Bailout Game Theory and the Least Worst Option
This afternoon Josh described some of the calculations involved in choosing the direction of the bailout process. When considering the validity of the current Treasury plan, compared to a receivership (or managed implosion) of the broken banks and AIG, the viability of the world economy over the next 5 or 10 years seems to be the most critical metric. So, there are about three options on the table: do nothing (the GOP plan, approximately), over-value and buy out toxic assets (the once and future Treasury plan), and start breaking down the banks and AIG (the fairness/realist/pragmatist plan).
In terms of the best overall outcome, the bank-breaking plan provides the fairest, cleanest solution over the long term. Risk takers - individuals and institutions - who took bad risks lose money. Taxpayers don't buy toxic assets at inflated prices. Institutions which created this cascading series of problems dissolve. Overall, these are good outcomes - this is how the regulated free market is supposed to work.
But that's not the metric they're working with at Treasury. They're focused on minimizing the down-side. The worldwide economy is in precipitous decline. There is a real possibility of unrecoverable failures in banking and securities, failures which would take more than a generation to overcome. You posited a 1/6 chance of economic catastrophe if we follow the biting-the-bullet, managed-restructuring approach. And maybe there's a 50/50 chance of collapse if we do nothing. So what is the full-on-catastrophe risk associated with the toxic-asset-buyback approach? I'm guessing it's less than 1 in 6 - maybe 1 in 10 - and that looks pretty great, whether you're at a bank or the Fed or the Oval Office.
And that's the really, really hard choice to make, politically. If you start breaking down the banks, you appeal to populists, pragmatists, and free-marketeers of all stripes. It's a good solution on paper and it's fair to everyone involved. But it poses an unacceptable risk of destroying the world economy. This is what I think is happening between Obama, Geithner, and everyone else who gets a say in the solution. They're willing to get beaten up on this, day after day, week after week, because their job is a lot bigger than looking good on television.
In terms of the best overall outcome, the bank-breaking plan provides the fairest, cleanest solution over the long term. Risk takers - individuals and institutions - who took bad risks lose money. Taxpayers don't buy toxic assets at inflated prices. Institutions which created this cascading series of problems dissolve. Overall, these are good outcomes - this is how the regulated free market is supposed to work.
But that's not the metric they're working with at Treasury. They're focused on minimizing the down-side. The worldwide economy is in precipitous decline. There is a real possibility of unrecoverable failures in banking and securities, failures which would take more than a generation to overcome. You posited a 1/6 chance of economic catastrophe if we follow the biting-the-bullet, managed-restructuring approach. And maybe there's a 50/50 chance of collapse if we do nothing. So what is the full-on-catastrophe risk associated with the toxic-asset-buyback approach? I'm guessing it's less than 1 in 6 - maybe 1 in 10 - and that looks pretty great, whether you're at a bank or the Fed or the Oval Office.
And that's the really, really hard choice to make, politically. If you start breaking down the banks, you appeal to populists, pragmatists, and free-marketeers of all stripes. It's a good solution on paper and it's fair to everyone involved. But it poses an unacceptable risk of destroying the world economy. This is what I think is happening between Obama, Geithner, and everyone else who gets a say in the solution. They're willing to get beaten up on this, day after day, week after week, because their job is a lot bigger than looking good on television.
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Good post!
the answer to Josh's rhetorical question on the front page: why are we still at this? Because it is the best of all options and the only thing that will work.
March 22, 2009 11:13 PM | Reply | Permalink
That's the big question, though: is the risk of catastrophe actually lower with the toxic-buyback approach? There's a lot of handwaving on that question, but no good answers. In a bad-case scenario, the toxic-buyback approach leads to the US becoming a bigger economic version of Argentina or Mexico, where the public debt required to do the buyback is beyond the government's capacity to issue at a sustainable price. Then you get excessive inflation, a collapse of the dollar and no real improvement in the financial system.
If the bite-the-bullet approach fails catastrophically, we at least have a functioning, credible government and rest of the economy to deal with it. If the buyback approach fails, we don't.
March 23, 2009 9:36 AM | Reply | Permalink
I think I overstated my certainty here:
"But [the bank-breaking option] poses an unacceptable risk of destroying the world economy."
That's not my position, I think that's the Treasury argument, which they could make more persuasively. Hopefully Geithner's announcements today will help.
March 23, 2009 11:57 AM | Reply | Permalink
And in this episode Tim Geithner, "Blush" contestant, learns how to put lipstick on a pig.
March 23, 2009 2:35 PM | Reply | Permalink