Welker’s Wikinomics Blog » The Costs of the Bailout, More Government Debt

Sep 22 2008

The Costs of the Bailout, More Government Debt

Published by Joe Hauet at 7:22 pm under

Economists see financial bailout as necessary - Yahoo! News

Economists in the US are calling this week’s bailout of numerous US companies a necessary step in ensuring that no permanent harm is caused to the financial system and that we do not head into a deep recession.

The Treasury Department under the leadership of Henry Paulson is currently asking congress to move quickly on a bill that would provide $700 billion to the Department to buy up much of the bad debt that many financial institutions have incurred over the past years. Where’s this money going to come from? Since it doesnt look like the Bush Administration will be pushing for increased taxes anythime soon, Congress will have to borrow the money.

Though most economists are agreeing that this is a necessary step in ensuring the integrity of the economy, I believe that it is important to look at how this additional debt may effect our government and economy in the future. So lets start with some numbers. The following statisitics are taken from the above article.

The deficit for this budget year, which ends on Sept. 30, is expected to rise to $407 billion, a figure that is more than double the $161.5 billion imbalance for 2007, reflecting what the economic slowdown and this year’s $168 billion economic stimulus program are already doing to the government’s books.

The Bush administration is estimating that the deficit for the budget year that begins Oct. 1, which will cover the new president’s first year in office, will hit $482 billion, a record in dollar terms.

And that forecast doesn’t include the $200 billion the administration committed to spending two weeks ago when it took over the nation’s two biggest mortgage companies, Fannie Mae and Freddie Mac.

And it doesn’t have any of the $700 billion the administration is seeking to soak up the bad mortgage-backed securities that have been at the heart of the severe credit crisis the country has been struggling with since August 2007.

The legislation the administration is now seeking to authorize the financial system bailout, according to a draft obtained by The Associated Press, would boost that debt limit to $11.3 trillion, up another $700 billion.

It is the rapidly rising debt that is cause for concern. The government is already spending more than $400 billion a year just to pay interest on the national debt. The higher that debt goes, the higher the government’s borrowing costs and the less it has to spend on other programs.

Discussion Questions:

What impact does the knoweldge that the government will bailout struggling financial firms have on investors willingness to take risks?
Should the government intervene in these finacial markets or leave the “invisble hand” to its own devices?
What are the opportunity costs associated with this decision?
What are some short term and long term implications of this bailout?

About the author: Raised in Japan, Joe was an international school student throughout his school years. He studied government and religion at William and Mary, and later economics at UNC Asheville. He has taught in North Carolina, Hong Kong and Switzerland. Joe now teaches AP and IB Economics at Zurich International School.

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10 Responses to “The Costs of the Bailout, More Government Debt”

# Bjorn Borgerson 23 Sep 2008 at 3:34 pm

Though having the assurance that the government will get you out of any financially problematic situation is nice, I do not feel that companies would therefore be more willing to take huge risks. In the end, there is always going to be somebody responsible, who will loose their job. Though the government interventions are contradicting the view of a free market economy, I feel that it is still important for the government to intervene. Really, it is the banks’ fault, when they gave too many loans to people who couldn’t pay them back. The banks should be the ones suffering a punishment, not the people who will be loosing their jobs, or even money. I however still wonder where the US is getting all of this money from… at a certain point, they will have to reach a point where other countries will not want to lend them any more money, wont they? 400 billion annually in interest only! They can’t solve this problem by just printing more money…
# Steve Latteron 23 Sep 2008 at 4:45 pm

Hi Bjorn,

I couldn’t agree with you more! The press is at it again calling this a “Wall Street Bailout” when it really is a “Main Street Bailout”. “Wall Street is being pummeled where thousands of employees are lsoing their jobs and their bonuses. At the University of Virginia and other prestigious schools, students who have already received offers to go work on Wall Street likely will see their offers rescinded

Moreover, all of the shareholders of Fannie Mae, Freddie Mac, and AIG (Government bailout companies) have lost billions on their investments…their share values have plummeted towards zero. The Government took action to save the economy, not the owners and managers of the companies. In fact the Government shrewdly provided an $85B line of credit to AIG to give them liquidity (cash) but ensured that their shareholders would be punished by taking over 80% of the stock.

Our country will be much better off after we get through this financial and credit crisis, in my opinion. New regulation will be passed and targeted to prevent this risky behavior (too much debt vs. risky assets) from occurring again. The great minds in economics (Paulson and Bernanke in the US) know that perhaps the tax payer money “put at risk” today ($700B) may save the economy (tax payer) more money in the long run than not acting at all. Also, “put at risk” is the key words……the government has not spent $700B…that number is a combination of loans which should be paid back and “at risk money” which could be spent if the underlying government possessed assets are worth less than they have already been written down to at the time the Government took them over.

Only history will tell how good the decisions the Government has made to bail out Main Street really are. I support ACTION & LEADERSHIP by independent Government economists like Bernanke and Paulson, fully realizing that not everything will work out according to the plan. Inaction shows weakness and leads to greater uncertainty and calamity. We have a “mixed economy” and to let the free market to fully prevail without Government intervention, in this situation, would have, in my opinion, been a disastrous choice as our banking system literally would have failed.
# Guillaume Duboison 24 Sep 2008 at 3:43 am

Steve, I couldn’t agree more with your final paragraph and statement that, without a mixed economy, our economy would have failed leaving our banks to sink even further into the debt.

