Some politicians and government officials are making reckless charges of greater financial turmoil in the absence of a bailout. These grossly irresponsible statements may cause short‐term market losses as investors try to second‐guess how other investors will respond, but the assertion that the stock market’s health — especially in the long run — depends on bigger government is belied by real‐world evidence. Japanese politicians made many of the same mistakes in the 1990s that American politicians today are considering, and the Nikkei suffered a lengthy period of decline — and remains today far below its peak level.
Proponents of a bailout also are trying to rattle credit markets by arguing that inaction will cripple commercial and household lending. Fortunately, there is little evidence of a freeze in credit markets, though the Administration’s rash rhetoric and the specter of a bailout doubtlessly are causing needless uncertainty and temporarily higher interest rates. Once the issue is resolved, one way or the other, credit markets will resume normal operations. The only question is whether capital allocation will be distorted — and long‐run growth hindered — by government intervention.
Providing government with enormous — and opaque — new powers is likely to exacerbate economic uncertainty and increase system‐wide risk. There is no need to incur this additional risk when the Federal Reserve and Federal Deposit Insurance Corporation have been able to deal with several major institution insolvencies (Washington Mutual, Wachovia, Bear‐Stearns, Lehman Brothers, and AIG) with existing authority.
Why The Bailout is Bad for America
- The bailout rewards executives and companies that made poor choices. Unfettered markets are the best generator of prosperity because people have incentives to make wise decisions. If an entrepreneur figures out a way to provide a valued good or service to others, he can become wealthy. But if that entrepreneur makes a mistake, he will suffer losses and maybe even bankruptcy. If investors put money into a well‐run company, they can increase their wealth. But if they put their money into a poorly run firm, the opposite can happen. In other words, market forces encourage people to make smart decisions so they can prosper. But it is equally important that people bear the consequences when they make wrong choices. Capitalism without bankruptcy (or losses) is like religion without Hell.
- The bailout will encourage imprudent risk in the future. The debacles at Fannie Mae and Freddie Mac, as well as the savings & loan failures from the late 1980s/early 1990s, are compelling examples of the negative economic consequences that occur when profits are privatized but losses are socialized. Faced with this perverse incentive structure, people engage in riskier behavior (analogously, if you are in Vegas, and somebody else is going to cover your losses, you obviously have an incentive to make bigger bets). A bailout would extend this risky behavior to the whole financial system, if not the entire economy.
- The bailout is bad for the economy. The unfortunate truth is that bad government policy has resulted in excess investment in the housing sector, and the inevitable reallocation of labor and capital is going to cause some economic dislocation. The good news, though, is that this process — if not hindered — will create a stronger and more vibrant economy. A bailout, however, will discourage this process and reduce economic efficiency. This may not seem important in the short run, since modest changes in the rate of economic growth are difficult to perceive. But in the long run, because of compounding, even small changes in the rate of growth can have a significant impact on living standards. Small differences in annual growth rates are why disposable income in the United States is substantially higher than disposable income in nations that practice economic interventionism, such as France, Germany, and Japan.
- The bailout repeats the mistakes Japan made in the 1990s. There are several historical episodes that indicate the dangers of government intervention to prop up a bubble. Japan faced a similar situation at the end of the 1980s, with real estate prices rising to absurd levels. The bubble then burst, but rather than let market forces operate, Japanese politicians sought to prop up both insolvent institution and asset prices. This interfered with the orderly reallocation of labor and capital, created considerable uncertainty, and contributed to a “lost decade” of economic stagnation. Another worrisome parallel is what happened during the 1930s. Policy mistakes such as protectionism (Hoover), higher tax rates (Hoover and Roosevelt), increased government spending (Hoover and Roosevelt), and increased intervention (Hoover and Roosevelt), helped turn a stock‐market correction into the Great Depression.
- The bailout will increase corruption in Washington. When politicians have more power over the allocation of economic resources, people have an incentive to play the “rent‐seeking” game of exchanging campaign contributions and hiring lobbyist in hopes of obtaining unearned wealth (or, more honorably, taking the same steps in hopes of protecting themselves from those seeking unearned wealth). The squalid mess at Fannie Mae and Freddie Mac was made possible in part because politicians received enormous amounts of money from advocates of the two government‐sponsored enterprises. If the government obtains power over financial markets, including the ability to steer money to particular firms, it will create a feeding frenzy of lobbying and influence peddling.
Government Caused the Turmoil in Financial Markets. One of the ironies of the bailout debate is that supporters think that more government intervention is the solution to problems caused by bad government policy. The main mistake was probably the Federal Reserve’s easy‐money policy. By creating too much liquidity and by driving interest rates to artificially low levels, the Fed set in motion the conditions for a housing bubble.