The case against the bailout

Jeffrey Miron:

Congress has balked at the Bush administration's proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the "troubled assets" of financial institutions in an attempt to avoid economic meltdown.

This bailout was a terrible idea. Here's why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

...

I think voters probably agree with Miron who is a Harvard economics lecturer. I understand his point, but it is hard for politicians not to do something. That is their first instinct and they are bent on following it even if voters think they are wrong.

What is really interesting is that no politician has really stepped forward and taken a position of leadership on this alternative which so many voters seem to support. Even in the vote today, the two parties are pointing fingers at each other rather than admitting they are following the wishes of their constituents.

That is some strange politics.

It seems clear that both candidates for President are in the limbo position and neither wants to step up to what the voters want.

Comments

  1. Agreed, it is bizarre that such simple economic reasons to have no bailout aren't being championed by anyone in congress. (There's a few Repubs who say things like this, but they aren't consistent.) I think it's because no one will go to the mat for businessmen, because businessmen are presumed to be immoral. And it does not help that investors like Buffett actually encourage a spike in central planning -- when it benefits their portfolios.

    The current price instability is the effect of not knowing day-to-day what the government is going to do. The government distorts the market just by threatening to distort the market.

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