Thursday, November 13, 2008

More on Emergency Rescue Plan

My view on the bailout for the financial sector is that the credit markets are a lot like gas supplies in that if there is a major shortage of liquidity (caused by the frozen credit market), the economy is going to seriously slow down (major recession), just as would happen to transportation if there was a major shortage of gas.

The government keeps a stockpile of petroleum in case of a gas shortage. When there is a shortage of liquidity, it is an rare emergency situation where the government needs to pump more money in (either by borrowing or printing money). The real debate then becomes how best to inject liquidity into the markets, or in other words, who do you give the money to? And that is the question very few people really have a good answer for.

I bet if you could ask Milton Friedman, he would have backed some form of capital injection into the markets. He blamed the Great Depression on the Federal Reserve printing less money after the 1929 financial crisis, where the Fed was trying to fight inflation. But a shrinking money supply will single-handedly cause a recession.

My view is that the frozen credit markets will lead to a large ineffiency in the economy, and even though I would oppose bailouts to specific companies 99% of the time because of the perverse incentives and distortion of markets they create, I think that is less a danger than the frozen credit markets were/are.

I don’t trust the government to handle the $700 billion, but what other choice do we have? Remember that Larry Kudlow, Steve Forbes, Tom Coburn, Paul Ryan, and even Newt Gingrich (after he pushed for a better bill) supported the $700 billion emergency rescue plan.

I think the cleanest way to inject liquidity would be to take whatever dollar amount you wanted to inject, and spread it as evenly as possible over the entire financial sector, including successful companies. Then, for the most part, let institutions fail if they still can’t make it. No more bailouts. No money for any other industry. No trough for the pigs to line up at. No rewarding failure.

Of course I can think of many problems with this proposal as well. What if successfuly companies use the money to buy up failing companies? Still better than a government bailout. What about creating a moral hazard for the financial industry as a whole? Still better than letting the entire economy suffer for the financial industry’s failure. What if the companies that still fail cause too much disruption in the economy? I don’t have a good answer.

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