The Case for Doing Nothing

The only plausible argument for bailing out banks crumbles on close examination.

The first thing to note about the financial crisis is that the federal government never had any business intervening in the personal decision of whether you want to own a home. There is no rational economic argument, or any argument I know of, that says the market of buying and selling homes is imperfect in some way, requiring government action. Construction firms have plenty of incentive to build homes and sell them. People who have the wherewithal have plenty of incentive to buy homes if they so choose. For the government to intrude into homeownership was an off-budget, nontransparent, backdoor attempt at redistributing income. And when the policy became a way of transferring income to people who couldn’t afford those homes, it was doomed to failure. 

This provision of risky debt to low-income homeowners was exacerbated by a second misguided federal policy: the longstanding practice of bailing out private risk taking. Although this has gone on for decades in the U.S. and other countries, the Federal Reserve played a special role during the tenure of former chief Alan Greenspan. The Fed’s implicit and almost explicit policy before the housing crash was to say to the financial markets: “Don’t worry about the fact that there’s a bubble. We’ll lower interest rates and keep them low enough to prevent a collapse in asset prices.” This logic, broadly applied, was commonly called the Greenspan Put. The Federal Reserve was basically selling the market an option for getting out comparatively unscathed when things turned bad. The result has been a widely held assumption that market actors would not have to bear the full losses from their own risky behavior.

When people try to pin the blame for the financial crisis on the introduction of derivatives, or the increase in securitization, or the failure of ratings agencies, it’s important to remember that the magnitude of both boom and bust was increased exponentially because of the notion in the back of everyone’s mind that if things went badly, the government would bail us out. And in fact, that is what the federal government has done. But before critiquing this series of interventions, perhaps we should ask what the alternative was. Lots of people talk as if there was no option other than bailing out financial institutions. But you always have a choice. You may not like the other choices, but you always have a choice. We could have, for example, done nothing.

Unfair in the Short Term, Inappropriate in the Long Term

By doing nothing, I mean we could have done nothing new. Existing policies were available, which means bankruptcy or, in the case of banks, Federal Deposit Insurance Corporation receivership. Some sort of orderly, temporary control of a failing institution for the purpose of either selling off the assets and liquidating them, or, preferably, zeroing out the equity holders, giving the creditors a haircut and making them the new equity holders. Similarly, a bankruptcy or receivership proceeding might sell the institution to some player in the private sector willing to own it for some price.

With that method, taxpayer funds are generally unneeded, or at least needed to a much smaller extent than with the bailout approach. In weighing bankruptcy vs. bailouts, it’s useful to look at the problem from three perspectives: in terms of income distribution, long-run efficiency, and short-term efficiency.

From the distributional perspective, the choice is a no-brainer. Bailouts took money from the taxpayers and gave it to banks that willingly, knowingly, and repeatedly took huge amounts of risk, hoping they’d get bailed out by everyone else. It clearly was an unfair transfer of funds. Under bankruptcy, on the other hand, the people who take most or even all of the loss are the equity holders and creditors of these institutions. This is appropriate, because these are the stakeholders who win on the upside when there’s money to be made. Distributionally, we clearly did the wrong thing.

From the perspective of long-run efficiency, the question is also relatively straightforward. By the end of 2005, it should have been apparent that the U.S. economy was fundamentally misaligned. We had significantly overinvested in housing and significantly underinvested in factories, plants, and equipment. In effect, we needed a recession: a period to readjust the balance between the different types of capital.

More broadly, failure is an essential aspect of free markets. Failure shows capitalism is working, because it means resources are moving from bad uses to good uses.

There are other long-term problems with the bailout approach. Bailouts create moral hazards going forward, meaning market players will be more inclined to take excessive risks. Bailouts encourage inappropriate goals, such as propping up insolvent banks. Bailouts give the government ownership stakes in these institutions, which means that politics, not economics, is going to decide where these firms invest in the future. And bailouts set the wrong precedent for other industries.

The Only Plausible Argument

There is therefore only one reasonable argument for choosing bailouts over bankruptcy. Bailouts might make sense if bankruptcy imposed an externality—an unwelcome spillover effect. The argument for that goes as follows: When a given bank fails, it loses intermediation capital, or the ability to make loans. Any given bank knows a particular sector of the economy, a particular region of the country, or a particular kind of loan market. So if that bank fails, that specialized knowledge gets destroyed; therefore, at least in the short term, no one can easily make that kind of loan.

If that happened to one bank, you’d say it was no big deal; there are plenty of banks that have lots of knowledge. But if one large bank fails and defaults on obligations to lots of other banks, forcing some of them to fail, you might worry that contagion could lead to a lot of intermediation capital disappearing in a short period of time.

That story sounds somewhat plausible. But it has two key weaknesses, one theoretical and one empirical.

