Understanding the $700 Billion Bailout - A Business Economists Perspective

Earlier today in my International Relations class the topic of the $700 billion bailout came up. My professor said "I do not have a degree in economics or business, so I have been reading articles to try and figure out the debate. I have come to understand that wall street business man direly want it to pass while economist want it to fail." When I heard this, I decided to ask an expert in the field - Robert C. Gay, P.h.d. of business economics, former professor of economics at Harvard University, and a private sector business man for over 25 years.

Here are his thoughts, enjoy!

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We are in a serious situation and we need some form of fix-very quickly. This problem can melt down into all parts of the economy both here and abroad. Wall Street is looking for a quick fix that takes the responsibility from them and their customers and turns it over to the government. They can essentially wash their hands of a problem they created and put the cost of it on the American taxpayer. The advantage of this is that it immediately frees and shores up the lending markets and gives desperately needed liquidity back in the system-- but the risk is the government becomes the largest mortgage institution in the world. When has the government ever administered something well-

You may also want to note this system would be favored by socialist economists who look to government to solve all free market interruptions. It is also favored by the Democrats because they were the ones under the Clinton Administration who began pushing sub prime lending to unqualified borrowers who were their voting base through Freddie Mac and Fannie Mae-they now want to bail out this constituency before the election. To be fair the Republicans pushed through the repeal of the Glass Steagall Act under Clinton which allowed investment banks to become unregulated "banks" which then worked alongside Freddie and Fanny to highly expand at very risky levels the home lending markets. They all took these risks knowing what they were doing because they could earn great bonuses and profits---By the way Bush wanted to make reforms a few years ago-- but he could not get Democratic support for reform because they did not want to cut back sub prime lending to their voter base and he couldn't risk losing their vote for funding of the Iraq war effort-This is a long way of say both political parties knew the game and played politics all the way till this point-so in a way we should not be surprised that all the old established guys want to make this go away as quick as possible through a government fix because in a very real way the government got us into it.

Free market economists would hope that we adopt a more market driven alternative. Don't bailout people but maybe look to new government loans to get people through the economic liquidity cycle where they are still responsible for the debt but only having the government taking some of the risk. One of the key triggers of this crises is the over leveraging of the non bank financial sector. All the investment banks, after the repeal of Glass Steagall, were allowed to borrow up to 35 dollars of debt for every 1 dollar of assets. A normal company can borrow about 2 or 3 dollars to every 1 and a typical bank 8 dollars to every one. So we should look to insure that all future borrowing is done at reasonable not excessively risky levels. Also another problem in the system is that government accounting standards require financial institutions to mark their assets to the current value of the market every quarter. What happens is that when a crises comes current values become overly depressed and the assets are marked to values that are much lower than their intrinsic worth making the financial institutions seem like they have much less assets than they currently have-when that happens they need to come up with more money to have assets to back the loans they already have. What happened here is they couldn't come up with any more assets and had no new way to borrow money so the markets closed down and crashed. If we marked assets to their average value over the previous two years instead of to a precise moment in time than we would not be in such a mess-so look to free market economists to modify these regulations to let true value as opposed to accounting standards become part of the fix.

Finally free market economists ultimately believe markets are self correcting and that no bailout should be made because those who created the problems should be responsible for it and if it that means the financial and housing markets fail and we go into a depression that is okay because it is the risk you have to run-ultimately the markets will rebound but the right people will have paid the price not all of America's taxpayers.

Finally you should know what is going on here is a classic economic problem of what is called by economists "moral hazard"-- Once the government become the lender of last resort or the bailout guy-every financial institution will not try to solve the problem themselves because they know the government will stand by and rescue them---ie private market solutions don't come forward because they say why should we risk our money when we know the government will solve it-that is why Secretary Paulson couldn't get any other private sector guy to bail out AIG or any other bank as of now.

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What do you think?

-Kyle Gay