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Main Street vs. Wall Street — The American, A Magazine of Ideas

Main Street vs. Wall Street

By Arnold Kling Friday, October 3, 2008

Filed under: Economic Policy

The financial bailout isn't as bad as Main Street thinks. It's worse.

Main Street remains suspicious of government plans to buy distressed mortgage assets. Leading politicians and newspaper editorials are struggling to explain how the financial bailout will help Main Street. They see that the challenge is to get the American people to come around.

In fact, it is the elites who are badly misguided. The reality is that the Paulson plan is nothing more than a government assistance package for a declining industry. It has been embraced eagerly by Democratic politicians who welcome the enhanced power they will enjoy as a result of merging Big Finance with Big Government.

The American people are being given two reasons to support the bailout, namely, that it is needed to prevent another Great Depression and that it will actually earn a profit for taxpayers. Both rationales are suspect.

The most credible evidence that the Main Street economy is in danger is that "Ben Bernanke is worried, so everyone should be worried." In fact, no economic textbook, including Bernanke's, offers any theory that predicts depression as a result of consolidation in the financial sector.

Harvard economist Kenneth Rogoff views the financial bailout as akin to a tariff for the steel industry or a subsidy for the auto industry.

There is an important difference between the financial sector today and the financial sector of the early 1930s. Back then, our financial services were underdeveloped. There was no deposit insurance. When banks failed, there was no safe place for households to put savings, other than under a mattress. There was no place for them to go for mortgages.

Today, if anything, we have an overdeveloped financial sector. Harvard economics professor Kenneth Rogoff, former chief economist at the International Monetary Fund, believes that the financial sector in the United States is bloated and needs to shrink. The ongoing consolidation in finance has even further to go, in his view. While this is unpleasant for those who work in the field, it is necessary to achieve better balance in our overall economy. We could see a large reduction in the number of firms and the number of people employed in financial services without impairing households' ability to invest safely or obtain credit that they can use prudently.

Rogoff views the financial bailout as akin to a tariff for the steel industry or a subsidy for the auto industry. It is testimony more to the power of the financial industry's political connections than to its role in the economy. Banks are important, yes. But so are manufacturing firms and software companies. Rogoff points out that when the Internet bubble popped, we did not send government aid to the technology industry, which has since recovered nicely following a shakeout.

The other claim that is made on behalf of the bailout is that Treasury will make a profit for taxpayers by buying distressed mortgage-related assets. However, this claim is being made by the same people who did not see the crisis coming, in large part because they do not understand how the values of these sorts of securities behave.

Harvard finance professor Robert Merton, a Nobel laureate, notes that one of the problems at large financial institutions is the gap between the executives and the financial engineers, or what I call the "suits" and the "geeks." The geeks possess knowledge that is highly specialized and extremely technical. Many suits have never even taken a course in the fundamentals of valuing complex financial instruments, even though the health of their firms depends crucially on that very issue.

Today, the suits are saying that mortgage-backed securities are undervalued, and that if the government just holds them to maturity it will make a profit. But the geeks will tell you that we cannot be certain these securities are undervalued.

The valuation of mortgage-backed securities is marked by an enormous asymmetry. If house prices rise, the security holder gains little. He or she is happy to be relieved of the risk of default, but he or she cannot share in the homebuyer's profit. On the other hand, each drop in house prices lowers the value of the security further.

Saying you will be just fine if you hold a mortgage-backed security to maturity is like saying you will be just fine if you don't evacuate when Hurricane Ike is approaching. Depending on where it makes landfall, that strategy may cost you nothing—or you could be Galveston.

In terms of the bailout, a Galveston-like scenario would be a decline in the housing market that turns out to be steeper or more protracted than what financial markets currently expect. If such a hurricane makes landfall, almost the entire $700 billion could go down the drain. Under better scenarios, a small profit could materialize.

Main Street might prefer to have a choice about whether to take that risk. Instead, the choice is being made by politicians, who are gambling with other people's money to advance their own agendas.

This bailout isn't as bad as Main Street thinks. It's worse.

Arnold Kling is an adjunct scholar at the Cato Institute. He was an economist with the Federal Reserve Board from 1980 to 1986 and with Freddie Mac from 1986 to 1994.