Post-Keynesian Observations

Understanding the Macroeconomy

Whom Should We Bail Out?

with 2 comments

EDIT: It bothered me when I wrote it, but only now did I bother looking it up. I have changed to title to “Whom Should We Bail Out?” from “Who Should We Bail Out?” on the assumption that the who/whom takes the objective and not the subjective case. I think this is right now.

Since I mentioned my blog to my friends at the Breakfast Club this morning (thanks again for inviting me–it’s always a pleasure!), I figured I had better post an update! Just a quick thought (and I am not the first to mention this): if we were going to bail out the financial industry, why did we not do so by bailing out their debtors? Consider this.

Let’s say A owes B $500, B owes C $500, and C owes D $500. Think of A as a homeowner and B, C, and D financial institutions up the food chain. A finds they can’t make a payment, which impacts on B, C, and D. Further assume that this is widespread and of a magnitude high enough to put B, C, and D in danger of failing. Financial crisis.

So, the Bush and then Obama administrations decide to bail out B, C, and D (particularly D, at the top of the pyramid) so that we can restore liquidity and get the economy rolling again (the premise being that we need B, C, and D to loan money to firms and consumers if they are to buy goods and services and create employment).

Set aside any sense of moral outrage or accusations of blame for a moment and just consider this one act, the bailing out of the financial industry. What I cannot for the life of me understand is why we didn’t bail out A and not D. If you bail out A, then A repays B, B repays C, and C repays D–the same result as bailing out D, but in the process you wipe out a chain of debt that is otherwise acting as an anchor around the necks of those who need to get this economy going again. It’s true that given what we actually did, D has fewer financial problems, but it’s A that needs to go out and buy that new car, eat out, get new clothes (that last one is to help you, Laurin!), etc.. They can’t because of the burden of debt. I’m not sure why this would not have been easy enough to do. You could even still give the money directly to D, but then tell them that as a condition they had to count that money as writing off debt (it wouldn’t even have to be $1 for $1). As it stands, I’m worried that the shrinking middle class with its current debt burden cannot be the engine we need it to be.

I’m sure there’s something I’m missing here, but I just don’t get it.

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Written by rommeldak

February 26, 2010 at 10:21 am

2 Responses

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  1. Just found your blog. Wish you had told me about this earlier. But anyway here is my thought on this post.

    I thought about what is missing for a long time and I think I understand what is missing and why D had to be paid. When the loans were made the accounting of the loans on the banks sheets were placed there based on the present value of the lifetime payments of the loans including the interest payout of the loans over the time period of the loan. So lets say we talk about the present value of a 100k mortgage over a 30 year period. That mortgage is worth some far greater value 300k. (principle and interest) That value is of coursed based upon the assumption that the individual will pay out that money over the time. Now the bank’s present value of that loan is going to be discounted at some rate since the stream of income is over an extended period. However the discounting rate and the interest rate paid by the borrower are going to be different interest rates. The borrower would be paying 7 or 8% whereas the present valuation discounting rate would be perhaps 2% inflation and 3% time return. Leading to a perverse present valuation of the portfolio of loans on a banks books.

    The value placed on the books is going to be based upon the value to the company of the loan not the payoff value of the loan. So a person may owe 100k on a mortgage but the value to the bank is some greater value lets say a present value of 150k. (that extra value being the difference between the interest rate paid by the borrower and the present value discounting rate used by the bank.)

    So if the banks were to be paid off the entirety of their portfolios at current payoff values the banks would be wholly insolvent. That is a guess and may be completely incomprehensible and faulty, however I think that may be part of the issue.

    tim wunder

    September 7, 2010 at 5:54 pm

  2. That’s an interesting point. Of course, if we are extending extraordinary help, you’d figure people could get a little creative! Part of the problem is who has the most power to bend the ear of government, and part of the problem is that our discipline believes that the economy will rapidly return to full employment, anyway–why fret over who gets bailed out?

    rommeldak

    September 10, 2010 at 4:30 pm


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