Who Should Pay for the Bailout?

Luigi Zingales’ reaction to the financial market bailout plan, “Why Paulson is Wrong,” has been getting a lot of attention and a Vox EU version of the argument appears below (my initial reactions are here). The main point is that taxpayers should not pay for the bailout.Several points on this. First, if the government does do a bailout, the size of the bailout won’t necessarily be $700 billion, and it is unlikely that it will be. The government is using the money to purchase assets. Some of those assets will appreciate, some will depreciate, and we don’t know for sure what the net result will be. We could make money on the deal, we could lose money, we just don’t know. But one thing is fairly certain, it’s unlikely that the value of every security the government purchases will fall to zero, and that would be required for the government to lose all the money it spends (invests). See knzn on this point.However let me be clear, even if the expected value of this deal is zero, that is, even if we expect losses and gains to cancel over time, taxpayers still need to be compensated for the risk they are taking. There is a risk that this bailout could lose hundreds of billions of dollars, and, just like in any financial transaction, the parties assuming that risk need to be compensated for it.

Second, I am not too concerned about the particular mechanism that we use to compensate taxpayers for the risk they are assuming. One way is the method below recommended by Luigi Zingales where taxpayers are bypassed altogether, but charging a higher than market interest rate on loans, entering into a formal profit sharing agreement, increasing taxes for corporation who take out a loan, all of these are ways of recovering some of the investment, a way of sharing the upside with taxpayers, and these don’t exhaust the possibilities. To me, what’s important is to get this rescue in place as soon as possible, to compensate taxpayers for any risk they are assuming, and to be sure that if the bailout does cost money, that the people who did nothing to cause the crisis and who did not benefit from it are insulated from paying for it. The particular mechanism for extracting payment for the bailout is less important and will likely be dictated by the politics, some solutions will be more politically viable than others.

If it was up to me, I’d get a government bailout going as soon as possible, we shouldn’t rush into a bad agreement but we shouldn’t waste time either, and use progressive taxation as the way to extract the payment for the rescue operation. As I look at the large corporate profits in the finance industry, and as I think about what has happened to the distribution of income since the Great Deregulation begin in the 1970s, it seems pretty clear that those at the top received most of the benefits on the upside of the boom. So it’s only fair that those who had the largest share on the way up ought to pay the largest share on the way down. If this bailout costs us money, that is who should be paying for it.

But why raise taxes for everyone at the top, shouldn’t the burden be limited to people in the finance industry who made out like bandits? The benefits from the housing boom weren’t limited to fat cats at hedge funds and other financial entities. If you built houses, poured concrete, sold doorknobs, had a roofing company, etc., you benefited from the housing boom. And there are secondary effects too. During a boom more cars are sold, people eat out at restaurants more, they buy more TVs, go on more expensive vacations, all sorts of business did better because of the boom, and hence, so did the business owners (the benefits probably weren’t distributed equally at the top, but even if you were, say, a major league baseball player, if attendance was higher, if you starred in more car commercials and so on because of the booming economy, then you shared in the profits from the euphoria).

But not everyone did better. Workers, in real terms, did not get a share of the profits from the boom, their wages stagnated over this time period. So why should they pay for the bailout? This is nothing more than The Little Red Hen run backwards, they ate the bread first and now the hen is asking “Who will help me pay for the bread?” It shouldn’t be those who weren’t allowed to sit at the table.

So I would increase taxes progressively, and I would do it in proportion to the changes in the distribution of income over this time period. And I like this a little better than Luigi Zingales’ solution for precisely that reason, it puts the burden directly on those who benefited from the boom.

I understand that this may not be the best solution politically, taxation is a hard sell, and so is the argument that the benefits from the boom were general rather than confined to the finance industry. But if it was up to me, I would do a government bailout as soon as possible, and raise taxes progressively to compensate taxpayers for risk and to cover any losses. But in the end, I will be happy with any solution that insulates taxpayers in the middle and lower income classes from sharing in the burden of the bailout, a solution that places the costs directly on those who benefited most from the housing bubble.

Update: Comments are not pleased with this post, so let me potentially dig the hole a little deeper by trying the argument from another perspective:

Another way to think about the progressive tax approach is that it internalizes all of the costs. If there are indirect benefits from a boom, then those people who get the indirect benefits have an incentive to encourage a boom – it helps them while it’s on, but they can argue it’s not really their doing, so why should they be penalized for the clean up? They at least have an incentive to look the other way, to not get involved in stopping whatever behavior leads to booms. Why should they? While it’s on, they do better, when it’s over, the cost of the bailout falls elsewhere (assuming it’s not a big crash that eventually leaves them worse off on net).

