Fail Economics & You

Long answer: A bailout is usually suggested as a solution to market failure. In many cases a bailout can make a profit for the government from two perspectives:

1) From a pure monetary perspective a frozen/panicked/dysfunctional market places a premium on liquidity that is disproportional to the fundamentals involved. Considering the extremely long term time horizon that the government operates on, it is likely that purchasing these assets which have suffered large declines in current market price because of market failure will be profitable for the government in the long run. This was done in Japan in 2002 with shares and resulted in a large profit for the government as the shares were sold off over the years when prices recovered.

2) The purchase of the distressed assets themselves can lead to the avoidation of worse economic conditions. Both the psychological impact of the governments actions, the removal of "harmful" assets from the balance sheets of market participants and the lessening effect the purchases have on the magnitude of the excessive price decline of the asset in question (perhaps this could be called a reduction in volatility) all have positive economic effects. Furthermore these economic effects will benefit everyone, not just the ones being "bailed out". 

Stimulus packages on the other hand are just basically equivalent to robbing money from your child's piggy bank and then forcing them to pay back the robbed sum with interest. Stimulus packages are far too blunt an instrument to be used effectively in dealing with economic crisis's that have specific causes. While a bailout is also funded with debt, the bailout precisely targets the area where the economic disruption is being caused. A bailout also receives assets for its cash, assets which may even appreciate in value over the long term given the nature of such crises as stated above. A stimulus package in tax rebate form produces less spending than its issue amount and arbitrary spending itself will only very indirectly give any sort of relief in a crisis with specific identifiable issues. It is also questionable as to whether encouraging consumption for the sake of consumption is a good thing at all. Should we just go around smashing windows during an economic crisis so as to encourage window consumption? Also if one were to subscribe to Ricardian assumptions, then the populace may end up just saving the rebate money in the expectation of higher future taxes to pay for the current government deficit, therefore creating no real economic effect. 

A stimulus package involving deficit spending on public works or other government spawned activities will result in physical assets being created. But one must ask, if these works lacked enough merit to be undertaken by the government under normal budget constraints, then surely the return on investment or benefit to society from such constructs will in no way be able to match the great burden of public debt and the required interest payments thereof that they necessitate. Again as above, the stimulus to economic activity will be blunt and matched by a large issue of public debt which may itself create a large crowding out effect on the private sector.

Bailouts are economically effective and the moral hazard they create is greatly exaggerated and in my own opinion, non-existent in the case of equity confiscation. No market participant ever wants to be in a situation where they need to be bailed out. Fannie Mae and Freddie Mac were "bailed out" - their shareholders lost almost everything. It is absurd to say that, if market participants were put under the assumption that their businesses would be prevented from collapsing in the event of overwhelming losses by government nationalization at the expense of the vast majority of their equity position, that this would be an incentive to take excess risks. Businesses exist to make profit for their shareholders, they inherently abhor anything that involves massive destruction of equity value. A bailout and collapse are for all intents and purposes equally disastrous to a business with a fiduciary duty to shareholders. So long as a government receives equity for providing it's "bailout", there will be no significant moral hazard.

Thank you for your question - it provided a great "stimulus" to get me writing :)


> To: faileconomics
> Subject: bailouts
>
> http://faileconomics.posterous.com/nevar-forget
>
> So you oppose stimulus packages and support bailouts? (Just clarifying)