Article published Thursday, October 02, 2008, at Fox News.

Economists Raise Concerns About Bailout Plan

By John R. Lott, Jr.

While some politicians were reconsidering their opposition to the bailout this week, there is one group that still expresses a lot of concerns with the legislation: economists.

Interviews conducted with a dozen prominent academic economists, Obama supporters as well as McCain supporters, found little support for the bailout bill. Indeed, even the one economist who supported the proposal passed by the Senate Wednesday night had serious reservations.

Jonathan Berk, an award-winning finance professor at Stanford University and a strong opponent of the bailout plan, expressed the concerns of many: “I have never been so frustrated, I have never wanted to speak out publicly before on these political issues, but politicians don’t know what they are doing, they know nothing about these issues.”

The economists did not all emphasize the same reasons for the current financial crunch and they all did not agree how serious the problem is. But there are a number of similarities that can be seen in all their answers.

There is little agreement on how serious the current problems are. Take the statements from three of the economists. John Cochrane, a professor at the University of Chicago Business School, worried that the solution was out of all proportion to the problem.

The legislation is like this: some boats are sinking, so rather than bailing those boats out, you blow up the dam and drain the whole lake.

Robert Hansen, senior associate dean and professor at the Tuck School of Business at Dartmouth College, summed up his view this way:

Does this justify some government intervention to jumpstart the market? Yes.

Is this the best way to solve the problem? I don’t know.

Does this justify this level of intervention? No.

At the other extreme is Daniel McFadden, a professor at the University of California at Berkeley and a Nobel Prize winner. McFadden could not paint the situation in more dire terms:

I think that the U.S. is in the same position as the Soviet Union in 1988. We are about a year behind them when they collapsed. We are one year away from when our economy could not function, that we could not keep order in the country.

Yet, even McFadden said:

I don’t think it is a great package .... It is more important that something be done than what is in the package. . . . I don’t know about one approach versus the other, but psychologically it is important that something be done.

The economists offered a range of explanations for the problems, but they did agree on a few things. All were concerned about the way that the government set up Freddie Mac and Fannie Mae, though they did not all agree that it should be fixed immediately as part of the bailout. Jon Berk pointed out:

Freddie Mac and Fannie Mae -- all of us knew it was going to happen. You don’t have an implicit agreement where you cover their losses and don’t expect these types of problems [their large financial losses].

All the economists criticized the government-mandated accounting rules, so-called “mark to market.” While these rules were reasonable in principle, they were applied to situations that they weren’t meant to apply to. Paul Evans, an economics professor at Ohio State University, explained that you run into real problems when “someone trades a tiny fraction of a particular type of asset at a very low price to clear it off the books. It is then used to estimate the price of all these other assets.”

In addition, most of the economists criticized the federal government for restricting mortgage lenders’ ability to require down payments and properly check credit scores, but they were not unanimous on how much of the problem could be attributable to this.

While they agreed with these points, many had their own additional reasons for the problems. Paul Evans complained about the very loose monetary policy that drove down interest rates and caused people to buy too many houses. Hansen argued that there is very bad information on the quality of the mortgages, and that lack of information is making it so people are afraid of trading them. Ray Fair, a professor at Yale University, pointed to how highly leveraged these mortgage-backed securities were, though even here at least part of the blame was due to the “perception that government would cover the losses.”

The economists’ list of objections to the bailout proposals is long, but the most common was that the aid should be targeted to those financially troubled enterprises and that the Federal Reserve already has its traditional power to act as a lender of last resort. As Fair notes, “a lot of things could be done that are much smaller than what is being proposed.”

Cochrane pointed out a major contradiction in the bailout bill. The legislation promises the “minimization of long-term costs and maximization of benefits for taxpayers,” while it also promises that the Treasury Secretary “shall implement a plan that seeks to maximize assistance for homeowners . . . the Secretary may use loan guarantees and credit enhancements to facilitate loan modifications to prevent avoidable foreclosures.” As Cochrane makes clear, “you can bail out homeowners or you can make money on their mortgages, but you can’t do both.”

Some economists criticized raising the level of deposits covered by federal deposit insurance from $100,000 to $250,000.

Sure, deposit insurance can prevent runs, but the government deposit insurance system is not very good at charging banks higher insurance premiums when they make riskier investments.

Indeed, the vast majority of economists point to this as the cause of the Savings & Loan problems during the 1980s, but at least some better linkage in insurance premiums and risk have been made since then. Still, the threat that large depositors could withdraw their money from risky banks helps keep them in line. Raising the amount of money insured could lead to somewhat riskier behavior by banks.

Many of the economists objected to the provisions in the bailout bill, as Cochrane noted, that were “completely unrelated” to financial markets. The bill has grown from three pages when first proposed by Treasury Secretary Henry Paulson to 102 pages when the House rejected it on Monday to 451 pages when it was passed in the Senate.

Evans was concerned about the “Christmas lights being added to buy support and get the proposal through.” The legislation now contains mandated mental health care and addiction coverage in private insurance to attract liberal Democratic votes, and undoing the Alternative Minimum Tax as a way of appealing to conservative Republicans in the House. Other provisions are provided to help out groups such as those who use wool products, tax breaks to disaster victims, and promote renewable energy. Hansen called the bill a “monstrosity.”

While FOX News did not ask who the economists were supporting for President, Berk offered that he was supporting Obama and Fair and McFadden are listed as Obama supporters on the website Economists for Obama. Only Paul Evans was on the list of economists who had endorsed John McCain. Four of those interviewed (Berk, Cochrane, Evans, and Fair) were also among the 230 economists who had signed an open letter to Congress calling for them “not to rush” in passing legislation.

Economists might be known for disagreeing with each other, but there is surprising agreement regarding the bailout and the causes for the current financial problems. There was no support for the broad bailout being discussed in Washington, and the economists believed that the same outcome could be achieved at much lower cost to the taxpayers.

*John Lott is the author of Freedomnomics and a senior research scientist at the University of Maryland.

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