Why the Bailouts are a Bad Idea

I have been consistent in opposing the “bailouts” that have been cropping up since about August of this year. I opposed the bailout of Bear Stearns, AIG, the auto industry, and the $700 billion bailout bill. One of my arguments against such a bail out is that we will set ourselves up for the next round of bailouts down the road. The logic goes something like this:

  1. Some firms are deemed to big to fail.
  2. The government, worried about the economy bails out these firms.
  3. The upper management of these firms now have less incentive to be prudent in their risk taking.
  4. Some time in the future, these firms will find themselves in a bind again due to their imprudent risk taking and expectation that the government will bail them out.
  5. Go back to step one.

Now some might argue, sure Steve, but who the heck are you, just some guy writing on a blog. Fine. How about George Akerlof, Nobel Prize winner in economics, and Paul Romer, a good candidate for a future Nobel Prize? Just a couple of guys writing on some blog?

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values…

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters’ current extractions with no regard for future losses….–emphasis added

Now some could argue, “Okay, good point, but if we don’t do something there will be lots of pain, so how about we do it this once then promise not to do it ever again?” Sorry, for this we can turn to the work of two other Nobel Prize winning economists, Edward Prescott and Finn Kydland who put forward an idea called time inconsistency. The idea here is that the optimal plan at the current time is no longer the desired plan at some future date. Now that sounds kind of odd, so here is an example from monetary theory/economics regarding the inflation/unemployment trade off:

Back in the 1960s and 1970’s economists (most notably Alban William Phillips, for whom this curve/relationship is named after) noted a relationship between unemployment and inflation. When inflation increased, unemployment went down. So the Fed would engage in counter-cyclical policy by tweaking the inflation rate via its various instruments controlling our money supply. However, eventually people figured out the price increases they were seeing were simply inflation, that is there was no real price increase.1 Once consumers and firms figured this out, the Phillips curve went vertical and increasing inflation left you simply with both high unemployment and high inflation…stagflation anyone?

So, if inflation is undesirable then the optimal policy is to set inflation to zero. However, if consumers and firms believe this policy, then at a later date the policy maker can increase inflation, reduce unemployment and make everyone better off. Sounds good right? Well, Kydland and Prescott pointed out that people (consumers and who run firms) are forward looking. As soon as they anticipate this kind of policy deviation, and they should since it is in the policy makers best interest2, then the improvement the policy maker wants to attain wont be attainable and neither is the zero inflation outcome either. We are in a sub-optimal situation.

Now we can apply the above reasoning to our problem with bailouts. If the government announces that there will be no more bailouts, forward looking and reasonable agents will not find this policy credible. Why? Because in the face of a similar crisis they know the government, even with a wonderful, kind and caring elected leader, will have an incentive to deviate from the initial stated policy in favor of bailouts. Lets return to Akerlof and Romer,

The S&L crisis in the United States leaves us with the question, why did the government leave itself so exposed to abuse? Part of the answer, of course, is that actions taken by the government are part of the political process. When regulators hid the extent of the problem with artificial accounting devices, when congressmen pressured regulators to go easy on favored constituents and political donors, when the largest brokerage firms lobbied to protect their ability to funnel brokered deposits to any thrift in the country, when lobbyists for the savings and loan industry adopted the strategy of postponing action until difficulties were so large that general tax revenues had to be used to address the problems instead of revenues raised from taxes on successful firms in the industry — when these and many other actions were taken, people responded rationally to the incentives they faced in the political process.

The S&L crisis, however, was also caused by a misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it could be. Thus, the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself.

Whoops, guessed they missed that one. We did repeat history. Will we repeat it again? Absolutely. Why? Because we have a government that utilizes discretionary policy that Kydland and Prescott noted is pretty much assured of repeating these problems.
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1More rigorously, the Phillips curved rested on the notion that people suffer from money illusion; an equal increase in all prices and incomes didn’t make people better off. That is, if we double all prices and double income people still have the same budget constraint. Suppose our initial budget constraint is,

P*X + Q*Y = I.

Where P is the price of good X, Q is the price of good Y and I is income. And suppose we double all prices as well as income.

