EFF: The term "systemic risk" is less than 20 years old. It has become a scare term that governments use to justify bailout actions detrimental to taxpayers.

"Too big to fail" is an especially perverse use of the systemic risk scare tactic. I think the policy rule should be "too big not to fail," that is, big losers among financial firms get shut down first, to signal other big financial firms that "too big to fail" bailouts are over, so the firms will behave more responsibly in the future.

EFF/KRF: As far as I can tell, the government bailout of AIG has gone largely to prop up its $2 trillion of credit default swaps. The fear of the Treasury and the Fed is that if AIG is forced to default on its credit default swaps, the "insurance" they provide to the value of bank assets will disappear, the value of the assets will fall, and lots of big banks will be insolvent. I agree that this is likely to be the eventual outcome, in other words, the Fed and the Treasury will eventually say "uncle" and let AIG and the bad banks fail. I think this is what they should have done from the beginning, and if they had we would be in better shape now. The stockholders and the bondholders of AIG and the failed banks will lose big time, but this will allow the banking sector as a whole to emerge in a stronger state. (See also my little paper "Bailouts and Stimulus Plans.")

EFF/KRF: Even in good times, economic systems are often changed dramatically by political decisions. (Think about South America over the last 30 years.) Capitalism is always under threat in the U.S., and the threat is higher when the legislative and executive branches are both in the control of liberal Democrats, who seem to be big admirers of the European system of high social welfare expenditures and "managed" (or better, mismanaged) capitalism. Unfortunately, the current political period may result in stagnation of the sort that other managed capitalist economies (Japan and most of Europe) have experienced. But we hope the pioneering free enterprise spirit of the U.S. can quickly reassert itself.

EFF/KRF: Government intervention affects the market in two ways. First, it affects the level of expected future profitability, which has direct effects on stock prices. Second, government intervention and uncertainty about the government's future actions change the risk of expected future profits, which affects stock prices by raising or lowering the discount rates for expected future profits, and thus raising or lowering expected stock returns. Our view is that the rhetoric and sweeping initiatives of the new administration have lowered market expectations of future profitability, and the uncertainty about government policies has increased the risk of expected future profits. Both effects have contributed to the lower stock prices we have seen as the policies of the new administration have unfolded. If the market has it right (that is, if the market is efficient) all this is built into current stock prices, and expected returns are higher going forward. (See also the answers to Expected Return in a Bad Economy, Expected Return and Stimulus Efforts, Hedging Inflation with Bonds.)

by EUGENE F. FAMA

In his NY Times blog Paul Krugman attacks my piece on the stimulus plan.

Again, here is my argument in three sentences.

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

Are any of these statements incorrect?

by EUGENE F. FAMA

There has been lots of response to my little essay on bailouts and stimulus plans. I will only comment on the negative ones that I think have merit and are overlooked in my original paper.

First, however, I want to restate my argument in simple terms.

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

Are any of these statements incorrect?

by EUGENE F. FAMA

There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),

In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole. For example, in recent years private investment in the US has been greater than the sum of private, corporate, and government savings in the US. This means the US has been importing savings from the rest of the world (by selling US securities to the rest of the world). But the equation always holds for the world as whole.

KRF: It is not obvious that financial regulations were weakened during the last few years. This claim seems to have been the product of a Presidential election in which both candidates were running against the incumbent. In fact, one could easily point to important new laws and regulations such as Sarbanes-Oxley to argue that market regulation increased. As more tangible evidence, the SEC's budget increased from $377 million in 2000 to $906 million in 2008. It is certainly true that different regulations could have reduced the magnitude of the current turmoil, but that is like saying a different portfolio allocation could have produced higher returns.

EFF/KRF: Gary Becker (University of Chicago faculty member in economics and business and a Nobel Prize winner in economics) and Richard Posner (University of Chicago Law School professor and a US Appellate Judge) are intellectual giants of economics and law.  Whatever they have to say is worth a read.