Financial Crisis and Public Policy

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This Policy Analysis explains the antecedentsof the current global financial crisis and criticallyexamines the reasoning behind the U.S.Treasury and Federal Reserve’s actions to propup the financial sector. It argues that recoveryfrom the financial crisis is likely to be slow withor without the government’s bailout actions.

An oil price spike and a wealth shock in housinginitiated the financial crisis. Declines instock values are intensifying that shock, threateningto deepen the current recession as U.S.consumers and investors cut their expen​di​tures​.An offsetting wealth injection from additionalrisk‐​bearing investors could initiate a quickerrecovery. Thus, supporters of government interventionjustify the bailout’s debt‐​financed fundinjections — in essence, they want to compelfuture taxpayers to join the group of today’s riskbearinginvestors.

However, the bailout is poorly designed andits implementation appears panicky — marked bya knee‐​jerk trial‐​and‐​error process that may haveheightened market uncertainty. Worse, currentinterventions in market processes and institutionscould become permanent, to the probabledetriment of the nation’s long‐​term economicprospects. With or without the bailout, theongoing recession is likely to be deep and long.

From a philosophical perspective, any bailoutaction provides a host of bad incentives.Moreover, we should be mindful that future generationsalready face massive debt burdens fromentitlement programs. Increasing those burdensby expanding the bailout program or enacting amassive fiscal stimulus will hasten the long‐​anticipatedcrisis in entitlement programs. Thus,the ongoing economic crisis could usher in permanentlyhigher taxes, greater governmentinvolvement in the private sector, and a prolongedperiod of slower economic growth.