Monday, September 24, 2007

Summers on Moral Hazard

Larry makes the case for bailouts. This is a topic on which there is little consensus among professional economists. Larry represents the more activist point of view.

In the process of making some general points, Larry defends the 1990s bailouts he was involved with:
A competent lender of last resort – in Bagehot’s sense of one who lends freely at a penalty rate against good collateral – actually turns a profit, as the IMF did in its response to the financial crises of the 1990s.
The fact that this particular bailout was profitable ex post is, however, scant evidence that it was wise ex ante. In particular:
An important corollary to recognizing that decisions are about probabilities is that decisions should not be judged by outcomes but by the quality of the decision-making, though outcomes are certainly one useful input in that evaluation.. Any individual decisions can be badly thought through, and yet be successful.
That piece of wisdom, by the way, is from Robert Rubin.

Larry concludes with some general guidelines for when bailouts are okay:
First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability or does it involve problems of solvency? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.
These questions are sensible, but they are hardly an algorithm for good policy. They are extraordinarily vague, leaving a lot of discretion to those in power.

Bailout critics are skeptical that government policymakers are likely to have all the wisdom that Larry presumes. And they are skeptical that those who oversaw the "successful" bailouts of the 1990s were actually as wise as they think they were. After all, "individual decisions can be badly thought through, and yet be successful."