In attempts to investigate further on this issue with minimal bias, let us rid ourselves of any possible attacks on credibility. Laffer may, in this instance, have failed to account for a variable or two. However, we know the man is no idiot. Similarly we have no reason to believe that current economic theories entail predictive perfection. Rest assured, to the contrary of what many believe, public intellectuals such as Laffer and Lavorgna (whom we'll be discussing in a moment) are indeed fulfilling their contributions to society as intellectuals. By maintaining opposing sides of a debate concerning the American public's well-being, both successfully bring to the table considerations which either side may or may not have taken into full account. By doing exactly this, intellectuals such as Laffer engage in what Stephen Mack would call "keeping the pot boiling."
What I'd like to draw attention to in particular, is Laffer's reappearance on Kudlow & Co. In an October 2008 reappearance, in answering one of Kudlow's questions, Laffer raised a critical point in a correspondence with Joseph Lavorgna, Managing Director and Chief US Economist for Deutsche Bank, Inc. In attempts to avoid any possible errors which may result from paraphrasing, let us frame their respective dialogue:
Host: Banks are worried about leverage ratios. If the government gives banks money at 5% and they have debt at 7-10%, won't they use the cheat money to retire their expensive debt and wouldn't that be prudent for shareholders?
Laffer: Sure it would, one of the problems was they didn't have enough capital per unit liability. And one of their problems is to build reserves to and part of it to build business. The real problem is government involvement in the banks.
Lavorgna: I fundamentally disagree with that. You wanted Freddie and Fannie to go under, and we would've been in Armageddon.
Laffer: When you bail someone out like Freddie or Fannie, you put someone else in trouble. [You would then] have to take from somewhere else. We're going to have to live with the taxes that this operation has done. The result from this is worst than anything Nixon did.
Taking a common sensical approach to this paradox, let us assume that the best decision is the one which will cause the least havoc to the least number of people. Therefore, decision X is better than Y if and only if X causes less financial distress to less people than Y. And indeed, the decision as illustrated in Lavorgna's and Laffer's dialogue is two-fold: Congress can either do absolutely nothing concerning the failure of certain banks, or Congress can authorize (as has been done) the Treasury to go through with liquid injections with the hope that assets can be recovered in the face of (every-body-crossing-their-fingers) strengthening consumer optimism.
The first option sounds easy in principle: the government does nothing and the free market tends to itself. Things can indeed work out that way. And hopefully, I'll find employment in less than 10 years. However, in avoiding Hoover's mistake, or at least trying to find more practical means to more efficiently remedy the situation, we try to further complicate the matter. Perhaps some sort of government interference (although Adam Smith or Milton Friedman may deem unnecessary) would indeed speed up the recovery process. Let us take this crazy notion, and turn it on all sides to see whether or not we can derive benefits which outweigh consequent costs.
A hypothetical plan would consist of 2 main courses of action: purchasing of distressed assets by the Federal Government, and the Treasury's injection of an upward of $700 billion liquidity into effected banks. An infinitude of possibilities may arise as a result of such a plan ranging from a best case to a worst case. At best, we can expect a minimal amount of purchases of bad assets (say 0) and a liquid transfer of any amount which would ultimately stir enough consumer confidence and optimism to restore pre-2008 housing values – which will essentially give support to the artificially inseminated $700 billion+ dollars. In this fantasy world, we can imagine that inflation will be minimal (as reclaimed assets will support the new capital) and the markets will resume with original pace, or somewhere near that. Hopefully, new legal restrictions will also be set in place to avoid encountering the same problem again.
We then try to come back to grips with the real world and the most probable outcome. Let us first visit a worst case, before mentioning all the in-betweens. If all goes bad, a 90%+ accumulated depreciation of all government-purchased assets (funded by citizen tax-dollars) will run up a tab that will have Americans paying socialist tax-rates for years to come. Alongside such a disaster, the capital injection can render itself wholly unbacked which most definitely would result in loss of purchasing power (exactly by the amount transferred to banks), which would further result in hyperinflation. Minimized disposable income and acute loss of purchasing power are two factors not embedded in a healthy economy. We can, in such a case, expect extreme economic hardship – possibly even worst than not having ever done anything at all.
The most likely scenario lies somewhere in between these two exaggerated possibilities. We now ask ourselves: all this being said, was Laffer right? The answer to this question is simple. Given our current predisposition and factual knowledge, we cannot yet know definitively. Some possibilities may arise which would ultimately deem Laffer correct in believing minimal government involvement with banks would be in the economy's best interest. This proposition is true in possible instances of hyperinflation and marginalized disposable income. However, if indeed consumer confidence can somehow be restored and some depreciation recovered, we can expect government involvement to cause a more favorable outcome. In either case, government interference entails risk with an outcome that can be actualized either way.
