One job that economists enjoy is predicting what effects certain policies will have. This could be the effects of a policy from the government, or a policy enacted by a small business owner. Either way it is very important to look at the effects from as many sides as possible.
For example, when Congress passed the TARP legislation they basically agreed to purchase enough shares of certain banks available stock so that the investors THAT HELD BONDS WOULD BE BAILED OUT... the stockholders were not bailed out.
Let me explain. Large companies need to invest. 30% of the money they use to invest comes from selling bonds, not from profit or from the stock market. Bonds are popular purchases because they accrue a constant interest rate over several years and because they are much less risky than stocks. The reason stocks are more risky is because they "protect the bonds." In other words, if a company is headed towards bankruptcy, every penny of every stock becomes worth $0.00 before any bonds can be defaulted upon. Therefore, bonds are safer than stocks. In return for this protection stocks, obviously, have more potential for profit.
To clarify, use this analogy: pretend you are an archer in a medieval army. You, as an archer, wouldn't stand in the middle of the battlefield. You stand behind the frontline (the swordsman and shield-bearers and cavalry, etc.) The infantry, in other words, protects you from attacks. The archers are like the bonds of businesses, and the infantry is the stock market. The archers (bonds) are more important than infantry (stocks) and are therefore heavily protected.
TARP, in essence, did NOT bailout any shareholders (unless you consider stocks going from $100 to $2 a bailout). They injected just enough cash into the stock market to make sure the BONDHOLDERS were not touched. For that to happen, remember, they simply have to keep stock from going to $0.00.
So here is the challenge for Fellow Bernanke Fans: What future effects does TARP have on banking stocks (stockholders), bonds (bondholders), and bank CEO's and executives.
Here is an example from an MIT professor named Simon Johnson (www.baselinescenario.com). Johnson argues that CEO's of the future will not have an incentive to take excessive risks independently (like many pundits now argue), but they will have incentive to take excessive risks that all of the other CEO's are taking. This is because they realize that while they're bank may not be systemically important by itself, if all of the banks mess up than the government will bail them out so the economy does not go into a recession.
While I generally agree with Johnson, we know this is somewhat oversimplified. He is 100% correct if CEO's retire every couple of years, thus being able to sell their stocks at a high price. However, if the laws are changed so CEO's can only sell a certain amount of shares each year after retiring (and presumably close to none before retiring) than they will have an incentive to grow their company over the long term.
Anyways, if you can think of any effects that TARP may have on bonds, stocks and CEOs let us at The Bernanke Files know!
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Is TARP a thing which happened once, for that one bad situation, or some program which has been started and which will be around indefinitely?
ReplyDeleteI like your idea about not letting CEOs (and I assume other high-ups who are paid primarily in stock) sell their stock instantly, but I'm not sure it would totally fix the problem of everyone taking the same big risks.
If a CEO in an environment where other entities are taking some high risk, he has two options. Either also do the risky option or not.
If he does the risky thing then either A: It pans out (at least in the near term) and his company stays competitive with the field, and his company makes a lot of money. He makes money too. or B: It blows up and the whole field needs to be bailed out. The company loses money, he loses money, but since they are bailed out it's not a total failure.
If he doesn't do the risky thing then there is only one outcome. C: Every other company makes money on the big risk (in the short term remember), his company and he aren't competitive. He gets fired and the company hires someone willing to be comptetitve (do the risky thing).
He has competing incentives then - if doesn't take the risk the company won't lose big which would normally be good, but he'll get fired. If he does take the risk then his stocks might not be worth anything, or they might be worth a ton.
TARP was a one time thing. I believe it has about $250 Billion left to spend. However, in the future there will be an implicit TARP tied to all large financial firms even if they are not banks. This is because a "systemic regulator" will be able to unwind any company it deems necessary.
ReplyDeleteYour right, in the future CEOs will have an incentive to "follow the crowd." Hopefully, though, smarter regulation will keep systemically risky companies to a minimum.