Five questions for ...

Ross Levine, professor of economics

One economist’s opinion: “The best minds at the Federal Reserve and Treasury could have designed an intervention that penalized those who created this mess while saving the system on which we rely for our prosperity.”
By TAB staff  |  September 22, 2008  |  Email to a friend

Prof. Ross Levine: Prof. Ross Levine With U.S. banks and other financial institutions in danger of going belly-up in the worst financial-markets crisis in decades, President George W. Bush has been defending the federal government’s $700 billion rescue package to buy back bad debts and preserve jobs and pensions. “I'm convinced,” he said on Saturday, “that this bold approach will cost American families far less than the alternative.”

One expert who disagrees with the particulars of the Bush economic bailout strategy is Ross Levine, the James and Merryl Tisch Professor of Economics and director of Brown’s William R. Rhodes Center for International Economics. Today at Brown asked Levine to explain his opposition.

What’s your reaction to the government’s bailout of failing financial institutions?

After the world finishes praising [Treasury Secretary Henry] Paulson and [Federal Reserve chairman Ben] Bernanke for saving the world from financial collapse, we might look at the details of the plan and ask why they did this to us.

Do you think the plan is fair?

No. These two have engineered the largest redistribution of wealth from the middle class to the rich that the world has ever experienced. They are quite literally taking tax dollars from all of us and giving them to extremely wealthy individuals who made bad investments – all in the name of saving the system.

While the time has come for a $1 trillion government-sponsored program, this particular solution damages the free-market underpinnings of the very system they are supposedly trying to save.

Does your criticism go beyond the immediate bailout?

Yes, the long run is my biggest concern. The U.S. financial system has helped produce innovation, growth, and improved living standards in this country. I’m afraid that the current plan will hurt our financial system’s ability to promote economic growth and expand opportunities in the future.

Why, specifically, does the current plan concern you?

There are two reasons. First, a well-functioning economy requires some degree of market discipline and personal responsibility – that is, people should be rewarded for successful ideas and suffer the consequences for bad ones. Government regulation is supposed to limit the potential dangers of pursuing socially risky endeavors, but this time the regulatory part of the system failed. This is what needs fixing.

The current plan seems to create the worst incentives. Consider an investor with the following choices. She can invest in a sound investment, or she can gamble. If she gambles and wins, she wins. If she gambles and loses, she still wins – because the government saves her. Therefore she will be more inclined to gamble and not invest in the sound investment.

The above scenario hinders the economic dreams and aspirations of people with good ideas and sound projects, while those with the risky schemes find it easier to get funded. The Paulson-Bernanke policy induces society’s savings to flow to bad, risky investments, not to sound and productive investments. This undermines the system that we want to save and improve. 

Second, by bailing out existing financial institutions and individuals, this plan sets the political stage for massive and pervasive regulation of the financial system. While this may seem like a good idea right now, overregulation has long-run consequences. The goal of a free market system is to allow those with the best ideas, skills, and drive to succeed, not to protect those with the most wealth, social status, and political connections.

The goal of financial regulation is to create incentives for participants in the financial system to help in achieving these goals. Just as the wrong regulations can induce crises like the one we are experiencing, we can go too far in the other direction. Evidence from around the world suggests that invasive government regulation of financial institutions tends to funnel credit to political cronies, limiting others from realizing their economic aspirations.

What should the government have done to prevent the current situation?

This crisis has been unfolding for over a year. Bernanke is one of the best economists of our time, and Paulson is a stunningly successful financier. They could have – and perhaps still can – devise a more equitable and forward-looking plan than simply giving money to those who messed up. The government could purchase equity in the firms they are bailing out. The government could write warrants with the firms they are saving, which turn into equity if the firm does not buy out the government over the next five years.

The best minds at the Federal Reserve and Treasury could have designed a massive intervention that penalized those who created this mess while saving the system on which we rely for our prosperity. Besides being fairer, this would increase the chances that the country will be able to create a well-functioning financial system in coming decades.