Henry Hazlitt on the Bailout

Treasury Secretary Henry Paulson needs to change his reading list. Instead of reading the balance sheets and income statements of the failing banking industry, he needs to read Henry Hazlitt's classic book Economics in One Lesson. It will cost Paulson far less than the $700 billion that he is spending on the bailout, and he might just learn a little economics in the process.

Hazlitt delivers his "one lesson" in chapter 1, and proceeds to spend the rest of the book giving examples. His lesson, based on the work of Frédéric Bastiat, is that "the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

For example, in chapter 2, Hazlitt delivers the well-known "broken window fallacy" in which a hoodlum breaks a shopkeeper's window with a rock. The common folk see it as a tragedy, but an astute Washington bureaucrat could argue that it creates new jobs for glaziers. As Hazlitt points out, though, any resources that the shopkeeper spends on the new window would have been used elsewhere, perhaps for a new suit. So while the glazier gets new business, the tailor loses the same amount of business. There is no net benefit; in fact there is a net loss. Absent the hoodlum, the shopkeeper would have had both a window and a new suit; given the hoodlum, the shopkeeper has a window but no suit. Even though the damage was to the window, it is the suit that is lost to the shopkeeper and, hence, to society.

In chapter 6, entitled "Credit Diverts Production," Hazlitt discusses government lending policies, such as additional credit to farmers or business owners. However, he points out, the recipients of such programs are rarely the more-productive farmers and business owners. After all, the more-productive people are able to borrow their money from private lenders. It is only the less-productive individuals and firms, unable to get funds on the free market, that must turn to government.

For example, suppose that there is a farm for sale. A private lender would normally be willing to lend money to farmer A who has proven his abilities in the past, rather than to farmer B, who has demonstrated a lower level of productivity than has A. However, because government taxes citizens or borrows money itself in capital markets, private lenders have fewer funds available to lend to A. Instead, government lends the money to B on the grounds that B is underprivileged, in need of a hand, or some other politically based argument. The more productive borrower, A, loses out on the scarce land while the less productive borrower, B, gains the resources. Because the less-productive individual acquires the scarce resource, there will be less total production, and the entire society is worse off.

Further, Hazlitt states, the government takes bigger risks with taxpayers' money than private lenders take with their own money. Private lenders who make bad loans will go bankrupt and be forced out of business. But when the government gets involved, it lends funds for riskier ventures since the bureaucrats who approve the loan face no personal recriminations — much less loss of profit — for error.

In other words, private lenders would take Action A while government lenders would take Action B, and Action B is the less-productive path. After all, there is no need for government to take Action A: it can be handled quite well in the free market.

So it is with the current rash of bailouts. Whatever the final price tag — $500 billion, $750 billion, $1 trillion, more — the fact is that government gets its money either from taxes, borrowing, or the printing press. It is hard to raise taxes by $1 trillion on short notice, and since there is a small hurdle that slows the government's ability to print the money,[1] we know that government will issue bonds. In other words, government will borrow the money from private capital markets.

As Hazlitt points out, though, the private capital markets (those that aren't bankrupt and standing in line for a bailout) would otherwise lend their funds to more-productive ventures. If private capital wants to lend directly to the failing banks, it is already capable of doing so. The fact that such private capital is not lending to the banks is a clear indication that the government's current bailout is contrary to free-market principles.

The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.

Economics in One Lesson

So when Henry Paulson argues that it is necessary to pump money into credit markets to prevent them from freezing up, he doesn't bother to realize that the money he pumps into the credit markets is coming directly out of the very same credit markets. He is doing little more than rearranging the deck chairs on the Titanic; shuffling the money from one set of financial intermediaries to another does not increase either liquidity or solvency. It merely delays the problem for a few brief moments.

Even the failing banks pay lip service to their fiduciary responsibility, but any privately funded firm that took money from more-productive people to give it to less-productive people would soon go out of business. Only the government can violate Hazlitt's logic and survive, because only government can socialize its losses through the tax system.

I should clarify my scenarios a little. There are three basic scenarios: (1) hyperinflationary boom (mostly commodities), (2) off and on stagflation and recession like Japan (but worse), or (3) crash. Crash is inevitable after #1, so they really don't want that either. But trying to avoid a decade of #2 or a quick #3 will generally produce #1 because their only tool is inflation.

Here's what my best guess is, Bernanke understands #2 can't really be cured with inflation (contrary to his 2002 speech). So he will aim for #2, the least expected alternative, and hope for a miracle. A miracle is not an unreasonable hope, for example technology creating some sort of cheap energy breakthrough.

The result however may not be what he wants or aims for. So far inflation is a reality and if the credit spigots are unclogged that credit will produce an inflationary commodities boom as the path of least resistance and the most susceptible to malinvestment from mispriced credit. The result of such a boom will be a very large distortion of the economy to the point of people scavenging for commodities of value like highway asphalt to burn or phone wires to tear down and recycle.

Last spring was a small taste and the current crash is partly due to the malinvestment caused by that boomlet. What happens, as Mises explained, is that credit fueled speculation starves productive enterprises of the resources they need and so the whole economy suffers. When the inevitable crash happens, there is no economy left to pick up the pieces. In the current situation we have some businesses holding their own next to empty real estate offices and closed auto component factories. After the commodities superboom there won't be much of anything left to fall back on.