2*P*X + 2*Q*Y = 2*I.

Which can be re-written as,

2*(P*X + Q*Y) = 2*I.

And now we can cancel to the 2’s to get back to our initial budget constraint,

P*X + Q*Y = I.

In other words, there is no reason for people to change their behavior and buy more goods because their income has doubled because prices have doubled too.

2Kydland and Prescott assumed a benevolent social dictator, hence this isn’t simply a problem of “getting the right guy” or political wheeling and dealing or having a bad elected leader.

FILED UNDER: Economics and Business, Government, , , , , , ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. odograph says:

    I think this deserved a bold as well:

    Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

    Done artfully, the perpetrator is retired 3-4 years before it hits the fan, and the bailout becomes a question.

  2. odograph says:

    (Cynics might note that if done REALLY artfully, the principal has moved to a government oversight job.)

  3. raoul says:

    Classic macro-economic theory should have been applied during the last eight years. It was not which has contributed to current problems. It is a little late to tweak the problems among the humongous disaster we have in our hands. One of the problems of economic theory is that it does not take into account popular will. If there is no will to implement what would be “proper” policy, then one must come with alternate functioning theories. All I hear now is essentially reverting to a modified 19th Century laissez-faire model; but for good reasons, there is no political will to do that. Let’s be clear: old fashion economists are advocating that people need to suffer more; well, that’s a hard sale considering the well off have done like bandits (pun?) the last twenty years, the national income has grown commensurately but the living standards among the majority has at best stagnated. And now the princes of wisdom want people standard of living to degrade. I hope we have better economists; otherwise, we are heading straight to a socialist republic. The economic class lost much of its credibility by subscribing to supply side lunacy, and it seems they are still in the asylum.

  4. Steve Verdon says:

    Done artfully, the perpetrator is retired 3-4 years before it hits the fan, and the bailout becomes a question.

    Does Howell Raines fit that description?

    (Cynics might note that if done REALLY artfully, the principal has moved to a government oversight job.)

    A reverse Madoff? Heh, now that is disheartening.

    Classic macro-economic theory should have been applied during the last eight years. It was not which has contributed to current problems.

    What do you mean “classic macro-economic theory”? Neo-classical growth models? New Classical economics? Neo-Keynesian?

    I’d argue that most of the Bush Administration was characterized by Neo-Keynesianism. Mankiw is probably best described as at the very least sympathetic to that view of macro-economics. The tax rebates and cuts fit in well within the Neo-Keynesian paradigm.

    One of the problems of economic theory is that it does not take into account popular will. If there is no will to implement what would be “proper” policy, then one must come with alternate functioning theories.

    This makes no sense. There is no will for a “proper policy” hence we have to jettison a perfectly fine theory? What?

    All I hear now is essentially reverting to a modified 19th Century laissez-faire model; but for good reasons, there is no political will to do that.

    Actually it is the opposite. Obama is a technocrat and he will fiddle with the economy just as Prescott and Kydland posit in their seminal paper “Rules Rather than Discretion: The Inconsistency of Optimal Plans”. Even Bush, the supposed Arch-Fiend, has admitted to sacrificing free market principles to “save the economy”.

    Let’s be clear: old fashion economists are advocating that people need to suffer more; well, that’s a hard sale considering the well off have done like bandits (pun?) the last twenty years, the national income has grown commensurately but the living standards among the majority has at best stagnated.

    The evidence is far from conclusive on this. If you look at things like wages, yes they have been stagnant, even income has shown at best weak growth. However, in looking at consumption data the story is different, and consumption is probably a better way of measuring standard of living. Then there are issues like health care expenditures and income…is income stagnant becuase health care is sucking up all the productivity gains made by labor? And something that is probably of secondary importance is immigration, especially illegal immigration, to the extent that illegal immigrants are captured in official data, we’d want to account for that.

    And now the princes of wisdom want people standard of living to degrade.

    No. Standards of living may degrade, but that is not the desired result, although it might be the result of a policy of not bailing out these various corporations. And is your argument really for corporate welfare?

