Monday, December 15, 2008

Bailout Nation and the Dangers from the Political Allocation of Capital

Just released from the Joint Economic Committee, a new study "Dangers from the Political Allocation of Capital," excerpts below:

Since the financial crisis began in August 2007, the federal government has become increasingly involved with U.S. banks and other financial institutions and U.S. financial markets. The Federal Reserve has greatly expanded the size, duration, and scope of its credit facilities. The Department of the Treasury has agreed to 1) inject up to $100 billion of taxpayer funds into Fannie Mae and $100 billion into Freddie Mac, 2) purchase up to $250 billion of preferred shares in banks, and 3) purchase $40 billion of preferred shares in AIG. Now, Chrysler, Ford, and General Motors along with the UAW are seeking emergency financing to help these automakers avoid bankruptcy reorganizations.

This raised an important question – how would the political allocation of capital affect the performance of the U.S. economy? The political allocation of capital misdirects investment based on political criteria. Product innovation and process improvement in firms suffer. Over time, diminishing productivity gains slow real income growth and reduce real GDP well below its potential. Economists attribute the deterioration of economic performance under the political allocation of capital to several factors:

Information problems. The knowledge necessary to allocate capital efficiently is widely diffused throughout the global economy and costly to obtain. It is impossible for any one person or organization to acquire and to update constantly all of the information necessary to allocate capital efficiently in a complex economy.

Unresponsiveness. A constitutional republic such as the United States places many restraints both legal and practical upon policymakers and bureaucrats. These restraints necessarily slow the response of policymakers or bureaucrats to changing conditions or prospects.

Bias against entrepreneurship and innovation. With the political allocation of capital, there is a bias against funding entrepreneurship in emerging industries producing new goods and services using innovative technologies, and toward funding existing firms in established industries producing known goods and services using conventional technologies. The political allocation of capital discourages entrepreneurship, slows product and process innovation, and retards the development of new technologies.

Political Bias for constituents. Under the political allocation of capital, the natural tendency of legislative policymakers to serve the special interests of their constituents may cause such policymakers to direct or at least to influence the flow of credit and investment to their constituencies.

Resource diversion ("rent seeking"). The political allocation of capital encourages firms to devote management time and firm resources to lobbying activities to secure funding from policymakers or bureaucrats.


Corruption and crony capitalism. Finally, the political allocation of capital may foster corruption. When policymakers and bureaucrats make credit and investment decisions, entrepreneurs and firm managers may be tempted to bribe policymakers and bureaucrats to secure funding for their firms or to prevent their rivals from securing funding.

Conclusion. While the severity of the financial crisis may justify some of the recent federal interventions, these interventions, if not reversed once the crisis has dissipated, may retard the efficient allocation of capital in the United States and thus diminish its long-term growth prospects.

9 Comments:

At 12/15/2008 4:07 PM, Anonymous Machiavelli999 said...

Yes, the government can inefficiently allocate capital. So, can the private sector as it has done in the run up to this housing bust. It can also be prone to corruption and cronyism: see Bernie Madoff.

We must detach ourselves from the free market orthodoxy. Markets can be useful, but we must recognize that they can and often do fail.

The Federal Reserve came about because policy makers realized that failure in the fractional reserve banking system is common, so a government backstop is needed to ensure trust and confidence. Few serious economists will argue this point.

So, what the Federal Reserve is doing now is necessary. It may not be very efficient, but the consequences of doing nothing are dire.

 
At 12/15/2008 5:03 PM, Blogger 1 said...

"So, what the Federal Reserve is doing now is necessary. It may not be very efficient, but the consequences of doing nothing are dire"...

Hmmm, an interesting way to sell the idea of socialism...

Karen De Coster wrote: In 1913, at the behest of the richest and most powerful banking elites in the world, an agent of social decay was established in the United States. Indeed, the Federal Reserve was founded. The stabilizing influence of gold money, gradually, was replaced by government fiat. Consequently, the character of Americans depreciated in lockstep with its fiat currency.

 
At 12/15/2008 7:12 PM, Blogger Michael Smith said...

We must detach ourselves from the free market orthodoxy. Markets can be useful, but we must recognize that they can and often do fail.