We want this to be internalized – we don’t want people indirectly supporting a boom, we want them to say hey, stop that, if it continues it’s going to cost me money.

Update: Before getting to Luigi Zingales’ argument, let me insert this from Paul Krugman:

Thinking the bailout through, Paul Krugman: What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.

First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Here’s the argument from Luigi Zingales:

Why Paulson is Wrong, by Luigi Zingales, Vox EU: When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices – the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity. The old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt holders can agree to trim the face value of debt in exchange for some warrants.

Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. So why is this well-established approach not used to solve the financial sectors current problems?

No time for bankruptcy procedures

The obvious answer is that we do not have time.

Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. The negotiations would take months and we do not have this luxury. However, we are in extraordinary times and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector.

But at what price?

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay.

Would the government be better in valuing those assets?  No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price?

The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich – at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis.

But, again, at what price?

The answer: billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC.

A alternative to Paulson’s RTC

Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes. They force a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move.

During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision.

My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices but bond prices as well soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equity holders, but also the debt holders.

If debt forgiveness benefits both equity and debt holders, why do debt holders not voluntarily agree to it?

· First of all, there is a coordination problem.

Even if each individual debtholder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay.

· Secondly, from a debt holder point of view, a government bail-out is better.

Thus, any talk of a government bail-out reduces the debt-holders’ incentives to act, making the government bail-out more necessary.

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture.

But if it is so simple, why no expert has mentioned it?

Taxing the many to benefits the few

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt-forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill. The financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

Profits are private but losses are socialized?

The decisions that will be made this weekend matter not just to the prospects of the US economy in the year to come. They will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?

For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.


Originally published at the Economist’s View and reproduced here with the author’s permission.

8 Responses to "Who Should Pay for the Bailout?"

  1. DJB   September 22, 2008 at 10:04 am

    Nobody should pay for this mind-bogglingly corrupt and unnecessary bailout. It shouldn’t happen.

    • Anonymous   September 23, 2008 at 11:50 am

      There is a problem with this countries economy and I for one do not mind paying higher taxes to help this country fight this problem. This effects everyone there for everyone should pitch in and help!

  2. Anonymous   September 22, 2008 at 1:31 pm

    I wonder how the investment banking industry is feeling about The Glass Steagall act now? Seems when Bill Clinton and Dem congress de-regulated that industry by taking down Glass Steagall. They inessence put the fox in charge of the hen house. When a home builder can own the realestate office, the appraisal office, the title insurance company, and the mortgage approval office. you have the recipe for bank failure. I urge you to go to wiki and read what caused the first crash in 1929. Then go to the store and buy all the canned food you SUV will haul.This will get much worse before it gets better.

    • Guest   September 22, 2008 at 10:14 pm

      Look at the names of the sponsors of the bill repealing Glass-Steagall: The bills were introduced in the Senate by Phil Gramm (R-TX) and in the House of Representatives by James Leach (R-IA). The bills were passed by a 54-44 vote along party lines with Republican support in the Senate[1] and by a 343-86 vote in the House of Representatives[2]. Nov 4, 1999: After passing both the Senate and House the bill was moved to a conference committee to work out the differences between the Senate and House versions. Democrats agreed to support the bill only after Republicans agreed to strengthen provisions of the Community Reinvestment Act and address certain privacy concerns.[3] The final bipartisan bill resolving the differences was passed in the Senate 90-8-1 and in the House: 362-57-15. Without forcing a veto vote, this bipartisan, veto proof legislation was signed into law by President Bill Clinton on November 12, 1999. [4]from wikipedia.Where’s Phil Gramm now? Read the news.

  3. Anonymous   September 22, 2008 at 3:25 pm

    I have been having almost precisely the same thought. The upper portion of our wage structure has the been the almost sole beneficiary of this long and always obviously unsustainable brew. A better argument for a significant upper 5% or upper 1% or upper 1/2% tax increase has never been made. This money was not obtained by a legitimate means and needs to be recovered as the first method of paying for this misadventure – particularly from those who trashed companies and their employees and then walked off with huge parachutes.

