EconomistMom.com
…because I’m an economist and a mom–that’s why!

EconomistMom.com

CBO Explains Why It’s Hard to Know How Much Taxpayers Will Pay

September 25th, 2008 . by economistmom

Yesterday the Congressional Budget Office’s (CBO) director, Peter Orszag, testified before the House Budget Committee on the “Federal Responses to Market Turmoil,” focusing on the Treasury proposal for a $700 billion rescue plan.  Peter’s blog post on it is here.  Here are some key passages of the testimony that explain why it’s so difficult to quantify the ultimate cost to the taxpayer–and will remain so even after more details of the plan get worked out by policymakers.  (Emphasis added.)

The legislation would appropriate such sums as are necessary, for as many years as necessary, to enable the Secretary to purchase up to $700 billion of troubled assets at any point during the two-year window of opportunity (though cumulative gross purchases may exceed $700 billion as previously purchased assets are sold) and to cover all administrative expenses of purchasing, holding, and selling those assets. The federal debt limit would be increased by $700 billion.

At this time, given the lack of specificity regarding how the program would be implemented and even what asset classes would be purchased, CBO cannot provide a meaningful estimate of the ultimate net cost of the Administration’s proposal. The Secretary would have the authority to purchase virtually any asset, at any price, and sell it at any future date; the lack of specificity regarding how that authority would be implemented makes it impossible at this point to provide a quantitative analysis of the net cost to the federal government.

CBO expects that the Treasury would probably fully use its $700 billion authority in fiscal year 2009 to purchase various troubled assets. To finance those purchases, the Treasury would have to sell debt to the public. Federal debt held by the public would therefore initially rise by about $700 billion. Nevertheless, CBO expects that, over time, the net cash disbursements under the program would be substantially less than $700 billion, because, ultimately, the government would sell the acquired assets and thus generate income that would offset at least much of the initial cost.

Whether those transactions ultimately resulted in a gain or loss to the government would depend on the types of assets purchased, how they were acquired and managed, and when and under what terms they were sold…

Concerns about the government’s overpaying are particularly salient when sellers offer assets with varying underlying characteristics that are complicated to evaluate… [but on the other hand,] [i]t is…at least possible that the prices of some assets are below their fundamental value; in that case, to the extent that the government bought now and held such assets until their market prices recovered to reflect that underlying value, net gains would be possible.

In addition to any net gain or loss on the purchase of $700 billion or more in assets, the government would also incur significant administrative costs for the proposed program.

[T]he federal government could purchase too many risky or impaired assets without enjoying sufficient price discounts…[D]etermining fair market prices using an auction is difficult for assets that are not clearly the same or very similar in quality—that is, when the seller has more information about the quality of the asset than the buyer does. In such cases, each auction participant will offer up assets with unique attributes known only to the seller, thus increasing the likelihood that the government will pay too much. That type of problem is likely to be particularly severe for assets like individual home mortgages or esoteric derivative products entirely owned by specific financial institutions.  Substantial purchases of such assets would make it unlikely that the Treasury could operate the proposed new program at little or no net cost. 

In other words, the more that the Treasury program concentrates on assets that are difficult for a buyer to value, the more likely that the government will overpay. The more that occurs, the more the program moves beyond simply reestablishing trading in illiquid financial markets and instead subsidizes the particular financial institutions selling assets to the government, at a cost to taxpayers…

So how to build in more “protection” for the American taxpayer?  Try to build in more of an equity stake (rather than just a debt stake) in these financial companies that are being rescued.  (I like how Paul Krugman yesterday explained on his blog how buying “bad paper” is not how the government normally rescues financial institutions.)  CBO explains there are alternative strategies that would try to give the government (and taxpayers) more claim to such equity:

Under some alternative proposals, the government would receive shares in an institution if it ultimately lost money on the sale of assets purchased from the institution…

[Or a]n alternative approach that is more directly aimed at addressing insolvency concerns is for the government to invest directly in financial institutions to strengthen their capital positions, without directly purchasing troubled assets…along the lines of the Reconstruction Finance Corporation, a Depression-era institution.

The testimony goes on to explain that these alternative approaches have their advantages and disadvantages, an illustration of the broader challenge of this federal bailout/rescue of the financial sector:  the “inherent tension between minimizing the costs to taxpayers and pursuing other policy goals.”

So it’s very difficult to guess how much this will ultimately cost taxpayers, or probably more likely, future taxpayers.   I don’t pretend to know, but I worry we shouldn’t necessarily take $700 billion as an upper bound, even with all the talk of the potential to get some money back to the Treasury over time.  There’s just too much uncertainty to (prudently) count on the eventual cost being much less than that.