What "free market"?

In a free market, there is:

1)No fiat money that can be expanded at the government‘s whim.

2) No Federal Reserve central bank with unlimited power to manipulate the fiat money -- to create credit out of thin air -- to hold interest rates far below market values -- and to generally follow such a long -term policy of inflation as to convince virtually all Americans that the purchase of a home is a good investment because one can count on eternally rising asset prices.

3) No Federal Depositors Insurance Corporation to convince depositors that no care is necessary in deciding where to deposit their funds and to thereby eliminate any necessity for banks to compete for customers on the basis of sound reserve policies.

4) No government-mandated fractional reserve banks that are allowed to run preposterously low reserves of cash, all resting on the Fed’s guaranteed role of being “lender of last resort”.

5) No Federal Housing Authority, Federal National Mortgage Loan Association and Federal Home Loan Mortgage Corporation -- all of which exist exclusively to insure that mortgage loans are made to individuals that would not be able to obtain such loans in a free market.

6) No Community Reinvestment Act, which exists solely to give the Federal banking regulators the power to pressure private lenders into making riskier loans than they would otherwise make.

7) No Federal government with a long-term, on-going history of bailing out institutions that make irrational business decisions, thereby encouraging the taking of risks that would not be taken in a free market.

8) No government-controlled and government-protected cartel of securities rating agencies that can make disastrous decisions to rate risky securities as “AAA” -- and then not only remain in business, but continue to be required, by law, to be used by all those selling securities.

Those are just a few things that presently exist that don’t exist in a free market. Thus, anything that happens under economic conditions that includes these entities has nothing on earth to do with a free market.

What you’ve witnessed is the failure of the highly regulated, highly socialized, highly politicized, government-controlled and government-manipulated market, i.e. you’ve witnessed the failure of the UNFREE MARKET -- and nothing else.

 
At 12/15/2008 7:59 PM, Anonymous David said...

(from earlier post)
I'm against the bailout, but the critics of keynesianism miss a point: the taxes financing the stimulus will be paid by our children, not some «unseen» group in the economy right now. A stimulus can ease the pain for some people momentarily. See it as an insurance, with the premium to be paid later.

Of course that doesn't make a stimulus a good policy. On net, it's a loss, an unproductive use of money. But that doesn't mean it can't ease the pain for some. Yes there is a cost, but it is to be paid later, when hopefully the economy will be stronger.

That's why I find the Bastianian argument of the «unseen» group rather weak in this case.

 
At 12/15/2008 8:48 PM, Blogger David said...

See my post leaving a trillion on the table for a discussion of some of the issues with politically-driven resource allocation.

 
At 12/15/2008 10:30 PM, Anonymous Machiavelli999 said...

Michael Smith,

You should read some history. Some economics history to be exact.

Before the Fed and before the fiat money system, financial crises happened all the time. In fact, the 1800s in America is full of examples of deep, long and protracted recessions all started by one financial institution making a bad bet, losing tons of money, causing a bank run and finally causing trust to dissapear in they system causing total financial collapse.

The last straw for policy makers was the Crash of 1907 in which one New York financial institution made a ridiculous bet and lost causing the events to unfold that I outlined above. In that case, JP Morgan acted as the lender of last resort on the condition that policy makers would seriously deal with this problem. In the Congressional hearings that followed, a famous exchange took place between a free market idealist Sam Untermyer and Morgan:

Untermyer: Is not commercial credit based primarily upon money or property?
Morgan: No, sir. The first thing is character.
Untermyer: Before money or property?
Morgan: Before money or anything else. Money cannot buy it ... a man I do not trust could not get money from me on all the bonds in Christendom

This conversation is very relevant to today, when people dismiss the Fed's actions to thaw the credit crunch claiming that credit is based on savings. No, credit is based on trust.

Is the Federal Reserve and the fiat money system an intrusion on your liberties? No question about it, but so is your local city's police force and yet no one is arguing for the disbanding of the police. But its not like police forces around the country are not prone to corruption. On the contrary, whole books have been written and movies made about police corruption. But despite the demands of anarchists, the majority of the public understands that even though it is not a perfect institution, the police force is a net plus for our society and we give up some liberties in order to ensure a more stable society.

