Thursday, October 02, 2008

Unintended Consequences

The Bail-out bill continues it's steady march to realization. While the mainstream media and a lot of intelligent people I know continue to advocate for the bail-out, the narrative of the proper causes of the bailout is making it into the mainstream. I don't think it's a majority voice yet, but it is a mainstream voice. Radio commentators like Glenn Beck, Dennis Miller, and even morning radio entertainer Mancow (this morning he identified Fannie/Freddy, the CRA, and government intervention as the key causes of the mess) are openly advocating and identifying root causes properly. Senator DeMint and popular economic commentators are starting to advocate strongly against the bail-out.

The problem however, judging from those I've talked to is that the analysis of the cause and effect seem to be superfluous to the thinking of what to do going forward. I have a whole post brewing on why this is, but I think that we who advocate on the principles of free markets, also have to begin to articulate the concrete free market options, and question the wisdom of the prevailing thinking. That is why I changed my tone on the last letter to my Congressman. I don't think it's necessary that you have a knowledge of economics take this tack. You can also focus on experts in the media who are advocating options, and pointing out problems with the bail-out option.

I have a post brewing on some of what I perceive as the faults in this line of thinking. One aspect is that while many people consider the intended consequences of any advocated action, it is many times the unintended actions that actually can do the damage. Many examples abound, and here are two regarding the crisis.

From a Wall Street Journal Article "Free AIG", it appears as though, in retrospect, the nationalization of AIG a few weeks ago, may not have been a good idea (bold mine).

We don't know if AIG debt deserves a downgrade, but the ratings drama tells us something about the original deal. In fact, the further we get from the New York Fed's takeover of AIG, the worse this transaction appears for both taxpayers and shareholders. In the wake of Lehman's bankruptcy filing, an intervention might have appeared necessary. Now this alleged rescue is even drawing skeptical looks from state insurance regulators, triggering a surreal press release on Monday.

The New York Fed's release had no news, only an assurance that its credit facility was actually intended to help AIG: "This program is designed to stabilize AIG with sufficient liquidity, and to enable AIG to make appropriate dispositions of certain assets over time." (Read full press release here.) Why does the Fed need to convince people that it's helping a company it is lending $85 billion to? Perhaps because shareholders didn't vote for this federal help and might reject it if they could.

There's also downside for taxpayers, because the bizarre structure of this deal encourages the company to put them on the hook for all $85 billion. AIG would have to pay 10.5% this year on the full $85 billion, even if the company didn't borrow a nickel. Taking the money only increases the rate to about 14%. Naturally, the company has already borrowed more than half of the available taxpayer funds.

Once accepted, the onerous terms of this facility force AIG to immediately commence asset sales. Taxpayers might celebrate that the Fed is driving such a hard bargain when owners of a business come to Washington for help, but again, the owners never did. We have found no evidence to suggest that the AIG board, the Treasury or the New York Fed consulted the firm's largest shareholders before striking this deal.

Some shareholders are wondering if a Chapter 11 filing wouldn't have been a better deal. Clearly the word "bankruptcy" in news stories about an insurer can be toxic. Customers begin to flee and state regulators might seek to put even the healthy insurance subsidiaries in conservatorship. But with the company preparing to sell off pieces to satisfy Fed loans, AIG is not exactly in a growth phase now. Shareholders have occasionally prospered when a holding company with a liquidity problem but otherwise healthy business has reorganized under Chapter 11.

Only weeks after the deal, it's unclear that it had any effect that a Chapter 11 filing wouldn't have had. Here's a great example of a free market option that simply wasn't taken, that could have been, and may have been better for the company in the long run.

And on another note, the common belief among many smart but pragmatic advocates of the bail-out today deals with the belief that the short term credit market (commercial paper, and money markets) is too big to fail. This market is used to fund ongoing operations (payroll, accounts receivables, etc) at many companies, and so many CEO's are worried about how to finance these operations, and whether they can raise capital. This is one key aspect addressed Treasury's "sorta" plan. However, some technically knowledgeable people are now considering whether the act of the FED raising $700B in capital by selling Treasury notes won't harm these short term markets rather than help them, simply by sucking cash from them, because of investors seeking safer investments than the currently shaky markets are offering. Think about that. It starts to make everyday common sense. If the problem is one of liquidity (cash flow), where is Treasury going to get the $700B? By sucking it out of the markets that are already illiquid! An unintended consequence. See discussion here, and here.

It is the unintended consequences that will hurt us here, and given that it is highly unclear that government action will improve things and it is very possible that it will make things worse.

These types of arguments are directed at the question "What do we do next?" and they are concrete. I believe that this is what we can start to point out. In essence we argue for more time and consideration, for a rational consideration of the options. Argue it on common sense grounds. Argue to give more time for the voices which are starting to hear raised. Yes, argue in principles, but we also need to make those principles understood by chewing them and giving very easily inducible, concretized arguments that they support. "Capitalism by Induction" if you will.

No comments: