Sunday, October 19, 2008

Bailouts accomplish the opposite of stated goal

Frank Shostak of the Ludwig von Mises Institute discusses the bailouts of Fannie Mae and Freddie Mac in his article Are Fannie and Freddie Too Big to Fail?

Leaving aside the obvious problem of moral hazard (in this case, foreseeable and widely exploited moral hazard), Shostak explains how the bailout actually causes more immediate damage to the economy than would allowing these institutions to fail,

"The view that some institutions are far too big to be allowed to go under is another fallacy. According to the popular way of thinking, if a large institution is allowed to go under, this could cause severe damage to the economy, since the failure of a large institution would generate large disruptive shocks. Since everything in an economy is interrelated, this means that a major shock could end up in a massive disaster.

In a market economy, a business that reaches the state of bankruptcy is most likely pursuing activities that do not contribute to real wealth but rather squander wealth, i.e., activities that make losses. Since such activities cannot support themselves, it means that real savings must be taken away from activities that do generate real wealth.


We can infer from this that a large misallocated business is too big to be kept alive rather than too big to be allowed to fail, as the popular thinking has it.

"The government intends to restore their cancerous creatures to "normalcy" with help from the Fed - which means they intend to continue the absurd "business" of insuring the uninsurable. The reason Fannie and Freddie failed is that they are fundamentally inviable businesses which were knowingly leveraged by the mortgage industry, foreign governments and others to create a massive misallocation of resources, knowing full well that they would be bailed out when the time came to pay the piper.

He also dispels the myth that US government debt will become worth less by not bailing out Fannie and Freddie than it otherwise would become:

"The argument that the government seizure of [Fannie and Freddie] prevented the downgrading of US Treasury debt by foreigners is suspect. The key factor that has been providing the high rating to US government debt is the perception that the US economy is still very wealthy. Every investor implicitly or explicitly holds that, without support from private-sector wealth, US Treasury debt would have been worthless.

As long as the economy still generates wealth, the government debt will be considered safe. Once the pool of wealth starts to shrink, foreign buyers of US government debt are likely to abandon the sinking ship, irrespective of government "rescue" plans. If the US pool of real savings is falling and the housing market remains depressed, then this will result in the US Treasury incurring large losses in order to maintain so-called credibility, i.e., by not allowing [Fannie and Freddie] to go under. Needless to say, this is likely to further undermine the pool of real savings and the process of wealth formation. We suggest that a less wealthy US economy is going to hurt all other economies through the channel of international trade."

In other words, regardless of how much the US government has degraded its status as a borrower through its destructive fiscal policies, further impoverishing the US economy by perpetuating the misallocation of resources that got us into the mess cannot possibly help.

These bailouts only serve one group: the politically well-connected, established players. Obama has (alone) called for the management and shareholders not to be bailed out, but we'll see how it actually goes down. The whole purpose of these actions is to bail out the politically well-connected, senior stakeholders in these firms. Somehow, I think Obama is either not going to be President, or if he wins, will have a revelation and suddenly realize that we cannot afford to punish our "most experienced" financial leaders by forcing them to bear their losses... it might hurt the market!

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