Categorized | economy

Fama on government bailouts

As much as I like to hallucinate about my own greatness, I can never approach the lucidity of Eugene Fama’s discussion of all these government bailouts. His basic argument, which is the common-sensical nose-on-your-face obvious argument any freshman in macroeconomics will give you, is this:

  • Government bailouts must be financed.
  • Since the government does not have the money for the bailouts, then it must borrow.
  • The money that the government borrows displaces other investment and consumption uses of that money.
  • Which means that, in order for the bailout to “stimulate’ the economy, the use of the money in the bailout must be more productive than the use it would be put to in the consumption or investment it displaces.

    Which provides you with the basic tools for evaluating all these bailouts popping out of the ground like daisies (or Huns).

    This is what a good bailout would look like:

  • Banks are hoarding money because the risk of lending it is too high in case the economy worsens — that’s an unproductive use of the money (in fact, a zero productive use of the money).
  • The federal government can borrow that money by exchanging it for treasury bonds.
  • The federal government could give or lend that money to businesses or homeowners. Investment by businesses and home purchases are more productive use of that money than having it just sit in a bank.

    Fama would call that a “good” bailout because it results in more present and future income.

    Here’s a bad bailout:

  • Banks are in trouble because they have toxic assets that have lost tremendous market value.
  • The federal government borrows money — some of that money is borrowed from people who would otherwise spend that money or invest it in something else.
  • The federal government gives or loans that money to banks.
  • The banks then hoard that money rather than lend it out.

    Here, the bailout takes money that could be put to productive uses — either consumption or savings — and converts that money to unproductive uses, namely, moldering on a bank’s balance sheet. This explains why the $350 billion bank bailout has had almost no effect whatsoever on halting the slide in the recession (other than keep banks in business). Much of that money is simply being hoarded and the rest is being used to pay off debt.

    And if the bailout simply involves government spending the money, there are pitfalls:

    Government infrastructure investments benefit the economy if they are more productive than the private projects they displace. Some government investments are in principle productive. The government is the natural candidate to undertake investments that have widespread positive spillovers (what economists call externalities). For example, a good national road system increases the efficiency of almost all business and consumption activities. Because all the benefits of a good road system are difficult for a private entity to capture without creating inefficiencies (toll or EZ Pay booths on every corner), the government is the natural entity to make decisions about road building and other investments that have widespread spillovers.

    Like all government actions, however, government investments are prone to inefficiency. To survive, private entities must invest in projects that generate more wealth than they cost. Public investments face no such survival threat. Even good government investment projects can become wealth burners because their implementation is captured by interest groups (for example, minority or gender set asides, or insisting on unionized labor). Moreover, a $750 billion stimulus package will draw a feeding frenzy by public (state and local) and private interest groups, to pressure for their favored projects, which might not otherwise meet the market test. If the interest groups win, the country will be poorer, and future incomes will be lower.

    However, Brad DeLong doesn’t buy all this:

    The accounting identity that savings are equal to investment is true only under a particular definition of investment–one that counts unwanted growth in inventories as part of investment–and under a particular valuation of unexpected inventory accumulation–that which values unwanted inventory accumulation at its cost.

    In general, the value of unwanted inventory accumulation can’t be equal to its cost–the inventory accumulation is unwanted and unexpected, meaning that they tried to sell it at a normal price and failed, and it is now sitting in a corner of a warehouse somewhere. When Fama writes “bailouts and stimulus plans… absorbs savings that would otherwise go to private investment” he does not think that the rise in public spending is truly useful stuff while the fall in private investment is a decline in unwanted inventory accumulation . . .

    But I think that is exactly what Fama understands. When a recession happens, unwanted inventory stocks go up (because nobody’s buying). The government borrows money (which would otherwise go into inventory purchases or manufacture), puts it in the hands of businesses or consumers, who then buy inventory, and inventory stock goes down. So this, as far as I can see and I’m not smart like Brad DeLong or Eugene Fama, means that you’re taking an unproductive use of savings (unwanted inventory) and converting it into a productive use (sold inventories). Or am I wrong.

    But I rant. For anyone who is seriously following the bailout news, take a gander at Fama’s article and you’ll be in for fewer surprises.

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