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September 30, 2008

On rescues and bailouts

I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have, however, found it helpful to think through the following (not entirely original) scenario:

I am sitting on my back deck one fine afternoon and notice smoke coming from the kitchen window of my neighbor Joe. The color and volume of the smoke—and the fact that I know that Joe is not home—leave no doubt that the kitchen is on fire.

I begin to calculate my possible responses. I think Joe has a sprinkler system installed, so it is possible that safeguards already in place will soon put the fire out. Of course, I’m not entirely sure the system is up to the task—or even if it exists—so I consider a limited intervention in the form of running inside my own house and calling the fire department. They are a pretty efficient unit, but in the best of circumstances it will take them some time to arrive. So I also contemplate the most extreme measure available to me: grabbing my garden house, breaking down Joe’s back door, and addressing the fire directly.

It’s a hard choice, so I begin to think about the costs and benefits of each option. If I rely on the uncertain quality (or existence!) of the sprinkler system, or wait for the fire department to arrive, the fire could spread rapidly and possibly threaten my property. On the other hand, if I rush in with my hose, I could get hurt—the direct intervention could be costly, too. What’s more, my intervention might not do the trick—the fire could be too big, my garden hose too inadequate a firefighting tool.

I decide to throw caution to the wind, grab the hose, and burst into Joe’s house. I am able to successfully quell the flames, escaping with only a few minor burns and watery eyes. I feel pretty good about the whole business, but the truth is I discovered that the sprinkler system was indeed operating and may have put out the fire on its own (though it hadn’t yet). And just as the last flicker expires, I hear the fire engines in the distance. They may have arrived in time to spare my house (though it is clear that the fire was spreading quickly). So, I wonder. Did I do the right thing?

Actually, my dilemma deepens. When the fire marshal arrives, he discovers that the cause of the fire was a cigarette, foolishly left to burn near a stack of old papers. I knew all along that old Joe was the reckless sort, and now I fear that by stepping in and containing the damage that Joe had brought upon himself I may just be encouraging more such carelessness in the future.

Then again, the kitchen is a total loss, and the smoke has permeated Joe’s house and ruined more than a few pieces of furniture. Though it is obvious that Joe has been spared total ruin, will he really feel that his actions have gone without consequence? Will he feel that the fates have bailed him out?

I wonder.

UPDATE: I'm getting some ribbing over the similarity between my scenario and the analogy offered today by a certain well-known candidate for high political office. Though I did note that my story is not entirely original, I assure you that the present coincidence is, well, entirely coincidental.

September 30, 2008 in Banking, Financial System, Money Markets | Permalink

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Tracked on Sep 30, 2008 8:52:26 PM

Comments

Well what Joe learns is partially up to him.

But Joe IS your neighbor. His property values affect your property values. And the fire threatened the house of your cousin, who lives next door to him.

Let's imagine that the cause was not merely a careless act of a misplaced cigarette, but was rather induced by Joe's son Charley, a Gothic type, who had been experimenting with homemade explosives in the basement.

Charley was in over his head and thought that past experience with harmful chemicals proved that they could never combust spontaneously in his absence.

Furthermore, some of the chemicals in Charley's possession required the consent of an adult to purchase, a "technicality" Charley had never complied with. Should Charley's father be punished?

However, the whole analogy of a neighbor's house on fire is completely unacceptable because it does not convey the possible consequences of the offending conduct.

This catastrophe in the interbank market that is beginning to amplify through the "real" economy is not merely a "house fire".

There is a small but quantifiable chance it could cause millions of premature deaths worldwide over the next ten years.

A far more apt analogy would be if the glorious Government researchers at Fort Detrick Maryland had been searching for a "defensive" response to an al Qaeda biological attack and had inadvertently released a highly virulent strain of smallpox into the population that threatened to kill 30% of the people worldwide.

But they never intended to do such a harmful thing.

Should the Secretary of Defense lose his job over such an occurrence?