In essence, the invisible hand simply guides the economy in making choices of how, what, and for whom to produce the goods we are ‘given’. Usually, this system allocates our resources effectively taking in factors such as incomes, supply, and demand. However sometimes the free market system train will lose it’s tracks due to suspicion, expectations, or simply variable change (the invisible hand) which can bring it anywhere it NEEDS to go. Sadly the truth is that these NEEDS aren’t always the right choice for the economy.

When these situations strike, it is critical that the government take action, and, if you will, put the train back onto its tracks. The government may do this to jump-start the economy and save the economy from total failure. Proof that the government needs to intervene is the infamous Great Depression of 1929. The market was not saved, and the USA, for example, had a Real GDP only half of what it was in 1941. [source: US GDP from U.S. Department of Commerce: Bureau of Economic Analysis]

Strangely, as I type this now, CNN is reporting in the background that the S&P has just gone up by 2.5%. This could be perceived as proof that the new governmental action is taking place and succeeding. In my opinion, however, this 2.5% will soon be lost once again and therefore we are all still a long distance away from curing the economic slowdown and credit crunch.
# Alex Telfordon 25 Sep 2008 at 4:46 am

Interestingly Warren Buffet (the richest man in the world) has invested 5 billion in the troubled firm Goldman-Sachs, presumably he thinks that the financial situation will recover from its present point. Warren Buffet’s main tactic is buying shares when they are cheap and holding until the value increases, it certainly seems to have worked well for him so far.
# Gavin Steinhublon 25 Sep 2008 at 2:58 pm

I believe that the government bailout is a mixed blessing. Because the bailout shows that the government is there to help when things go bad. This gives people thinking about taking risks an assurance that if things go wrong that the government will come in and help the failing businesses out. This gives the future investors confidence because if things go wrong, they will always have a backup plan. The economic bailout could be bad to risk takers because if these firms go under, what says others couldnt. The government cant keep bailing out companies if they keep going under. This can be a word of warning for those risk takers who are thinking about investing. So this seven-hundred billion dollar bailout could be good or bad for risk takers, it just depends on how you see it. I personally think that this government bailout would help my chances of taking the risk.
# Steve Latteron 25 Sep 2008 at 4:50 pm

Gavin,

You make a key point! If the government steps in and bails out failing businesses the logic is that it would promote more ill-advised risk taking.

However, if you look at what is really happening, the owners are losing their investment as all of their stock values have fallen down towards zero. The CEO and management teams have either lost their jobs already or are in the process of losing them. Layoffs in those firms have already numbered in the thousands. Those companies are/will be no longer the same. They are paying for their risk in financial and personal terms, and potentially, down the road in lawsuits.

I think most Americans miss that point. What the US government is trying to do is save the average American (main street, they call it) by saving the financial system. Another issue that comes up is that these fired company employees are getting these big “severence pay” termination which makes a lot of people mad. That’s a tough one: every CEO knows that his/her day will come when they get fired and the severence package is one way to attract the very best talent as the fired CEO loses their reputation. I’m for having regulation on upper limits of severence packages for CEOs but we need to be careful or all of our Harvard MBAs will go run companies in Asia or Europe and not the US.
# Christian Evertzon 26 Sep 2008 at 2:21 am

I think its is not right that profits are being privatized, whereas debt is being nationalized by the government. However, the government is not innocent of the financial crisis, because it should have put tighter restrictions on the leverage of financial instituations. That’s why I think that the government is committed to jump in in order to reduce further damage to the financial system.No doubt that 700 billion dollars is a tremendous amount of money, but comparing this to the government’s yearly spending interest of 400 billion dollars, it is worth spending, because the government could thus stabilize the financial market. Just imagine what would happen, if there was no government intervention. The financial crisis in the US would affect the global financial system which would further damage the global economy, because companies wouldn’t be able to borrow money from financial institutes.
So all together I think that the investment of 700 billion dollars is a necessary step to ensure that there is no further damage to the financial system. I also think that the effect of a collapsing financial system greatly exceeds the effect of another 700 billion dollars of debt on the economy.
# Steve Latteron 26 Sep 2008 at 4:24 am

Hi Christian,

I think your views are shared by most of country….but certainly not all.

I think we will hear in the next few days that a bill has been agreed to by the Congress.
# Sebastian Son 26 Sep 2008 at 4:46 am

If the government keeps on bailing out the firms and I cannot believe that what happened now is the end of the financial crisis, one must ask oneself who will bail out the government if its budget deficit keeps on increasing? I hope that it will not come to that, as when the US economy collapses completely, world economy spiral down into a depression. So as it stands now there is a relative good chance of this happening as the US budged deficit is already incredibly high and is increasing steadily and with this there is a growing risk that the US will be declared bank rubbed. This is will also be accelerated by investors who are making risky investments and are encouraged to do them as they have nothing to lose if the government bails them out. With this I can say that the government should hold a bit back and let laissez-faire rule the market but not entirely. As it is better to let the situation settle then to waste money bailing out every firm.
# Steve Latteron 26 Sep 2008 at 6:45 am

The amount of US debt is very affordable very right now. On a percentage basis (of GDP or National Income) the US debt load is lower than Japan, Italy, Germany, and France.

In the longer term, however, the US will have to stop its debt from increasing on a percentage basis. The US debt levels, as a percentage of GDP are similar to the way they were in the early 1990s. How much this bailout adds to the deficit (an annual component of the debt) is not clear. Economists estimate anywhere from $0 to $700B. Few economist say more than $700B. The US, if the bill passes, will be buying assets assets (mortgage securities) from the banks with the money expected be collected by the government with a minimal cost to the tax payer.