8 Responses to “CBO Explains Why It’s Hard to Know How Much Taxpayers Will Pay”

  1. comment number 1 by: Jim Glass

    If the US followed any kind disciplined budgeting this up-to-$700 b (and the need to cover taxpayers from the cost of it via obtaining equity in the bailed out, or whatever) would be a big deal.

    But let’s be realistic. Compared to the >$40 trillion present value in unfunded entitlement obligations that start coming on budget in about 10 years, whether the final net cost of the bailout to taxpayers is $300 b or $500 b or whatever is little more than a rounding error on the nation’s liabilities … $500 b / $ 40 t = 1/80th.

    Since we actually budget this way, who cares about the small stuff?

    Arnold Kling asks, if the bailout was coupled with an immediate income tax increase collecting $700 billion present value of taxes to pay for it, would it have any chance of getting through Congress? — and suggests … probably not.

    And would Medicare as we know it have been enacted if current income tax increases sufficient to cover its cost on an actuarially sound basis had been attached to it? (As per Krugman telling the Asia Times that the US should be collecting 28% of GDP in revenue today, instead of only 18% — implying a 90% income tax increase).

    We all surely know the answer to that … and if there is any doubt consider how fast Congress repealed the long-term care benefit it added to Medicare (one seniors actually need) which it had the temerity to fund in part by attaching a small premium cost to Medicare … after it resulted in a mob of AARPers literally attacking Dan Rostenkowski in his car in the street.

    If a tax bill covering the cost of legislation is attached to it, maintaining real budget discipline, the voters get to decide whether that government expenditure is “worth it” to them or not.

    But Congress routinely acts as if the voters are incompetent to make such important decisions — on financial system bailouts, retiree entitlements, bridges-to-nowhere, whatever. So it doesn’t attach a tax covering the cost.

    Then because voters also are subject to the illusion that “debt is free” — if they don’t have to pay for such things now, they don’t have to pay for them — the spending bills sail through when otherwise, if paid for with taxes, they wouldn’t.

    Perhaps voters are incompetent to make cost-benefit judgments on such things — if you look at surveys of voter knowledge on the most simple political and economic basics, it’s hard to believe they are competent to judge anything.

    Be that as it may, this is how the political spending process actually works, and as long as this is the case it’s hard to see how any kind of systemic budget discipline is going to enter the system — short of a future financial crisis.

    I’ill note that that the idea that “debt is free” (at least in cases like this) is propagated even by PhDs in economics, such as

    What will the bailout cost the taxpayers?

    As I argued in my previous post, it will not cost today’s taxpayers anything. But what will it cost future taxpayers? I suggested in my last post that perhaps the government could roll over its debt indefinitely, and no taxpayers would ever have to pay it off….

    Yes, Virginia, when it comes to financing government bailouts of financial assets, there is a Santa Claus.

    When even experts are saying we can rely on the budget deficit Santa Claus, why would we expect politicians and voters to feel, and act, any differently?

  2. comment number 2 by: John Bailey

    Does anyone know how the $700 billion bailout relates to the previous bailouts of Bear Stearns, Fannie, Frieddie and AIG?

  3. comment number 3 by: B Davis

    Jim Glass wrote:

    I’ill note that that the idea that “debt is free” (at least in cases like this) is propagated even by PhDs in economics, such as…

    What will the bailout cost the taxpayers?

    As I argued in my previous post, it will not cost today’s taxpayers anything. But what will it cost future taxpayers? I suggested in my last post that perhaps the government could roll over its debt indefinitely, and no taxpayers would ever have to pay it off….

    Yes, Virginia, when it comes to financing government bailouts of financial assets, there is a Santa Claus.

    When even experts are saying we can rely on the budget deficit Santa Claus, why would we expect politicians and voters to feel, and act, any differently?

    I’m not familiar with knzn so, to me, he’s just some guy on the web who claims to have a Ph.D. in economics. Even if he does, to quote Shania Twain, “that don’t impress me much”. After all, Phil Gramm has a Ph.D. in economics.

    In fact, I think that his post is highly misleading. Throughout most of it, he truly does sound like he’s saying that the bailout is a free lunch. However, following is the final paragraph:

    Yes, Virginia, when it comes to financing government bailouts of financial assets, there is a Santa Claus. I should make clear, though, that Santa Claus is not omnipotent. He can come down the chimney and deliver a financial bailout on Christmas Eve, but he can’t make something out of nothing. If the government were to attempt some type of bailout that involved the production of large quantities of real goods and services, Santa Claus could only help to the extent that the economy had slack resources (as it does now and likely still will in the immediate future, but probably only a few hundred billion dollars worth, at most). When the economy runs out of resources, no bailout can make more of them.

