A Challenge to Voters- Part II

With the elections close at hand, I present part two of my voter guide.

Saving irresponsible firms from bankruptcy is an unfortunate side effect of the bailout. However the risk to the entire economy of allowing these major firms to fail is too great;  the credit markets are tight enough as it is.  Had the financial system been allowed to collapse, obtaining a loan would have been next to impossible.  The reason why the bailout has not been more effective at freeing up credit is actually an issue of scale.  The $700 billion that the bailout injected into the financial system is less than five percent of the GDP.  While it was enough to save firms from bankruptcy, it is not enough to provide them a safe cushion of capital to cover potential losses from making more loans.  While providing more capital would have had a better effect, the bailout still accomplished the goal of halting the downward spiral in the financial sector.  It also did this at minimum cost to the taxpayers.  The Congressional Budget Office estimates that the final cost will be $66 billion when the firms have finished repaying the government with interest.  Most of the funds have already been repaid.  Thus while the bailout was not ideal, it was effective.

2) The Stimulus

The American Recovery and Reinvestment Act was signed by President Obama on February 17, 2009 as the next stage in the response to the economic crisis.  Better known as the stimulus, it is a Keynesian style fiscal policy response aimed at expanding demand since the incredibly low interest rates set by the Federal Reserve were insufficient in spurring the economy.  The stimulus costs $787 billion, $288 billion of which is in the form of tax breaks.  It has also provided extended unemployment benefits.  The stimulus has been effective in creating jobs, but the job creation has been overshadowed by the stubbornly high unemployment.  The reason why the benefits have been relatively modest is three fold.  First, a large share of the stimulus was in the form of tax breaks.  Consumers deep in debt and uncertain about the future tend to pay off their debts or save the stimulus money they receive rather than spend it in a way that boosts the economy.  Second, stimulus money reserved for government grants or contracts takes time to be allocated and spent, thus the results are not immediately observable.  Third and most significantly, the stimulus package only totals slightly over five percent of the GDP.  This is not a large enough sum to make a significant difference.

Voters tend to claim that the government is not doing enough to stimulate the economy while at the same time  some complain about the high levels of spending on the stimulus bill.  While it is still an undecided economics question whether fiscal stimulus is the best solution to a recession, there is no question that a stimulus must be financed through government debt if it is to be effective.  Voters must accept that they cannot have their cake and eat it too.  When voting, you must pick a side and make up your mind.

3) Financial Reform and Regulation

The most important response in the long term is to reform the financial system to prevent a future economic crisis, but voters tend to overlook regulatory changes.  The Restoring American Financial Stability Act was passed on July 21, 2010 and contains numerous provisions designed to avert a future economic crisis.  A Consumer Financial Protection Bureau will be created to oversee mortgage and credit card practices with the goal of curbing the abusive and reckless lending that led to the housing bubble and meltdown.  To deal with the problem of “too big to fail” firms, a Financial Stability Council will be established.  This agency will be responsible for identifying and monitoring large firms whose bankruptcies would likely to trigger a financial crisis.  If any such firm is on the verge of collapse, the government will then be authorized to ease the firm into bankruptcy to prevent a shock to the market.  The goal is to prevent future financial panics from spreading without having to resort to another bailout.

Most importantly, regulations are placed on the so-called shadow banking system, which heretofore had a license to take irresponsible risks.  The shadow banking system is made up of non-depository banks such as hedge funds and investment banks.  Whereas depository banks were placed under strict regulation by the Glass-Steagall Banking Reform Act of 1933 due to the major role of bank runs in causing the Great Depression, investment banks were excluded from the regulation since they were not subject to bank runs.  These regulations included capital requirements, reserve requirements, and deposit insurance, and have been very effective at bringing an end to bank runs.  Now that investment banks manage a large proportion of the nation’s wealth, when investors panic and sell their shares en masse, it can have similar impact to a run on traditional banks as was observed during the recession.  The new regulation extends many of the rules that govern traditional banks to the investment banks.  If the success of the Glass-Steagall Act is any guide, this regulation will greatly stabilize the financial sector.

A Challenge to Voters

Now as voters you must make your decisions.  Many of you will be voting with the economy in mind, but remember to consider the complex realities of economic policy.  As covered, the federal government has undertaken extensive efforts to improve the state of the economy, but the economy will nonetheless be slow to recover as that is the nature of the beast.  When deciding whom to vote for, it is essential to compare the candidates’ stances on economic policy and not just vote against the incumbent out of frustration.  In a tough economy, it is easy for challengers to criticize those in office, but it is hard for them to govern any more effectively.  Trade-offs exist in many areas of policy including the conflicting goals of stimulating the economy and reducing the debt, a fact many politicians ignore.  All these factors must be considered when making an informed decision at the polls.

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