David Leonhardt is back to school this week with his first column in a while, and it's a good one, arguing that there are serious costs to bailing out the AIGs of the world. The problem is that bailouts discourage these industries from making key structural changes. By way of analogy, he deploys some healthy Chrysler revisionism:
The Chrysler bailout may have saved the company, but it did nothing, after all, to stop Detroit’s long, sad decline.
Barry Ritholtz — who runs an equity research firm in New York and writes The Big Picture, one of the best-read economics blogs — is going to publish a book soon making the case that the bailout actually helped cause the decline. The book is called, “Bailout Nation.” In it, Mr. Ritholtz sketches out an intriguing alternative history of Chrysler and Detroit.
If Chrysler had collapsed, he argues, vulture investors might have swooped in and reconstituted the company as a smaller automaker less tied to the failed strategies of Detroit’s Big Three and their unions. “If Chrysler goes belly up,” he says, “it also might have forced some deep introspection at Ford and G.M. and might have changed their attitude toward fuel efficiency and manufacturing quality.” Some of the bailout’s opponents — from free-market conservatives to Senator Gary Hart, then a rising Democrat — were making similar arguments three decades ago.
Instead, the bailout and import quotas fooled the automakers into thinking they could keep doing business as usual. In 1980, Detroit sold about 80 percent of all new vehicles in this country, according to Autodata. Today, it sells just 45 percent.
There is a similar chance for us to be fooled about the extent of today’s problems. Some day, house prices will stop falling and the financial markets will calm down. But the underlying problems aren’t going away on their own.
I think there's a lot of truth to this, and we'll be living with the consequences of today's bailouts for decades. Having said that, I still think Hank Paulson and Ben Bernanke made the right call.
To massively oversimplify, two things differentiate today from the 1980s (though this applies to the financial market turmoil generally, less so to AIG per se): 1.) The securitization trend of the last three decades means that many, many more people now own a piece of the rotten stuff (in this case, mostly foreclosed homes) than they would have back then. 2.) The magic of derivatives means people can use scary amounts of leverage--that is, place much bigger bets with the same amount of cash up front. If you're only leveraged 2:1 or 3:1, you may be able to cover your losses and stay afloat if an investment goes bad. If you're leveraged 50:1 or 100:1, which is not unusual these days, a drop in the value of your investment can wipe you out instantly, since you have to cover 50 or 100 times the size of the loss.
So not only is the rotten stuff more widespread than ever, people were allowed to place much, much bigger bets than they could have a few decades ago. Under those circumstances, not going the bailout route could easily lead to a financial market meltdown. The blame lies with the lax rules that got us to this point. And so the solution, as Obama has suggested, is to allow federal regulators to clamp down beforehand on the risks investors take with what is essentially taxpayer money. (Taxpayer money because, as I say, the feds have no choice but to bail out some of these financial institutions once they're on the verge of collapse.)