Posted by Ilya Somin:
Continuity We Shouldn't Believe In - Moral Hazard and the Geithner Bailout Plan;
http://volokh.com/archives/archive_2009_03_29-2009_04_04.shtml#1238539418
Nobel Prize-winning liberal economist [1]Joseph Stiglitz points out
that the Treasury Secretary Tim Geithner's plan to have the government
subsidize investments in "toxic assets" creates a serious moral
hazard: Private investors will pocket any gains, while the federal
government promises to cover virtually all potential losses:
Professor [Joseph] Stiglitz on Tuesday led a list of well-known
economists and high-profile industry figures who have said Treasury
Secretary Tim Geithner's toxic asset plan may not be as successful
as it first seems.
The plan involves ensuring up to $100bn of government funding is
matched by private investors, with the monies combined and
leveraged up, in some cases to by as much as 20:1, with the help of
the Federal Reserve and the Federal Deposit Insurance Corporation
(FDIC), to buy pools of unwanted assets.
Professor Stiglitz, speaking at a conference in Hong Kong, said
that the US government is essentially using the taxpayer to
guarantee the downside risks, namely that these assets will fall
further in value, while the upside risks, in terms of future
profits, are being handed to private investors such as insurance
companies, bond investors and private equity funds.
"Quite frankly, this amounts to robbery of the American people. I
don't think it's going to work because I think there'll be a lot of
anger about putting the losses so much on the shoulder of the
American taxpayer."
As Stiglitz suggests, this privatization of profits combined with
socialization of losses is likely to incentivize overly risky
investments that taxpayers will be left holding the bag for. It may
also lead to misallocation of resources, as investors transfer funds
from more economically efficient uses in order to take advantage of
Uncle Sam's blank check for investing in "toxic assets." Jeffrey
Sachs, another prominent liberal economist, makes a similar point in
[2]this Financial Times piece (free registration required).
Ironically, the moral hazard created by the Geithner plan is similar
to the incentivizing of risky mortgage investments by the government's
backing of Fannie Mae and Freddie Mac, which played a major role in
causing the financial crisis in the first place, as economists Peter
Wallison and Charles Calomiris describe in [3]this paper. Wallison
deserves some credit for[4] warning about this danger back in 2005.
Both parties deserve blame for policy of federal backing for dubious
mortgages and investments. Certainly, President Bush didn't help
matters when he, in his own words, [5]"use[d] the mighty muscle of the
federal government" to promote the issuing of risky mortgages.
Barack Obama, however, promised to break with the failed policies of
the past, and often criticizes those who he claims advocate [6]"the
same failed ideas that got us into this mess in the first place."
Ironically, he has now embraced some of the worst of those ideas
himself.
References
1.
http://www.telegraph.co.uk/finance/financetopics/recession/5045421/Geithner-rescue-package-robbery-of-the-American-people.html
2. http://www.ft.com/cms/s/0/b3e99880-1991-11de-9d34-0000779fd2ac.html
3. http://www.aei.org/publications/pubID.28704/pub_detail.asp
4. http://www.aei.org/publications/pubID.22514/pub_detail.asp
5. http://volokh.com/archives/archive_2008_12_21-2008_12_27.shtml#1230062822
6. http://www.thenewamerican.com/component/content/article/1-latest/769
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