    Reading carefully, he does seem to be admitting that this is the case only only to the degree that it makes use of “slack resources”. By “slack resources”, I assume that he is not referring to the $700 billion since there are plenty of good uses to which that could be put. I assume that he is referring to our financial system or the potential credit that the financial system could create, putting other “slack resources” to good use.

    However, I believe that even this is overly simplistic. There will likely be many “costs” to the bailout plan. They include not just the $700 billion (minus whatever is recovered) but also the potential moral hazard created if it is done incorrectly. As with all proposals, these costs need to be weighed against the benefits. These might include a deeper financial crisis which causes even more resources to be lost or idled. Hence, I think that speaking of the bailout as a free lunch is incredibly irresponsible. It’s an investment and, like all investments, it needs to be carefully considered. Calling it a “free lunch” implies that there is no cost and no careful consideration is necessary. In other words, nothing to worry our pretty little heads about.

    By the way, I did look more closely at the job growth under the two parties that we discussed earlier. I lagged the results as you suggested and that let me to conclude that I needed to look at job growth over entire business cycles. I posted the results at this link.

  4. comment number 4 by: Shannon

    I as a former student of Economics and someone who cares deeply about the problem of US debt (I have 2 small children), I absolutely LOVE your site.

    My husband and I were talking about the bailout and while it was primarily caused by the mortgage/housing mess, we were wondering if any portion of this could be attributed to the imbalance of trade - I believe somewhere about $500B/year? We are essentially exporting capital and importing goods and services and what seems like an ever-increasing rate. What role does has this played in the recent failures?

    OH - Just checked the Census Bureau - give or take $60B/month for 2008…make that around $700B/year.

  5. comment number 5 by: Jim Glass

    By the way…I lagged the results as you suggested and that let me to conclude that I needed to look at job growth over entire business cycles. I posted the results at this link….

    Thanks for the note.

  6. comment number 6 by: Jim Glass

    The WSJ (or at least a commentator there) joins the “it’s almost free” club….

    What’s the Real Cost of the Bailout?

    … .Let’s assume Hank Paulson gets his $700 billion appropriation. Let’s assume he then spends it all, immediately, buying up the financial toxic waste that is rapidly destroying the banking system.

    How much would that actually “cost” taxpayers?

    The Federal government pays just 4.34% interest on long-term, 30-year loans. So the government could borrow this money for 30 years at a cost of just $30 billion in interest per year.

    To put that in context, that is about one-fifth of 1% of our gross domestic product.

    One-fifth of 1%….
    [ WSJ]

    Why, that way $700 billon becomes almost ‘nuthin!

  7. comment number 7 by: B Davis

    Jim Glass wrote:

    To put that in context, that is about one-fifth of 1% of our gross domestic product.

    One-fifth of 1%….
    [ WSJ]

    Why, that way $700 billon becomes almost ‘nuthin!

    Ah yes, the magic of a credit card with no upper limit! Of course, since receipts are currently just under 19% of GDP, the interest cost would be just over 1% of receipts. That is, because of our little financial boo-boo, future tax payers will have to dedicate $30 billion of their annual receipts to paying this interest forever. Regarding our credit card with no upper limit, I recall the following quote from the Bill Moyers interview with former US Army Colonel Andrew J. Bacevich that I mentioned in my prior post:

    ANDREW BACEVICH: Well, we don’t live within our means. I mean, the nation doesn’t, and increasingly, individual Americans don’t. Our saving - the individual savings rate in this country is below zero. The personal debt, national debt, however you want to measure it, as individuals and as a government, and as a nation we assume an endless line of credit.

    As individuals, the line of credit is not endless, that’s one of the reasons why we’re having this current problem with the housing crisis, and so on. And my view would be that the nation’s assumption, that its line of credit is endless, is also going to be shown to be false. And when that day occurs it’s going to be a black day, indeed.

    As I mentioned, the interview can be found at this link. In addition, there’s a transcript of it at this link

  8. comment number 8 by: Jim Glass

    Larry Summers joins the “the bailout can be free!” brigade. Ever so appropriately, he says the Treasury’s buying those toxic bonds can be as safe and secure an investment as … buying a home!

    No one is contemplating that the $700bn will simply be given away… Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays….
    [FT ]

    ;-)

    (Although at the moment it looks like Congress has decided to rent.)