Bailouts Making the Crisis Worse?

Economic policies often have unintended consequences. While the decentralized actions of individuals in the market can effectively coordinate the supply of goods – Adam Smith’s invisible hand – centralized government actions cannot. So, when market crises come about, it is important to ask certain questions before looking to government to correct the failure.

First, was it a failure of decentralized actors? Was a market failure, or irrational speculation, at the root of the problem, or was it government intervention that caused it? The financial markets have not been free of regulation, and they have been bailed out before. Those companies most regulated were the ones that led the crisis. Similarly, in countries with even more regulated and state owned financial sectors, the crisis has taken down those nationalized firms.

If it was intervention that caused the problem, then there may be no need to tie the hands of the market to prevent future crises. Instead we could roll back the interventionist policies we’ve been using, potentially allowing firms more flexibility to solve market failures on their own. Even the most benign regulation might prevent the market from innovating, adapting and spurring growth. Literally throwing money at the problem, and then seizing companies at will, cannot solve the underlying problems.

Second, it is important to ask both what would happen without bailouts and what is likely to happen with them. Many commentators simply consider the first, and have a doomsday scenario, but they have not considered carefully how the bailing out itself might cause both short term, and of course long term, damage. In the short term some say that the bailouts “are actually making it harder for financial firms to raise the money they need to muddle through the credit crunch.”

Further intervention is likely to make it worse if intervention caused the crisis in the first place. In the long run you have serious moral hazard problems – this is well known. Trying to dodge some of these problems, the Fed is being inconsistent in its bail out policy. Playing favorites is a well loved perk of discretionary policy making because it allows for rent-seeking by firms and politicians. With bail outs and subsidies, bad firms and bad investments are propped up like petty dictators, serving themselves but not the people. All this waste is laid at the foot of the tax-payer.

Finally, if we create a crisis through use of intervention and then respond to the crisis with more intervention, which in turn makes the crisis worse, and then respond to that crisis with yet more intervention – when will it ever stop?

As CNN reports, “This is the federal government's most far-reaching intervention in the financial markets since the Great Depression of the 1930s.” It will cost hundreds of billions now, and much more later, if it causes more crises down the road. So, it is critical that we ask: do we need these bail outs, and what are we setting ourselves up for?