In this article (can't be posted to FR, so cut and paste link):

http://www.portfolio.com/views/columns/wall-street/2008/10/15/Credit-Derivatives-Role-in-Crash?print=true

I learned a bit more the marketing of credit default swaps, first that they were packaged into some of the financial vehicles sold here and abroad. We didn't just bundle and sell the securities (whether corporate bonds or mortgages) but bundled and sold the default risk as well.

The difference is explained here: http://www.federalreserve.gov/Pubs/FEDS/2004/200436/200436pap.pdf in that a cash CDO represents the underlying assets and income stream from those assets. It would have a fairly easy calculated value based on the pooling of default risk and assumptions about the asset values. Of course that could change with economic conditions which has obviously occurred.

The synthetic CDO sells the default risk by contract. The buyer receives premiums from the seller but is required to pay for defaults. That means mainly insurance companies here and banks abroad who have other forms of collateral that they can place against the default risks. Presumably the off-balance-sheet entity would sell both types of CDO's so that effectively the cash CDO buyers were protected by the synthetic CDO buyers.

The second thing I learned was there really was a liquid market for credit default swaps. As it says above in the popular article, individual contracts that cover just one company or entity could trade hands. In the PDF paper, it says that "arbitrage deals have been growing rapidly and now account for a significant majority of market activity" (referring to synthetic CDOs). That means people could speculate on the default potential of an entity like Lehman or a tranche of mortgages or anything else covered by such a contract.

There are several problems with such speculation, but the main one is the difficulty of calculating risk particularly with the government as a player. In the article above, the takeover of Fannie and Freddie was a credit event, thus triggering the credit default swaps covering those institutions. The government could have chosen a different tactic such as direct investment (that they are currently doing with the major banks). That would have prevented triggering of the CDS. The politics, general cluelessness and arbitrary nature of government involvement makes the risk calculation impossible.

When the F&F and Lehman events occurred, many European banks were left as bagholders on the CDS. The credit event meant that they now owed unknown amounts of money to cover the securities that would be defaulted upon. Naturally the interbank credit market froze up and bank shares plummeted and took down the rest of the market. This had nothing to do with recession fears or panic or any of the other media excuses. This was purely a result of the structure of the financial system, combined with government involvement, causing unpredictable amounts of insolvency among those banks.

As the PDF points out, synthetic CDOs make sense in reducing regulatory capital (although that means it makes sense from the bank's standpoint only, not from a systemic risk standpoint), and they provide liquidity to the corporate bond market. But the same function of providing liquidity provides a means to speculate on bond defaults. Here's an example

Creating a Financial Market

Joe's plumbing business has grown and provided him with lots of capital and a good cash flow, so he decides to sell insurance. Joe's neighbors can now buy insurance from him on loans they make to other neighbors' businesses. For example Mary could loan Bob some money for his lawn mowing business which he uses to buy equipment and pays Mary back from his revenue. Mary buys insurance from Joe in case Bob goes out of business, then Joe would pay what Bob owed to Mary. Joe calculates that risk and sets the premium which fluctuates based on the risk.

Next Joe figures out that he has more risk than he wants so he starts selling the risk. Sam comes along to buy it receiving the payments from Mary. Now if Bob defaults Sam owes Mary whatever Bob owed her. Joe may or may not have checked Sam's balance sheet before selling him the synthetic CDO, but is now Mary's problem not his.

Next some people who know Bob become convinced that Bob really will go out of business so they buy more insurance. The rates increase as Sam perceives more risk, but are still affordable. In reality Sam would not set the risk premiums, rather they would be set by the special purpose entity that Joe set up when he sold the CDO's. The bottom line is that people are now betting on Bob's failure.

In the political arena, Bob and Sam expect something from the government. Not that the government would care about whether Bob's customers get their lawns mowed, but that Bob's creditors get their expected payments. This creates a political uncertainty: will the government step in to bail out Bob if his business shrinks or will they allow him to liquidate and default on his credit obligations. The government probably realizes that if Sam is required to pay his credit default obligations, it will wipe out his business (he would have to sell the assets) and cause an undesired economic ripple effect.

Meanwhile the market for CDS means that people other than Mary (who is the only person Bob actually owes money to) may have sold their expected default payoffs for a profit on the public knowledge of Bob's troubles along with uncertainty about a government bailout. But they are also selling the requirement to pay premiums along with the potential for a payoff.

Tom also has a business with obligations and other parties have sold credit default insurance for those obligations. The government decides that the moral hazard of keeping all such creditors from liquidating is outweighing the immediate benefit of doing so. (The moral hazard misprices the default insurance, typically making it too cheap). So they let Tom default. Immediately all the speculators who bought policies on Bob's default have to start paying a lot more for their premiums. Their cash flow dries up and they may go under. But the expected value of the insurance payoff should go up to compensate for the added premiums, but unfortunately the market for the policies has now dried up and they are stuck with them.

The bottom line for them is they lose no matter what happens which is good comeuppance since they were just speculating, but bad for the system as a whole because it exacerbates the economic downturn. This simple scenario does not even include the leverage used to buy such financial vehicles. That means money loaned by banks so that the speculators (typically hedge funds) could buy $1 of CDO assets with just 10 cents and borrow the rest. When the market dries up their asset is worthless but they still owe the money, causing yet another blow to the balance sheet of the banks.

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