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September 25, 2008

Bill Clinton: You Know, We Could Maybe Wind Up Turning a Profit on This

And he has some basis for asserting that. The US turned a profit on the Mexican bailout. Which was only an incidental benefit. The primary benefit was arresting a financial panic in that country which would have spooked other emerging markets and turned Mexico into an even more dysfunctional country than it already is.

“We might actually get all our money back and then some, if we manage it right,” Clinton told Ballasy.

To make his point, Clinton said that previous federal bailouts, including the bailout of Chrysler and also the bailout of the Mexican government that Clinton engineered when he was president, turned out to be profitable for the government.

“So the devil here is in the details, and that’s what’s being debated, and I think it’s very important that, the American people understand this,” said Clinton. “It is necessary to stabilize the stock market. Over half of the American people have investments in the stock market. But you don’t want any unjust enrichment of just throwing the taxpayers’ money away. So, in the Chrysler bailout, so called, the American people made money. When I made the emergency loan to Mexico, which was very unpopular at the time, they paid the loan back three years early and we made $600 million in interest payments. We made a profit off of it.”

Over at the WSJ, a guy argues that the US could wind up making, um, about a 200% profit on this. $700 billion in, $2.2 trillion out.

I doubt that. No, I don't doubt it. I say it's flat-out ludicrous.

Nevertheless something has to be kept in mind: Markets are not entirely rational. In fact, in one instance -- a panic -- they're completely irrational, and they get spooked into a stampede that crushes anything in its path.

Which, in the present case, could be the entire US economy.

It wasn't "rational" that we had a depression from 1929-1936. The country was making money hand over fist in 1929. Within three years, 25% of all able-bodied men would be unemployed. Does anyone really believe that the basics of the American economy had changed so much in three years that a (guessing) 7% unemployment rate (which would be "full employment" for the era) went to 25%?

The markets were irrational before 1929. Too much confidence in the economy's capacity to grow. Far too much speculation and risk based on this undue confidence. And when this bubble of irrational exuberance broke, the markets went irrationally far in the other direction.

In neither case were the markets behaving rationally. A rational evaluation of the 1929 stock market should have pegged its cumulative price at, who knows, 1/3 less than what it eventually went up to. And a rational evaluation of the basics of the economy after the crash should have resulted in a big correction, and a contraction, and a recession, and a lot of leveraged investors taking a bath and losing all their money -- but it should not have resulted in a 3rd world banana republic barter economy with a 25% unemployment rate persisting for four or five years.

But that's what happened. Because although economic theory is based, ultimately, on rational behavior by millions of individual actors, the fact of the matter that rationality occasionally goes out the window. We know this for a historic fact. There is no point arguing doctrine and what people "should" do. We already know what the have done, and what they will do.

I was one of those angriest about the Mexican bailout at the time. I hated the idea that American taxpayer money was being put at risk to bailout the Mexican economy.

But the fact is I greatly overestimated how much risk we were actually undertaking.

What happened in Mexico? I don't know but I can guess. And I'm sure my guess is right in the basics.

Irrational exuberance bid up the prices of Mexican stocks until they were so inflated that the bubble burst. Then panic selling began. And continued. And continued. And even those who at first resisted panic selling -- thinking "This is a panic selling; if I just hold on to these assets they'll rise again in value when the market stabilizes" -- finally began dumping their assets, too, because now the floor was zero, and anything above zero was a good price (at least you get some money back), and everyone sold and sold to the point where Mexican stocks were irrationally valued at "just slightly north of zero" and the whole country's economy was on the verge of collapse.

So the US intervened. We put money into their economy, made loans. We forced the stabilization and rational reevaluation that should have happened but was not happening. Suddenly the panic sellers realized there was a significant player putting upside pressure on prices, and the value of stocks was no longer just a peso more than nada but something more reasonable, and people stopped panicking, started holding stocks... and then started buying stocks again. Until the prices rose again to a rational level.

And the US, whose money had in fact been at risk, got its money back. Because while we were at risk, we were not at tremendous risk. Clinton was right and I was wrong: Mexico was spiraling into economic disaster for irrational reasons, and it would only take a big splash of cold water from the US Department of the Treasury to snap them out of it, reassure investors, calm jitters, and get their markets somewhere close to sane again.

Some are philosophically opposed, on principle, to any intervention of this sort. Let the markets work it out, they say. Well, what if the markets are behaving irrationally? What if they've become dysfunctional? And, importantly, what if their irrational dysfunction affects not just the immediate parties but threatens to harm the entire US economy?

Irrationality is quite "natural." We've seen it enough times to know that panics -- spooked herds stampeding and trampling everything before them underfoot -- are very natural and even commonplace.

But is this admittedly "natural" feature of our economy a positive thing? Is it something we want to let happen?

Or is it better that, when the herd begins stampeding, the US occasionally stands in front of it, takes out a revolver, and fires it into the air, sending the herd scattering and retreating?

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posted by Ace at 02:54 PM

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