Liquidation Promotes Liquidity

This article on NPR and a similar explanation provided by made me question my objection to the government bailout.

However, I began to wonder if this wouldn’t play out like Y2K: There were predictions of doom and gloom. Enormous amounts of money were spent. Urban myths proliferated. But when the moment actually came, almost nothing happened. Much of the expenditure was discovered to have been wasted.

The discussion of the TED spread is key. The credit crunch described in the articles arose from uncertainty—each bank’s uncertainty about the value of other banks’ assets. Under such circumstances, a bank failure creates certainty: We know that the value of the failed bank is now zero, and the prices of any assets it held are established—with a generous margin of safety—as they are doled out “at pennies on the dollar” to expert buyers. A fire sale is still a sale. Liquidation promotes liquidity.

It seems to me that direct government intervention in this process can serve only to increase or at least prolong uncertainty. When the government purchases assets, it does establish their value—but much uncertainty remains about whether the government might have overpaid and might undersell later. Although we talk about “government” intervention, it is really intervention by the American public, who will pay for the intervention with higher taxes or by borrowing from foreign countries (= devaluing the US dollar). Either way, uncertainty is compounded by concerns about the future purchasing power of the US tax payer, who plays a critical role in the global economy.

Unlike Y2K, something bad will happen. The key questions are how long the uncertainty will last, whether the liquidations triggered by the uncertainty happen all at once, or over a long period of time.Â  If the pain and recovery are fast, then we will see a stock market dip. If they are slow then we will see a recession or a depression.

As in Y2K, there is the possibility of wasted expenditures. I would prefer the government to employ its resources on keeping liquidations fast and localized and on recovering from them rapidly, rather than on spreading the effects over time and across current and future tax payers.

Tags: Economics, Politics

Updated at: 30 September 2008 12:09 AM