Matt Dubuque

Posted by: Matt Dubuque | September 30, 2008 at 03:43 PM

Sorry, I don't feel *at all* like Joe's neighbor. I feel much more like the unwilling neighbor of a problem gambler.

Also on the face of it, it appears that Joe has a wealthy aunt (let's call her Sen. Auntie Em) he has ingratiated himself with. This is an aunt that he can intermittently tap for funds when he can't make his boat payment or those infrequent (but readily predictable) times when he burns his house down.

Makes the case for helping Joe a little less compelling, yes?

Posted by: IdahoSpud | September 30, 2008 at 03:43 PM

I suppose the question of whether Joe is careless again depends on whether he will be ever again be offered tens of millions of dollars in bonus to do so.

The real problem is that the incentives are skewed even without intervention.

Posted by: Anurag | September 30, 2008 at 03:54 PM

On the other hand, your other neighbors suffered no loss and will feel free to behave recklessly in the future, confident that you will save them.

Posted by: Erik | September 30, 2008 at 03:58 PM

The comparison isn't adequate. The risk/reward ratio in the case above should'nt motivate you to rescue joe's house at the risk of losing your own life.

To be brutal: that's why banks can't recapitalize at the moment unless at the cost of massive shareholders dilution.

To come back to your story: the owner would have called joe and asked 'if I go in now, do I get half the ownership of your house??'

Posted by: Marc | September 30, 2008 at 04:44 PM

The primary problem with this analogy is that it assumes an unlimited supply of water. But this type of fire, the more water you use, the less effective it becomes. Indeed, it won't be long before the water is actually fueling the fire.

The secondary problem is that it assumes Joe has morals. Forget it! He never had any and never will. The idea that the Joes of the world are affected by morality is something dreamed up by the government.

Posted by: Anonymous | September 30, 2008 at 06:10 PM

But Joe has only been occupying this house which actually is owned and guaranteed by his wealthy uncle and if it burns, it doesn't matter - he has partied there for a long time, all the while profiting considerably from the saved rent. Further, since as a neighbor he has been so ostentatious and selfish, and because we have a buffer zone in between our houses, I am willing to bet that my damages will be relatively minor in the hope that this pest of a neighbor will be effectively smothered by his benefactor.

Posted by: BR | September 30, 2008 at 08:16 PM

Just a mark of your obvious thoughtfulness Dave ... Don't disown the post!!

Posted by: Guhan | September 30, 2008 at 09:03 PM

Matt Dubuque

The interbank lending market remains in a coma threatening us all, irrespective of what the Dow Jones Industrial Average may be doing on a short-term basis.

As Senior Economist Gordon Sellon of the Kansas City Federal Reserve discussed in his seminal paper "Monetary Policy and the Zero Bound: Policy Options When Short-Term Rates Reach Zero" published in the Fourth Quarter 2003 edition of the Kansas City Federal Reserve's "Economic Review", the Federal Reserve should now consider under taking "twist" operations in the open market.

That paper is available here at the bottom of the link:

http://tinyurl.com/4o9a82

A "twist" operation by the Federal Reserve in the current context would consist of the Fed SELLING 3-month Treasury Bills while simultaneously PURCHASING 5-year Treasury Notes. Such operations, applied judiciously, would affect the term structure of various markets in a positive way.

Such "twist" operations are not without precedent. It was performed during the Kennedy Administration:

http://tinyurl.com/524lk5

I urge people to STUDY Sellon's critical paper at the link provided above to grasp some of the subtleties involved here before engaging in uninformed knee-jerk criticism.

This is not a cure-all, but it is clear that it should be on the short list of our policy options.


Matt Dubuque
[email protected]

Posted by: Matt Dubuque | October 01, 2008 at 09:30 AM

I like your metaphor - the only thing I think you missed is that the water hose used to put out the fire may bankrupt me and my children due to future taxes to pay for it. Makes me think more about taking some fire damage vs bankruptcy

Posted by: GR | October 01, 2008 at 09:53 AM

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