From a Forbes article:

"It's not based on any particular data point," a Treasury spokeswoman told Forbes.com Tuesday. "We just wanted to choose a really large number."

If that's not confidence-inspiring, I don't know what is.

chrisls asked me last week about the bailout and why I was unimpressed by it. Here is why I don't like it.

Generally, the discussion around the bailout from Paulson et al has focused on two things: the risks of doing nothing, and the benefits of his $700B plan. I think the risks of doing nothing are overstated, the benefits of the bailout are unclear, and the risks of the bailout plan are real and not at all acknowledged. This makes for a bad plan. Let me take those points in order.

There is definitely some risk in doing nothing. We may be in a recession, and are almost certainly headed for one if we're not. Tightening credit will absolutely contribute to that. People are making comparisons to the great depression, but that's highly overstated: one of the major causes (and maybe the major cause) of the GD was a 30% reduction of the money supply, but the Fed has powers that simply didn't exist back then to largely or completely mitigate money supply reduction. So already the risk is much reduced. The GD was also characterized by a sharp fall of GDP and rise of unemployment (to 25%!), but neither GDP no unemployment have changed much yet, and have a very, very long way to go to GD-like numbers.

The other thing that should be considered is the credibility of the messengers. Paulson and company have huge conflicts of interest in all of this; consider Paulson's rescue of AIG, in which Goldman benefited hugely, and the Goldman CEO was even present for the decision. Goldman, of course, being the firm at which Paulson spent his entire career. All of the top people at Treasury have deep connections to the places that will receive the largess in the bailout.

Not to mention the Bush administration's track record. The PATRIOT act was rammed through with threats of the dire consequences should we hesitate. Same with the Iraq war, which was based on shameless lies and bad intelligence, and where we only had to learn about the present real world, which is much easier than predicting what will happen in the economy. And like those other emergency initiatives, this gives vast and unprecedented power to the executive branch of the government. This is equivalent in size and scope to the Iraq war, and yet there's no time to talk about it? Is our economy so fragile that it can't limp along for another month? I don't think so.

But let's set all that aside. Let's say that the government officials want nothing but the best for the country and don't think about their conflicts of interest at all, and that indeed if we do nothing that we will see a serious recession.

It does not follow from that that this bailout will prevent those consequences.

It might help. Certainly it will cause the stock market to rise, as evidenced by the nice drop we all saw today when the bill failed to pass. But that in itself is pretty meaningless, since the stock market will like any $massive giveaway to corporations. The belief that it will help is based on the analysis of the very people who failed to see this coming, insisted every step of the way that things were ok, and in fact who enabled the problems in the first place by allowing 5 firms to leverage at 40:1 instead of the previous requirement of 12:1. It's not a coincidence that those are the institutions who are in the most trouble.

Anyway, predicting the future in the economy is hard; so hard, in fact, that basically nobody can do it with any assurance. So instead of doing even more analysis about the impact of the bailout, I'd like to consider incentives. After all, markets, like anything else even more so, are driven by incentives. If you offer someone a way to make money, they will. And if you tell them they can keep the profits from speculation but are insulated from the costs of failure, they will bet very big and very riskily.

Already the incentives are broken. For the individuals working at hedge funds or i-banks, they have every reason to ride bubbles and bet them hard. While the bubble is inflating, they are making commissions and bonuses and gaining a lot of personal wealth. They get to keep all that when things go south. This is theoretically mitigated by the fact that they work for a firm that really doesn't want to go bust, so there's some supervision (though it obviously doesn't always work: how many "rogue trader" stories have we heard in the last few years?). However, if you tell these firms that they are too big to go bankrupt, and that the government will step in and save them if they fail, now all the incentives are pointing in the same direction: inflate bubbles, takes as many risks as possible, reap the rewards, and avoid all the costs.

So even if this bailout does prevent a recession now, I believe it will encourage future calamities like this one. Remember that you can't rely on people to act responsibly. People respond to incentives. If you incent people to take crazy risks, many of them will. And here we go again.

Finally, this bailout is very expensive. It requires an outlay of $700B to buy assets at well above market price, and will return, in the end, the true value of those assets. If the government buys sensibly, then they may not lose much -- but they will be negotiating with the best in the world, and playing with the house's money, with a mandate to save the institutions with whom they are negotiating. This is not a good platform for getting good deals. And in fact, Treasury may be implying that they will buy the assets for what the banks originally paid, which, as you will recall, were horribly inflated bubble prices, thereby guaranteeing huge losses. And if there isn't a real market set up that responds to price signals, then there will be inefficiencies to exploit, and it will certainly be exploited to the detriment of the taxpayer.

So the government is going to lose a ton of money on this, even if they do everything right (and when was the last time that happened?). That is going to be financed by borrowing, which means higher taxes someday or higher inflation and a crappy dollar. If I were, say, China, I might decide that investing tons of money in US treasury bonds in order to enjoy being screwed by dollar inflation was a bad enough deal that maybe I should look to the Euro instead. And if that happened, the consequences would be much worse than the recession we're staring at right now.

My very last point is this: there are a lot of situations where meddling just makes things worse. The markets are very good at figuring out how much things are worth, and finding ways around problems. We have a lot of problems right now, but they'll sort themselves out eventually (and maybe painfully) if left alone. What we really need not to do is to enact a "cure" that is worse than the disease; that prolongs the suffering and problems now; that we can't afford; and that invites future recurrences of the disease.

And, just as a bit of an appeal to authority, here are a bunch of prominent economists from various parts of the political spectrum who sent letter opposing the bailout for some of the reasons I've outlined here. Also interesting reading is a blog entry by Nobel-prize-winning-economist Gary Becker about moral hazards of the bailout, among other things.