How the bailout has made things worse

Yale economist Jonathan Macey shows how the government bailout plan has contributed to the panic on Wall Street and to the crisis in the finance sector. The Treasury’s quick action immediately undercut all confidence in the free market and then put measures into effect that would prevent the free market from exercising its usual corrective mechanisms. From The Government Is Contributing to the Panic –

By the time the bailout package was passed, market sentiment had darkened to mirror the government’s own pessimism about the ability of markets to play a salutary role in repairing the fractured capital market. The notion that the government rather than the private sector can create a market for distressed bank assets seems particularly misguided.

The solutions being implemented also send the message that resources devoted to risk management are wasted. All of these plans reward the financial institutions that acted like lemmings by chasing the mortgage-related debt bubble rather than rewarding the financial institutions that exercised restraint and risk avoidance and independent thought and action. This unfortunate “heads Wall Street Wins, tails America loses” economic policy is wholly inconsistent with the principles of personal and corporate responsibility that are essential to a functional free market.

Firms like Merrill Lynch that took decisive steps to deal with their problems now look like suckers, as do banks that watched their leverage ratios and paid diligently into a deposit insurance program that offers protection on a far smaller scale than their investment banking rivals are getting for nothing. . . .

The Bear Stearns bailout, the restrictions on short-selling and the government’s new $700 billion commitment to buy toxic mortgage-based assets all share the same fundamental flaw: They prevent the market from imposing discipline on banks guilty of massive over-leveraging and excessive risk-taking. Moreover, they punish prudent managers who invested conservatively, kept their companies’ debt at reasonable levels and worked hard to raise new capital when necessary. The SEC’s attack on short-selling punishes savvy traders who invested resources and effort in identifying companies with too much debt and unrealistically valued assets.

Letting markets work is messy and costly. Nevertheless, the only sensible way to deal with the current crisis is to force the companies who created the mess to bear at least some of the costs of their mistakes. Most of all, if the markets are to get back on track our regulators must put an immediate stop to their current practice of publicly demonizing the markets and work to restore confidence in the system.

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  • “The Treasury’s quick action immediately undercut all confidence in the free market and then put measures into effect that would prevent the free market from exercising its usual corrective mechanisms.”

    This is being demonstrated, on-going, in the stock market. There is no turn-around. People who lost 20 to 40 percent are not getting that money back for quite a while (1 to 5 years), if at all. As a result, people have cut back severely on non-essential spending. The ripple effects of the bail-out will go out for a few years (3-5).

  • WebMonk

    He pretty much nailed it in one.

    Even IF the Bailout had been a good idea from a straight financial standpoint (it wasn’t), there’s the law of unintended consequences that the government seems to be so expert in using to get the worst possible result.

    We’re talking about a problem which involves, at a bare minimum, $50 Trillion. Those sorts of issues can’t be solved by throwing a bit of money at it – they have to be dealt with by systemic changes that shift the way everyone deals with finance.

  • Bruce

    What is confusing, and perhaps someone can straighten me out, is what the government seems to be doing is imitating actions that appeared to have worked in the past. One negative example is how government dithered before the Great Depression, taking action too late to stop the downward spiral in markets around the world.
    The positive example is the 1980’s Savings and Loan crisis, which appears to have been handled in much the same way as this crisis is being handled, and which ultimately–note that word–turned out right.

    Is it too early to be making any kind of judgment on the markets and how they are reacting to the bailout?

    I too am sympathetic to the notion of letting the market sort itself out. So, as I said, this is a confusing situation.

  • [Reply to Bruce]

    How do you determine whether an action worked or not? It cannot be merely that “We did x, and afterwards, y resulted.” That would be the post hoc. propter hoc fallacy. There has to be argument as to why the effect came from the cause. And it has to be convincing.

    To believe that Roosevelt’s spending got us out of the Depression requires a real leap of faith. Did the wealth come from nowhere? Can anyone really argue that if it had not been taxed away it would have produced no increase in wealth? That those who held it would have been so inept with it that there would be no benefit from it? I am more inclined to think that it would have been invested better, and conditions would have improved more rapidly. (The case has also been made that it was bad interventions during the Hoover administration that got us into the mess. In a freer market, there would have been smaller corrections earlier that would have kept the crisis from happening. Paul Johnson’s Modern Times makes that case.)

    What does it mean that the government intervention in the 1980 crisis ultimately turned out right? That suggests that if the market ever recovers, the government automatically gets the credit. In short, the only situation in which the government could be faulted would be if they acted and the market NEVER recovered. By that logic, you could prove the beneficial effects of any action.

  • PT Ben

    we needed to do a “work it out” instead of a bailout. the gov’t could have ‘loaned’ the money to people for liquidity sake but make the companies hold on to their paper. the pay back to the Treasurey could have been the loan, expenses, and 2-3 % so the taxpayers get some interest back on their loan.