17 September 2008

Government Bailouts Reinforce Irresponsibility

The recent bailouts of Fannie Mae and Freddie Mac, not to mention AIG, are indicative of a government determined to keep foolish investers from learning the necessary lesson about the risks they took when the bought into these companies. In fact, the bailouts rescue the most foolish of the investors, the ones who didn't get out earlier when it was clear that there were problems.

While it is not new for the U.S. government to use taxpayer money to bailout the creditors of failing companies, it is a trend that needs to stop if we don't want to strengthen the existing moral hazard. No company is too big to let fail and there is no "optimal" moment in the economy to let companies fail.

It is understandable that the government wants to avoid letting big financial institutions fail in the hopes of stemming a trend, in order to bail out foreign investors (especially foreign government investors), and in order to avoid letting the derivitives on the books of some of those institutions establish the new market price by which comparable derivitives on the books of other institutions must be measured. All of these reasons are short-term delays in the inevitable purging of over-extended companies and poor investments. Such interventions serve the political imperitive to postpone the inevitable pain of foolish investments, but may well make it worse and more prolonged in the process by deepening the moral hazard.

The standard response in times of crises of "we need more regulation" doesn't address the more fundamental problem of not letting investors bear the full risk of their investments. No matter how much regulation there is, if investors can count on being bailed out by the government when things get bad, they will make risky decisions assuming that the government will never force them to bear the full risk of their investments. There is only one clean remedy, let poor investments be liquidated automatically by the market.