  4. Guest   September 22, 2008 at 10:24 pm

    How The Grinch Almost Killed Wall Street(How the Grinch Stole Christmas revised byWilliam Banzai7)Every Banker down on Wall Street Liked CDOS a lot…But the Grinch,Who lived just north in Greenwich, Did NOT!The Grinch hated those Street jerks for a whole list of reasons!Now, that is why we are having this exciting fall season.It could be his trader head was screwed on just right.It could be, perhaps, that his white shoes were a little too tight.But I think that the most likely reason of all,May have been that his NAV was 12 sizes too small.Whatever the reason, His smarts or his shoes,He stood there last week, hating all Wall Street’s Whose Whos,Staring down at his trades with a sour, Grinchy frown,Detesting those warm lighted screens in Wall Street town.For he knew every Captain down in Wall Street beneath,Was busy now, trying to sail through the great Subprime reef.”And they’re firing their traders” he snarled with a sneer,”In three months its Christmas! It’s practically here!”Then he growled, with his Grinch fingers nervously drumming,”I MUST find some way to give those investment bankers a drubbing!”For Tomorrow, he knew, all the Whose Who of Bankers,Would wake bright and early. And rush to save all their paper earnings!And then! Oh, the noise! Oh, the Noise!Noise! Noise! Noise!That’s one thing he hated! The NOISE!NOISE! NOISE! NOISE!Then the Whose Whos, young and old, would all fly Far East.And they’d try to talk Korea and China into feasting on trading book yeast!And they’d feast! And they’d FEAST!FEAST! FEAST! FEAST!They would feast on champagne and rare banker roast beast.Which was something the Grinch couldn’t stand in the least!And THEN They’d do something He liked least of all!Every Who down in Wall Street, the Bulls and the Bears,Would stand close together, with opening bells ringing.They’d stand hand-in-hand. And the Whos would start singing!They’d sing! And they’d sing! And they’d SING!SING! SING! SING!And the more the Grinch thought of this Singing,The more the Grinch thought, “I must stop this whole thing!””Why, for year after year I’ve put up with it now!””I MUST stop a Wall Street bailout from coming! But HOW?”Then he got an idea! An awful idea!THE GRINCH GOT A WONDERFUL, AWFUL IDEA!”I know just what to do!” The Grinch laughed in his throat.And he made a some quick calls to spread rumours of unkown CDS stew.And he chuckled, and clucked, “What a great short seller trick!””With this phone and this screen, I’ll batter those Wall Street Dicks!””PoohPooh to the Whose Whos!” he was grinchishly humming.”They’re finding out now that no White Knight is coming!””They’re just waking up! I know just what they’ll do!””Their mouths will hang open a minute or two,Then the Whos down in Wall Street will all cry BooHoo!””That’s a noise,” grinned the Grinch, “That I simply MUST hear!”So he paused. And the Grinch put his hand to his ear.And he did hear noises over the trading screen glow.It started low. Then it started to grow.But the sound wasn’t sad! Why, this sound sounded merry!It couldn’t be so! But it WAS merry! VERY!He stared down at Bloomberg and Reuters! The Grinch popped his eyes!Then he shook! What he saw was a shocking surprise!Every banker down in Wall Street, the longs and the shorts,Was singing! Without any White Knight at all!He HADN’T seen a Big Wall Street bailout coming! IT CAME!Somehow or other, it came!And the Grinch, stood puzzling and puzzling: “How could it be so?””It came with out tickers! It came without a tab!””It came as Federal largesse in boxes and bags!”And he puzzled three hours, till his puzzler was sore.Then the Grinch thought of something he hadn’t before!”Maybe a Bailout,” he thought, “is not just for financial whores””Maybe Fed bailout…perhaps…means a little bit more!”And what happened then? Well…on Greenwich Main Street they say,That the Grinch’s taxes grew 12 sizes that day!And the minute his wallet didn’t feel quite so tight,He whizzed with his Lexus through the Bronx morning light,And he met those Wall Street boys for a Smith & Wolensky feast!And he, HE HIMSELF! The Grinch carved the beef!

  5. Guest   September 23, 2008 at 4:47 am

    The OWNERS OF THE FED who control the financial markets will own a larger chunk of the U.S. when it is all said and done. Welcome to THE NEW WORLD ORDER.

  6. Guest   September 23, 2008 at 11:57 am

    We should try and have more faith in our government then what we do! Its true that we have screwed up in life and we will always mess up but WE elected the people in charge! WE gave them the power to do the things that have been done! WE should have faith that they can fix what they have done… Faith is why the Chinese do so well. They believe in their government and believe that their government will help them. So any little bit of progress they make they see it as a mile stone and they rejoice in it! They don’t ask for more they take what they earn and they are happy with that!!!