Friday, October 3, 2008

Markets Say Bailout is Bad?

On Sept. 30 Bloomberg reported :

Senate Republican leader Mitch McConnell of Kentucky predicted lawmakers would wrap up work on the plan by the end of this week. A plunge in U.S. markets, partially erased today, makes it clear Congress must act, he said.

``I think the message from the markets yesterday was clear,'' McConnell said.

The "message" from the markets was that the Dow Jones Industrial Average settled that day at 10,365.45 and the S&P 500 settled at 1106.42. We are to believe that the stock market declines were due to Congressional inaction on the bailout. Christopher Dodd pointed out that many House members were having "second thoughts" after seeing the market reaction.

The media weighed in, of course. Most egregiously, David Callaway, editor-in-chief of wrote about "How rejecting a $700 billion plan cost us $1 trillion." He tells us that "Congress imperils the investments, deposits, money markets and life savings of millions of Americans, to say nothing of people around the world."

One problem: Now that the Congress has acted the Dow sits at 10,325.38 and the S&P 500 is at 1099.23.

Are our members of Congress really making decisions based on the swings of stock markets? By this logic the bailout is 40 Dow points worse than no bailout, and they should re-convene to repeal the law.

What David Callaway (editor-in-chief of, How does this happen?) fails to understand is that there is no real wealth in the stock market. Stocks represent a claim on future payment of dividends. Because those payments are in the future, they are uncertain. Stock market buyers and sellers try to evaluate how much will be paid and so sellers are willing to trade money (which can buy things today) for these future claims. The stock market stores consumption for later.

Furthermore, the stock market is not the only place where future consumption can be stored. One other example is the national debt, which is actually negative future consumption since portions of future earnings of American taxpayers must be used to pay principal and interest on the debt instead of buying goods and services.

The argument can be made that the bailout increases future earnings because it improves the cash position of (a small number of very specific) listed companies. This is true, but it also adds to the national debt in the same amount.

There are also other indirect effects. That is, the bailout diverts $700 billion from productive pursuits to compensate some of those who made bad decisions in the past. This in turn makes future bad decisions more likely as people do not see the full cost of their mistakes. It also means that people with good ideas, or who want to expand existing successful business models, will find it harder to borrow money. All this adds up to an exacerbated recession.

The stock market will fall much further. Neither I nor anyone else will ever be able to say exactly how much of that fall results from the bailout and how much is due to other factors.

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