Briefing Room


Questions and answers with Professor Dale Oesterle

January 5, 2009 | Faculty

What lessons should we take from the federal government’s recent intervention?

Lou Jiwei is the head of China’s sovereign-wealth fund, a fund awash in dollars (over $200 billion) seeking to invest. Our current Secretary of the Treasury, Hank Paulson, recently went to China to encourage China to invest in the United States financial system. Lou Jiwei said no, bluntly.

Why? He has “lost confidence” in the United States government due to its lack of consistency in its actions and plans. He will wait. There are two very, very important lessons here. First, the United States government cannot itself bailout out or restart our economy – the government’s goal is to encourage voluntary private investment to come back. This simple point is lost on my colleagues at work, journalists who write about the market, and many, many economists who write editorials. The government’s job is to get private investment up and running – not to be the primary investor itself. The government can solve the problem only if it is not the sole investor, only if it is a stimulant to the private markets.

Second, our government has deterred voluntarily private investment from reentering the markets; its actions are doomed and silly. The most important three means of encouragement – certainty, more certainty, and maximum certainty. Our government is doing the opposite – backtracking, lurching, and sputtering. Wise people with cash will wait our zany government out – until it has exhausted itself and admitted defeat – and becomes predictable. Then they will get in.

What happened to the banking industry? Was it preventable?

The banking industry, fueled by below market interest rates influenced by the Federal Reserve, took on too much risk by accepting too much leverage in their lending and investment practices. Banks’ risk control practices and policies were lax. The lending bubble had its strongest effects in the real estate market, where banks borrowed money at low rates (in a variety of clever ways) to lend money on homes on the assumption that home values would rise. When home price fell and mortgage defaults rose, the banks’ equity suffered and they could not meet capital requirements for future lending.

What’s the benefit of letting companies go bankrupt?

A good litigator knows that to clients things look very, very different when they are in trial. During a dispute but before trial clients (and their lawyers) can spin and rationalize, moralize and condemn, but once they get in front of a judge things get very, very – well – real. Once through the process, educated clients get real in anticipation of being before a judge; inexperienced clients still need to test the fire at least once.

How do we get managers of failing companies to get real? To tell the truth? To make the hard decisions? Managers in the news in charge of struggling companies spin and rationalize until bankruptcy is staring them in the face. Moreover, most managers are “good time Charlie’s” – they have never been through a bankruptcy or been associated closely with a management failure. Jim Cramer has them on his show, they spin, and he throws darts at their pictures when their stock tanks.

Bankruptcy forces managers to get real. If we short circuit bankruptcy with government bailouts or some other form of legislated relief we short circuit the equivalent of trial for disputes – managers will never get real.

What parts of the bailout will most affect the legal community?

Lawyers will be involved in bankruptcies and litigation over failed business relationships.  But normal business lawyers depend on healthy business doing deals (in its broadest sense) to sustain a business practice and unhealthy businesses do fewer deals. Business practices all across the country will suffer until the business community rights itself.

Do you think the government action will work? Why or why not?

No. Any bailout depends not on government money alone but on the use of government money to stimulate private investment. Treasury has been too inconsistent in its decisions and the investment market cannot predict its actions. Less certainty means more risk to investors who will demand higher returns to get in the market. The higher returns are not there. Private investors will thus sit out until the government gets its act together.

What do you believe is the most beneficial part of what the government has tried to do?

The government’s actions to keep credit markets open are sensible. These actions include the government’s purchase of commercial papers and of its guarantees against defaults in existing money market funds holding commercial paper as well as more traditional moves to lower interest rates.