Avoiding Deflation Without Bailouts

I have not posted in a while since I have been on vacation. During that time an interesting dispute has arisen among friends Tyler Cowen, David Henderson, Arnold Kling, Peter Boettke, Bob Murphy, Steve Horwitz and others over whether Ben Bernanke was right to bail out specific banks. (Some of this has gotten mixed up with the issue of what Brian Boitano would have done — oops, I should say Milton Friedman.)

I think the question could be simply stated in two parts. First, is it possible to prevent general deflation and not bail out big banks? Second, if so, what would be the effect on the economy of bringing the banks to bankruptcy court while preventing outright deflation?

1. The answer to the first question is yes. Even if the Fed ran out of short-term Treasuries to buy it could have bought longer-term Treasury obligations sooner. Unfortunately, in 2008 the Fed rescued Bear Stearns and AIG with Treasury securities. This then was a sterilized bailout. The bailout protected the banks but reduced the Fed’s balance sheet an equal amount. Thus, the bailout preserved certain sources of credit but did nothing to prevent deflation. The Fed’s own actions separated the two.

Then, of course, it could, and did, buy other obligations like mortgage-backed securities. (This of course is not a problem-free option since it injects funds into particular sectors.)

Therefore, I can see no reason why the Fed could not have prevented deflation without bailing out particular banks.

2. The answer to the second question is more complicated. If the Fed had not bailed banks out they would have had to go into traditional bankruptcy proceedings. This would have taken longer. Credit availability would have been impaired. But this is not altogether bad since excessive credit was the problem in the first place. The structure of production would have been shortened, perhaps by too much for the new equilibrium. Total spending need not have declined, with deflation averted, but its composition would have been altered.

Let us say for the sake of argument that the reduction of investment spending would have been greater relative to the bailout solution. Is that good or bad? First, any method of adjustment would have had transitional over/under shooting. Second, it is not clear what the socially optimal reduction in investment spending is. Third, it depends on what one’s time horizon is. The bailout solution produces long-term moral hazard. The bankruptcy path does not eliminate that problem but reduces it substantially. It also allows the market more of a say in the composition and firm-size of a restructured banking industry. (Why should we have such large banks?)

In addition, the bailout method opens the system to rent-seeking. In the absence of a clear-cut definition (or even conceptualization) of systemic risk, there is too much room for arbitrariness or political favoritism. The expansion of government power in the direction of saving particular firms is a seriously problematic precedent.

On the other hand, the difficulty is that markets may not have gotten the signal that the Fed was committed to prevent deflation even if it allowed particular insolvent banks to go into bankruptcy. But the Fed could have made that clear. In fact, this is the traditional role of the Fed so it would not have been too complicated to explain.

The danger is that we continue the process of getting out of one recession by creating the basis for another recession or, at the least, further significant financial difficulties. The long run begins sooner than many people think.

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