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 – WSJ.com:

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.