Government Bailout is Wrong Solution

Jeffrey A. Miron is a senior lecturer in economics at Harvard University. He is a Libertarian and was one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan. His commentary, entitled Bankruptcy, Not Bailout, is the Right Answer, was published today at CNN.com and the American Future Fund, an organization that advocates conservative, free market ideals.

The latest bailout plan that was voted down yesterday would have authorized $700 billion for the U.S. Treasury to purchase “troubled assets” from Wall Street financial institutions. Miron argues that this bailout proposal was a “terrible idea” and explains why. First, however, he explains how we got ourselves into this mess.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

After pinning the blame squarely on failed government policy, Miron correctly reasons that it is unwise to let government do more of the same in the name of recovery.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

Miron then builds a case for allowing financial institutions to declare bankruptcy which would mean their creditors would own the remaining assets.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

He argues that bankrupcy is superior to a government bailout because it punishes foolishness and protects taxpayers.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy’s allocation of its financial resources.

Miron admits that this process would be ugly and could make the credit situation worse before we would see improvement. However, he argues that “talk of Armageddon” is “ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.”

Miron also suggests that the current credit freeze conditions we’re seeing is “likely due to Wall Street’s hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.” I agree that good market-based alternatives are probably being overlooked in the hopes of a more favorable (in the short run, at least) government rescue.

So that’s the problem. Now for the solution. What should government do? Miron writes:

Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

Miron concludes that someone will have to pay for these mistakes but it does not have to be the U.S. taxpayer. I couldn’t agree more.

I don’t trust the government to fix this mess when their non-market-based policies were what created the problem. Undoubtedly any bailout plan would be filled with unnecessary spending and loaded with benefits for special interests. No big government, no bailout!