Wednesday, September 24, 2008

Morris Davis writes to me

Morris is currently at Wisconsin-Madison, and was formerly at the Fed.


Why I am opposed to the bailout, by Morris A. Davis

First, I've decided it is bad economics. Suppose the bailout costs 500 billion. Suppose the bailout is effective in avoiding a recession -- The bailout itself costs 3-1/2 percent of GDP. I think you have to go back to 1982, maybe further, to get that kind of contraction in GDP during a recession.

Second, Paulson and Bernanke have proven, repeatedly, they have no idea what is going on. For example, here is a published quote from Bernanke on June 5, 2007, available on the Federal Reserve Board web site: "At this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system." I can find similar quotes from Paulson.

If Bernanke and Paulson have been wrong, every time, why would they be right about the effectiveness or cost of a bailout now.

The reason I have no faith in Bernanke or Paulson is that they have no simple theory to explain what is going on. They know all the bits and details of current events, but they have no simple unifying underlying theory for events.

Third, what assets should be bought in a bailout? Mortgages? How about underperforming stocks? How will the government decide which markets are illiquid and which ones aren't? Forget the adverse selection problem for the moment. Just ask: Why would the government know which class of assets to buy and why?

Fourth and Fifth, the precedent this sets is terrible. This bailout means we have lost faith in free markets to allocate scarce capital to its most productive use. It also tells punishes responsible investors (who did not underwrite or hold high yield junk mortgages) and rewards exp-post the participants in financial markets who took the riskiest bets.

6 comments:

doc said...

"This bailout means we have lost faith in free markets to allocate scarce capital to its most productive use."

Ya know, just looking at the history of financial crises and panics through US history, one might wonder why we invest as much faith as we do in "free markets."

"Free markets" operate within institutional, legal, and regulatory structures. Always have, always will. We have managed, in the last 15 (?) years to screw parts of the legal and regulatory structure up. (And there's disagreement about what are the scrw-ups, and what are the advances.)

While I am very uncomfortable with almost everything in the original 3-page, give us unreviewable authority to do whatever we want Paulson proposal, I do not thinnk we should just say, "Oh, well, freemarkets will solve the problem." So, yeah, I don't believe in the ability of free markets, unregulated, unconstrained, to allocate resources. I do believe that imperfect knowledge prevents that, that externalities prevent that, and that workingon ways to design structures to make free markets work better is a worthwhole activity.

I could go on, but not now.

Anonymous said...

What an extremely ignorant and unintelligent blog.
"The reason I have no faith in Bernanke or Paulson is that they have no simple theory to explain what is going on."
Well that's because there is NO simple theory as to what is going on. It is multiple complex instruments unfolding at once. Man that would be the equivalent of someone saying, "The reason I have no faith in my brain surgeon is that he has no simple theory..." Morris Davis you should be ashamed

gnarlytrombone said...

multiple complex instruments unfolding at once

Oddly enough, that was the complex text of Jean-Baptiste Say's doctoral thesis.

Rylan said...

First of all, comparing economics to brain surgery is incomprehensibly stupid.

Secondly, is Capitol Hill going to rest on their laurels and call the bailout a "success" and never get to the bottom of what actually happened? Sounds like something the hacks in Washington would do.

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