Are Bailouts Necessary?

When discussing the role of government in the economy, bailouts come up quite often as a rationale for government intervention. I’d like to say a bit about that.

When businesses are very large, their failure can indeed send ripple effects through the economy–their suppliers, employees, customers, and others might find themselves trying to find alternatives. But generally the assets of bankrupt businesses are bought up by others who believe they can manage the assets better. That’s what the process of bankruptcy is supposed to be about–getting the assets out from under bad management, compensating the creditors to the extent possible, and getting the assets into a productive position again. Bailouts stop or delay that process. In other words, bailouts encourage a large mismanaged business to go on wasting resources, so that the short-term pain of a bankruptcy can be avoided. It’s not at all clear that this is economically helpful. And when large businesses get the message that they won’t really be allowed to suffer the full consequences of poor decisions, they tend to make more poor decisions. Economists call that moral hazard. And moral hazard can affect all large businesses, making their decisions worse even if they haven’t failed yet. This too means that the economy could be hurt by a bailout policy.

Some argue that the basic idea of bailouts is OK, but the execution of those bailouts is wanting. If there is a clear plan for repaying money, and for changes in management, then the bailout can be successful, it’s argued. But how is the government going to know what the best plan is? The government has no particular expertise when it comes to making financial decisions–in fact, there have been some well-publicized cases of government enthusiastically funding businesses that later go bust despite all the government help (Solyndra, for one infamous example; and the historical case of Japan’s MITI for another). In fact, the government is more likely to fail in its decision making than the private sector, because decisions are being made with at least one eye on what is politically expedient rather than what is economically efficient. Politicians ultimately care more about re-election than about the efficient use of resources. So it is unclear how government would be able to tell what companies should be salvaged and what companies probably need to go down permanently.

Here are some comments by Vern McKinley on the 2008 investment bank bailouts.

And here’s a 2013 speech by Charles Plosser, President and CEO of the Federal Reserve Bank of Philadelphia.