The theoretical weakness is that if a bank fails but its assets and its employees are bought by another bank, there is no reason for the intermediation capital to disappear. It just gets transferred to someone else. If you think that the good ideas for making productive loans are in the brains of the people of the failed bank, those people are probably going to go work at some other financial institution—a hedge fund, an insurance company, another bank. So you’re not necessarily going to lose all the intermediation capital as a result of the failure. Indeed, the failed bank’s employees may be put to work in more productive ways.

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  • ||

    I'm quite surprised that a CATO fellow is on the Harvard faculty. I thought that school was completely overrun with pinko rat bastards of the Keynsian orthodoxy. I guess there might be some hope for that school yet.

    -jcr

  • SpongePaul||

    Doing nothing would have been the only const. and the only American thing to have done, not stepping in like communist russia and spending taxpayer money to prop up failed dinosaur PRIVATE companies.

  • ||

    heh...the "do-nothing" approach applied to DC...we'll call it the "Tao of Congress".

  • ||

  • ||

    Is there a greater name in the universe than Elmo Studd?

  • IceTrey||

    Illuminati or incompetence?

  • Invisible Finger||

    The Legislative and Executive branches have done shitloads of stuff that adds up to less than zero.

  • mark||

    If only they had given the people what they wanted back in 1994 we wouldn't be in this mess.

  • </||

    How stupid is this?

    Everyone knows doing nothing was not an option.

  • ||

    I'm no economist, and what Jeffrey Miron says about doing nothing sounds appealing and all, but I was under the impression that doing nothing was already attempted. Wasn't Lehman Bros. allowed to fail and it sent such shocks through the worldwide financial industry that the government had to step in to stop further such shocks? Am I completely out to lunch on that one?

  • yitzhak arod||

    Well, I suppose if we had to do something, we could always try the Chinese method: having a couple of irresponsible CEOs rounded up and publicly shot as a warning to anyone else who wants to try these shenanigans. Short of that, though, I don't see why we needed to do anything else then, and I see no reason to do anything else now either. If anything, we should be actively doing nothing: that is, trying to prevent other people from "doing something" about the crisis. Specific examples: tell GM's executives to go to hell if they come begging for money, and send in riot police to crack a few heads if UAW protests over plant closings get too rowdy. Recession is when your neighbor loses his job, Depression is when you lose yours, and Recovery is when every "activist" and "community organizer" loses his.

  • kilroy||

    Recession is when your neighbor loses his job, Depression is when you lose yours, and Recovery is when every "activist" and "community organizer" loses his.



    I'm going to steal that.

  • DJF||

    Actually doing nothing is not what would have happened. Existing bankruptcy and other laws would have been applied and incompetent/crooked banks would have gone out of business and their remaining assets sold off to pay creditors. Failed business practices would have been exposed and repudiated.

    Instead the incompetent/crooked banks were bailed out and even today the FED and Treasury are attempting to prop up failed practices that got the economy into the mess its in.

    As to shock waves, that is what is suppose to happen when you lose trillions of dollars. It is the feedback that the free market is suppose to learn from. Instead the only thing the banks have learned is to make sure they control the politicians and media

  • ||

    Grr.. I munged the link above.

    Here's Tom Woods on "Why you never heard of the great depression of 1920":

    http://www.youtube.com/watch?v=czcUmnsprQI

    -jcr

  • Bruce Majors||

    You simply don't understand how Keynesian policy works.

    Paul Krugman has a nice power point presentationon it he did for the other 6 dwarves:

    http://www.chilloutzone.de/files/player.swf?b=10&l=197&u=ILLUMllSOOAvIF//P_LxP92A42lCHCeeWCejXnHAS/c

  • Some Guy||

    If elected, I would burn down the headquarters of Fannie & Freddie, and sow the ground with salt. I would require seppuku by the CEO of a bank as an application fee for a bailout. All applications would be denied. Every piece of legislation that had anything to do with "promoting home ownership" or "preventing foreclosure" would be repealed. I would tack on so many more requirements for TARPed up banks that they'd pawn their office supplies to try to pay the money back.

  • johnny john john||

    Stimulus money is not meant to to just help the economy. It is meant to help people; its a form of socialism to give disaster relief to people when an economic disaster strikes. It is not made to be efficient.

    In short: Liberals, democrats, and people in control don't give a shit about the economy. It's about the end goal: Keeping their constituents and voters happy by giving them relief.

    Maybe the economy would do fine without stimulus. But more people would suffer in the short term without it. That is why stimulus exists!

    Yes the bailout may not have been necessary. Disaster relief for Katrina was not "necessary". I'm sure everyone there deserved what they got when they didn't have hurricane insurance or whatever. But the gov't greedily redistributed wealth there to those black guys in New Orleans, huh? What an injustice! They deserved to die in the hurricane for their stupid mistakes for staying! (If you can't tell I'm being sarcastic...)

  • A T||

    You give it to that straw man, johny boy!

