Moral Hazard, For Real

26 July 2008 at 10:09 pm 4 comments

| Peter Klein |

I suppose I posted a whimsical item about moral hazard because I was too angry to write anything about the Financial Irresponsiblity Bailout and Reward Act of 2008, the moral-hazard story of the decade. Buy more house than you can afford? Sign a mortgage contract you can’t understand? Invest in risky mortgage-backed securities that lose money? Run your financial institution into the ground? Don’t worry, the hapless US taxpayer will pick up the tab!

I have nothing but contempt in my heart for all who asked for, drafted, and voted for this odious piece of legislation. If there were any doubt that the US is, in many ways, a socialist economy, this massive socialization of financial-market risk should put such doubts to rest. Capitalism, requiescat in pace.

Entry filed under: - Klein -, Bailout / Financial Crisis, Classical Liberalism, Institutions. Tags: , .

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4 Comments Add your own

  • 1. Joe Mahoney  |  27 July 2008 at 7:11 am

    From a knowledgable and reliable source I understand that doing nothing would lead to massive bank failures the consequences of which could be catastrophic. Thus, I posit that doing nothing is not an option. As a transaction costs scholar who looks at remedies from a comparative, institutonal perspective. what would you suggest be done, instead? As the saying in politics goes: “You can’t beat something with nothing.”

  • 2. Peter Klein  |  27 July 2008 at 8:23 am

    Joe, a fair question. But I can’t say I agree with your knowledgeable and reliable source. The “too big to fail” argument is far, far too elastic and easily manipulable. Remember Chrysler in the 1980s? The airlines and insurance industry after 9-11? Indeed, it seems that every large firm and industry in the US has an implicit government guarantee against failure. After all, if Industry X were to go down the tubes, there would be a massive ripple effect with catastrophic, economy-wide effects. Piffle! This is nothing more than special-interest pleading on the part of industry X. (Hazlitt’s chapter “Saving the X Industry” from _Economics in One Lesson_ spelled this out pretty clearly in 1946.) I mean, think about the Organizations and Markets blog. If our readership were to fall below a critical level, we could go down — and imagine the catastrophic ripple effects throughout the blogosphere! Federal subsidy, please!

    Now, to answer your question more directly: First, a complete comparative-institutional analysis must include intertemporal considerations. The bank bailout means (or, depending on you you ask, _may_ mean) a reduction in foreclosures and bank failures in the short term, followed by a massive misallocation of resources in the long-term, the result of the implicit guarantee against the consequences of imprudent lending and investment behavior (indeed, depending on how widespread the guarantee is perceived to be, any economic behavior whatsoever). What you call “doing nothing” could result in higher short-term adjustment costs (of liquidation and reinvestment) followed by fewer disruptions down the road. Which is more efficient?

    Second, by “doing nothing” I take you to mean “having no centrally coordinated, federally mandated and funded, government-imposed solution.” But private parties are free to craft remedies to these problems on their own, on a case-by-case basis. In the absence of a government solution, lenders can renegotiate contracts with borrowers; financial institutions can be liquidated, acquired, or otherwise restructured; and so on. In short, market participants can make their own adjustments. A proper comparative-institutional analysis should compare this solution to a one-size-fits-all, taxpayer-financed, politically crafted solution. Which do you think is likely to come out on top? :-)

  • 3. David Hoopes  |  28 July 2008 at 11:24 pm

    Fannie Mae and Freddy Mac are supposed to help more people become homeowners. However, it’s not clear they really help with this. Further, a good deal of money ends up in the hands of those who already are pretty well off.

    They spend a good amount of money on incumbent politicians and a good deal of money to rather liberal political groups. Pretty odd behavior for government agency to spend taxpayer dollars supporting politicians who vote on its bylaws etc.

    The bill costs about $300b and an April report by Standard & Poors estimates the bailout will end up costing taxpayers $1 trillion.

    They take in massive amounts of money, they are insolvent, they spend more money than any other government institutions on political spending (no. 1 and no. 2).

    I don’t know that they can be dumped in one fell swoop. However, the recent congressional bill gives the treasury enough to keep them floating while allowing F&F to make more and larger loans. As Peter notes, people who have made poor decisions are off the hook completely at a large cost to the tax payer.

    All of this happens off the government’s balance sheet because F&F are owned by shareholders.

  • 4. Rob Thomas  |  29 July 2008 at 5:28 pm

    I also am disgusted at Wall Street’s making investments that they know in the longer term will fail and require government bailout. Though I am not an economist I believe that part of the inherent efficiency in the theory of free market capitalism is that bad decisions should end in negative results. If not, then inefficiencies (bubbles, etc.) will develop and cause much larger problems than if the failed strategies were simply let to fail. Regarding the sub-prime meltdown, there were debates six or seven years ago amongst the participants about the huge long term risks. I worked in finance for one of the Fortune Ten and was involved in those discussions. Many folks determined that there was little risk in holding those collateralized (sp?) mortgage bonds as the government would have to guarantee then in a collapse. There is an old saying that if you owe the bank a little money it is your problem. If you owe the bank a lot of money it is the bank’s problem. If the problem is too big for the bank, then we the taxpayer must pay.

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