In Praise of Federal Loan Guarantees (Yep, Just Like Solyndra's)

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Karl Smith -- Assistant Professor of Public Economics at UNC-CH & Blogger at Modeled Behavior

Various forms of federal loan guarantees have come under attack, from clear industrial policy-like loans related to solar power to more mainstream corporate welfare in the form of the Import-Export Bank to vanilla social policy like student loans.

We may or may not question the wisdom of the federal government attempting to shape the future of US energy, rigging the game in favor of US manufactures, or pushing marginal college students to load up on debt. However, if we are going to do these things, it's important to recognize that loan guarantees are among the cheapest ways to do them.

Why?

Well, for one the United States has an incredibly low cost of credit. Lower in fact than any private organization on earth. If there were some way to handle the inevitable political corruption, it would make sense for the US government to act as a giant bank. Indeed, by using ever-rising debt to support unusually low tax rates, the US government does to a degree act as a bank.

By offering its good name to guarantee other lending ventures the government forgoes the revenues of a bank but provides much of the same service. It allows projects to be entered into which the principals could not afford alone.

This does expose taxpayers to risk. However, because of very unique features of the US government, it's especially low risk. For most lending institutions, the hardest risks to cover are high-beta risks. These are risks which swing wildly with the economy.

For example, I might loan money to a natural gas generator manufacturer and to a solar power manufacturer. One of these two technologies is likely to dominate but I am not sure which one. However, because I have loaned to both I have protected myself somewhat.

Yet, if the entire economy tanks and no power companies can raise money to add generation capacity of any kind, then I am screwed on both fronts. I can limit my exposure to the specific sector risks, but I can't limit my exposure to the entire economy.

The Federal Government is a bit different. The cost of borrowing money for the Federal government tanks exactly when the economy tanks. It is a negative beta borrower. That implies that precisely when things are at their worst, government credit is at its best.

So rather than facing terrible losses and the possibility of bankruptcy, as would a normal lending institution, the Federal Government has an easier time than ever.

Again none of this is to say that we should encourage government involvement in any particular market. Even if the financial costs are low, the temptation to specifically pick winners will be great. Yet, if the government is going to have these types of policies, then loan guarantees are among the cheapest ways to do it.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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