So, you must judge all government institutions not based on your idealogy, but whether or not they are a net plus for a society. The Federal Reserve is unquestionably a net plus.

 
At 12/16/2008 9:32 AM, Blogger Michael Smith said...

Machiavelli claimed:

"Before the Fed and before the fiat money system, financial crises happened all the time. In fact, the 1800s in America is full of examples of deep, long and protracted recessions all started by one financial institution making a bad bet, losing tons of money, causing a bank run and finally causing trust to dissapear in they system causing total financial collapse."

In the first place, there was noting in the 19th century that compares to the world-wide destructiveness of the 15 year-long period of economic calamity known as the Great Depression. Economic output (excluding the output of economically useless war machines and munitions) did not reach the levels of 1929 until after WWII. The lives of untold millions of people were economically destroyed forever.

In the second place, there was nothing in the 19th century that destroyed -- via inflation -- the value of the citizen's money and savings the way the Fed has destroyed the value of the dollar. Virtually without interruption, the Federal Reserve has systematically destroyed the value of every single American citizen’s earnings and savings. It’s a record of decades-long, nationwide theft that no private citizen or entity could ever achieve.

In the third place, if “economic stability” is the criteria for what constitutes a just and proper economic system, there is nothing more economically stable than a totalitarian dictatorship such as the one erected by the U.S.S.R. -- it experienced no “booms and busts” and no financial crises for decades. An economic system based on slavery is quite stable -- but utterly evil nonetheless.

He also claimed:

"Is the Federal Reserve and the fiat money system an intrusion on your liberties? No question about it, but so is your local city's police force and yet no one is arguing for the disbanding of the police."

Nonsense -- there is no comparison between the two.

Liberty -- political freedom -- has only one meaning: freedom from the initiation of physical coercion -- in any form, including fraud -- by other men. Far from being “an intrusion on liberty”, a police force exists to protect that liberty by catching and punishing those who DO “intrude on it”.

The Federal Reserve and its fiat money supply, by contrast, are nothing but legalized counterfeiters that can steal the value of our money at will by simply deciding to print more. And it has done precisely that -- steal the value of the our money -- relentlessly and virtually without pause, throughout its entire existence.

He also claimed:

"So, you must judge all government institutions not based on your idealogy, but whether or not they are a net plus for a society. The Federal Reserve is unquestionably a net plus."

In other words, we must judge government institutions based on YOUR ideology -- specifically, the ideology that the ends justify the means, that government may violate the rights of the individual if doing so is a “net plus” for society.

This kind of thinking - THIS ideology -- is behind every government-induced horror that has ever been perpetuated. For instance, the slaughter of 6 million Jews by the Nazis was justified on just such a basis -- namely, that exterminating the Jews was a “net plus” for German society.

But the end doesn’t justify the means. You cannot justify the existence of a fiat money supply -- which violates every individual’s right to trade in the currency of their choice and which gives government free reign to steal the value of our money -- based on some alleged good it achieves. No matter how many people may benefit from the proceeds of a mass, legalized robbery, a robbery is still an evil act.

 
At 12/16/2008 10:48 AM, Blogger 1 said...

Just curious Machiavelli999, why have you put on your socialist shirt lately?

David says: "the taxes financing the stimulus will be paid by our children, not some «unseen» group in the economy right now"...

Good point David but that's not all they'll be paying for...

When obligations of state and local governments are added, the total rises to $61.7 trillion, or $531,472 per household. That is more than four times what Americans owe in personal debt such as mortgages...

 
At 12/17/2008 3:52 AM, Anonymous James said...

@Machiavelli

You sort of hit the nail on the head. Trust is key. Trust is also exactly what the government is destroying. By propping up unprofitable businesses, prolonging their inevitable slide into bankruptcy, you create nothing but distrust. Who's profitable? Who's not? Who's going to last? Who's worth investing in? Nobody knows because of government interference. And the more they interfere, the worse things get.

And, as an aside, who would you ever trust less than someone who wields unbelievable power and is wholly unaccountable for the use of that power?

Another aside: you trust the federal reserve? You trust that 7 guys (now 5) rather than an aggregate couple hundred million?

 

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