record "performance" bonuses! They were bankrupt ninnies, but they were saved by the taxpayer and that had the ill grace to thumb their nose at the public by taking the public's money and using it to award themselves big bonuses!

One of the big drags on the US economy is the over-sized financial industry. It is a dead weight. It is supposed to earn its keep by doing the job of moving money from savers to entrepreneurs building businesses and creating jobs. But instead Wall Street has been extracting an outrageous "premium" for its services and on top of that it has crashed the economy. They caused the greatest crash since the Great Depression and they have gone on to pay themselves historically high "bonuses" for a job well done!

I can understand Bush and the Republicans sheltering the Wall Street bankers. What I can't understand is Obama and the Democrats allowing this charade of socialized losses (use taxpayer money to bailout the rich) while giving the crudest, meanest social Darwinist capitalism for the bottom 90% (letting them lose jobs and houses through no fault of their own but as innocent victims of the crash created by fraud and greed on Wall Street).

I will never cease to be amazed at the hideous immorality of the world. I can only laugh hysterically when religious types tell me that God looks after this world and ensures justice. Yeah, sure!

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