  5. You know Steve, your fundamental problem seems to be that you don’t have a handy set of simple conclusions and built-in biases before you begin.

  6. Randall Flagg says:

    I think Steve’s fundamental problem is not seeing the obvious- bail out the companies and punish them.

  7. raoul says:

    Steve: I appreciate your straight response to my rant. 1- I guess we are all neo-Keynesians now. Actually, I think Greenspan and the rest applied Keynesian principles in a manner that was not predicted by JMK which lead to several speculative bubbles as the cheap money looked for places to park. I would call it unnecessary stimulated hyper-growth. 2- I do not believe there is one absolute best solution to the economic problems, the different proposals compete against each other in the economic and political arena. You are correct that those in the administration (now and the next- but not before BB) are more of a technocrat variety- my criticism is directed to those outside who allowed the situation to deteriorate (we needed more Krugmans!) and now profess religion. And as to the standard of living falling- thsi should not even be an issue- the consumption pretext was recently applied to justify the ongoing shennigans- the collapse of the housing market is a direct result of believing this stuff. But fundamentally it really is scary- how can a country create so much wealth in twenty years while leaving a majority behind. That is what needs to be fixed.

  8. Steve Verdon says:

    I think Steve’s fundamental problem is not seeing the obvious- bail out the companies and punish them.

    What? How? This makes no sense. Do/would you do this with your children? Go to your room, oh and here is a cookie.

    Raoul,

    More Krugmans….*shudders* I don’t think granting corporations monopoly power is the solution at all.

  9. Countries don’t create wealth. Free people create wealth. Tethering us all together so no one can get very far in front of anyone else doesn’t work, no matter how many Krugman’s advocate it.

  10. odograph says:

    Actually Charles, man in nature is not a free individual in the sense of American myth. We are a social species, and before there were nations prosperity was in context of a tribe.

    Oh! And fairness issues span other social species … that was an earlier thread here, wasn’t it?

    (I’m all for rationality, but sometimes with bailouts & etc., we shouldn’t be surprised my a merely “human” response.)

  11. Randall Flagg says:

    What? How? This makes no sense. Do/would you do this with your children? Go to your room, oh and here is a cookie.

    Never mind. Your fundamental problem is understanding basic concepts. Bailout != cookie, or at least it doesn’t have to.

    And yes, parents bail out their children (Mr. Smith, here’s the money for the window Johnny broke) and punish them (Johnny, you’re grounded and you’ll do chores to pay me back) all the time.

  12. Steve Verdon says:

    Never mind. Your fundamental problem is understanding basic concepts. Bailout != cookie, or at least it doesn’t have to.

    A bailout certainly isn’t a punishment, and it mitigates the costs of imprudent risk taking behavior, at best an implicit reward if nothing else.

    And yes, parents bail out their children (Mr. Smith, here’s the money for the window Johnny broke) and punish them (Johnny, you’re grounded and you’ll do chores to pay me back) all the time.

    Two things here. First, parents are usually financially liable for the damages their children cause. These are goddamned children, but adults who were making their own decisions. They made bad ones, reckless ones in part due to ignorance of the impact of new financial instruments, but also because of the second reason; government has signalled previously a willingness to bail out companies in the past.

    The failure to understand is not mine, but yours. You can’t grasp the basic premise here: continuing to bail people out creates and incentive for them to not behave prudently. Parents do this. If their child breaks a window at 10, yes they pay the costs then punish the child. However, after a certain age the child is often left to their own devices…either that or you end up with a 42 year old who acts like a 10 year old.

  13. Steve Verdon says:

    Oh and the market can punish these corporations such as GM and Chrysler. Its called bankruptcy. If it is merely bad management, but a fundamentally sound business model, then you reorganize and toss out the old management. If it is a bad business model then you liquidate. The market is a regulator too. A firm either succeeds or it doesn’t and ceases to exist. The latter is the only real punishment…anything else creates perverse incentives.

  14. Actually Charles, man in nature is not a free individual in the sense of American myth.

    WTF? Over. I’m not sure I have the time to reach semantic agreement with you on words like freedom, much less American or myth.