  • johnny john john||

    A T: yah you got me I didn't really read the article I just skimmed it. My bad. But there still are plenty of libertarians opposed to the stimulus...

  • Some Guy||

    Disaster relief for Katrina was not "necessary".

    At least giving out trailers and ATM cards doesn't cause hurricanes. Past bailouts helped cause this mess, and the new ones are going to cause another meltdown in a decade or two that makes this look like good times.

  • johnny john john||

    Some Guy: Maybe you're right, maybe you're not. We'll see when the future comes.

    Then again, maybe giving out trailers and ATM cards do cause hurricanes. Have you heard of the butterfly effect? Well this wasn't a butterfly, this was billions of pounds of equipment moving in and out of Louisiana. Point is that it's hard to prove your assertion "Bailouts will cause another meltdown". It's hard to predict the future.

  • Some Guy||

    If the government would cover say 50% of your gambling losses but let you keep all your winnings, would you find yourself at the casino more often? I certainly would. Now explain how that is different from what is happening now, or why that wouldn't cause lots of people to gamble.

  • johnny john john||

    Some Guy: I guess that's a valid analogy. I feel the difference is that it is "common knowledge" that you can never win at gambling in the long run and that the house has advantage for pretty much every single game. For most people in the world, they will lose in the long run in gambling. The state would be foolish to cover gambling losses.

    However, unlike gambling, the state has a vested interest in encouraging MORE business, not LESS. Thus providing a safety net to business when times are tough is not a poor policy choice. When more people start gambling in business because of stimulus money or the promise of a safety net, economic activity increases.

  • ||

    Financial crisis...caused by bankers pumping loans to pump their own bonuses. Apparent failure to understand that the business model of a bank is to loan money and GET PAID BACK.
    Securitization of said "loans" rated by "bond raters" that is required by law(moodys, fitch, S & P)that rated these "securitized" bonds triple A, even though they were 750K loans to farm workers who made 14K.
    What to do.
    Give money to the crooked irreponsible idiots who ran the banks and brokerages that got us into this mess. Keep the same dunces at the FED. Don't prosecute anybody (at a bank or a brokerage - thank God for Madoff, who ripped off 1 penny for every million lost by AIG)
    Banks: Sounds good to us!!!

  • ||

    I wonder why we keep sidestepping much larger problems in the mortgage crisis. Creative mortgages (ARMs, interest only, 50-year loans, etc) allowed the housing market to do an end-run around supply and demand. If no one can qualify for a 30 year (or less) fixed rate mortgage to buy your home, then the price you are asking is too high. The market would have long ago corrected itself. But everyone involved made money either in interest or in fees for services for approving people who had no business buying a home or worse people who had no intention of living in that home and saw it only as a way to make a quick buck. I love making a quick buck myself but it was lunacy to believe (and plenty of us did not) that these kinds of price increases were sustainable. At some point the bubble was bound to burst. Add to that the securities based on loans that were given for no other purpose but to supply those securities (another part of the story not mentioned nearly enough) and the crisis was an inevitability.

    I was for the bailout. I regret that now because the same people are for the most part still in charge and haven't learned a thing. Do whatever you want. Take whatever risks you want and not only will the government bail you out when it goes bust, you'll still get your 30 million dollar bonus. People only learn from mistakes if there are consequences to those mistakes. Otherwise they will keep doing the same thing over and over again.

    No more.

  • Jesus||

    "For the government to intrude into homeownership was an off-budget, nontransparent, backdoor attempt at redistributing income. And when the policy became a way of transferring income to people who couldn't afford those homes, it was doomed to failure. "

    That's preposterous conspiracy theory nonsense blathered by the Rush's of the wing nut claptrap world. The banks weren't forced to give people that couldn't afford them home loans. There is no such law. The deregulation lead to exactly you might expect and exactly what the big banks and their government servants wanted. Stealing. We were stolen from and the "bailout" and followup "stimulus" package are just more of the same theft from scum bags that would be fearing a guillotine if this were late 1700's.

  • abercrombie milano||

    My only point is that if you take the Bible straight, as I'm sure many of Reasons readers do, you will see a lot of the Old Testament stuff as absolutely insane. Even some cursory knowledge of Hebrew and doing some mathematics and logic will tell you that you really won't get the full deal by just doing regular skill english reading for those books. In other words, there's more to the books of the Bible than most will ever grasp. I'm not concerned that Mr. Crumb will go to hell or anything crazy like that! It's just that he, like many types of religionists, seems to take it literally, take it straight...the Bible's books were not written by straight laced divinity students in 3 piece suits who white wash religious beliefs as if God made them with clothes on...the Bible's books were written by people with very different mindsets...in order to really get the Books of the Bible, you have to cultivate such a mindset, it's literally a labyrinth, that's no joke

  • nfl jerseys||

    bstgs

  • nike shox||

    is good

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