What, exactly, has been lost in the financial wreckage of this interesting week? How much will the bailout, whatever it turns out to actually be, cost taxpayers? The answers are not what you would guess from the public discussion: in both cases, not as much as you might think (though pitfalls surely remain in the path ahead).
But first, a reflection on what a loss is and isn’t. Loss is when economic resources go away. Economic resources are stuff and capacities. The stuff is obvious: your house, your refrigerator, the food in your refrigerator: capital goods and stocks of material. Capacities are resources too: the recipe you’ll add value to the food with is an economic resource, like your ability to do work people will give up resources for. One really important resource that doesn’t get sold (like your house), or rented (like your labor) is social capital, involving all sorts of things like a shared language, and trust that people will pay debts and deliver goods.
How does society lose these things? Several ways. Obviously, when your house burns down or gets sloshed away in a hurricane there’s a loss. When you eat the food, it’s gone. If you forget Mom’s pot roast recipe and it’s not written down, it’s a loss (well, my Mom’s, definitely). When photography becomes digital, a lot of the value of your fancy film camera is destroyed. And every day you don’t use your capacities to create value because you’re unemployed or your company forgot to order more of part 33962b-4, that’s a loss. But when someone steals your camera from your car, your loss is balanced by the gain to the thief. This doesn’t make it OK, and it’s just as sad for you, but it’s a fundamentally different kind of event from society’s perspective: a transfer, not a cost. [Update:The oversimplification in this example provoked Mark to reflections that are well worth a read.]
Money is the basic economic resource, right? We always talk about “losing money”. Nope, it’s not a resource at all, or a good. It’s a measuring stick, and a way to keep track of who gets to keep the value in, or created by, real resources. When you lose money, the right to benefit from resources has been taken from you and received by someone else (or it never really existed). Whether real resources are lost is another question entirely. Not all those “losses” we’ve been ogling this week indicate real economic costs, and the ones that do occurred before stocks and house prices went down; the financial indicators are just meters catching up to events.
The housing bubble and its collapse occasioned some real losses and some big numbers that are not. The losses are the destruction of value caused by using good lumber and sheetrock to build houses that, we now see, provide less value than they cost to build, and that happened before the price collapse; same with the goods bought by people who borrowed against all this deceptive appreciation and consumed stuff. The loss of speculative ‘value’ unrelated to housing services is something else, a recognition that certain economic value never existed in the first place.
The loss of market value of securities pasted together out of mortgages people can’t pay, similarly, has already occurred, and is currently being borne by a lot of businesses with a lot of stockholders. When the government buys them up cheap, much of the costs will stay with those investors, but a lot will be transferred to taxpayers. But this part isn’t costing society anything, just shifting around who hurts most. It’s like the war in Iraq: all the ammunition and blown-up humvees and houses and eaten MRE’s and lost production capacity of people who died young is gone, and can never be recovered. All we can do now is allocate the pain among people alive now, the Iraqis, and our children (this administration has notably decided to pass it on).
Why would we shift any of these financial costs from many of us to all of us, especially at the risk that doing so will just encourage even more foolishness in expectation of another bailout? In the end, it’s about social capital, and (because of the moral hazard problem) it’s not an obvious call. Remember the trust that lets us do deals and trade and combine my wealth with your recipes and business sense in a new restaurant that creates net value? The week’s financial losses are measuring a combination of irretrievable losses like (i) the foreclosed houses in the wrong places, (ii) recognition that a part of security and business valuation of a couple of weeks ago was tulip mania speculative vapor, and a recoverable (iii) loss of the particular capacity to create value that is embodied in trust, especially trust that promises will be kept and that a thousand-dollar bond will be exchangeable years from now for a thousand dollars’ worth of stuff. The third of these is not irretrievable, and it’s really important, because we can have a lot more real economic welfare if capital markets allow people to trade resources across time and among strangers. And it’s a cost that, if allowed to stand, is distributed all across society, in other words, almost like “across all taxpayers”.
The specific machinery of the bailout will have a lot to do with whether it successfully reverses this third loss, and with how fairly the other two are shared among us. I am deeply concerned about the outcome of the enterprise, not only because being new and big and complicated it will be hard to do well, but also because it will be done by a government eviscerated of the competent and the honest at high and medium levels (Paulson appears to be a straight-ahead guy and smart, but he’s only one), and larded with thieves, ideologues and idiots, over eight years. There’s some risk that the enterprise will be taken over by a McCain team, and if Phil Gramm is allowed anywhere near it, we’re in deep sh_t.
I’m not so sure about the private sector players, either; Wall Street has populated itself with a lot of idiot-savants, selfish jerks with the attention span of a gnat and the breadth of mind of a TV remote, drinking ridiculous bonuses in $50-a-drink bars. But I think we have to try it, even with the available sorry teams in place, and even with the risk of teaching wrong lessons, because all the social capital of the business world is a terrible thing to lose. Indeed, if we can’t recover at least most of it, we’re headed for a real catastrophe, because it’s the one resource without which we can’t create more than stone-age wealth levels.
Update: Mark says there’s reason to hope that Treasury has been less damaged by eight years of the W team than Justice, partly because of historical high competence and agency inertia; more social capital, in this case a convention and tradition of excellence.