Bankruptcy, not bailout

At cnn.com economist Jeffrey A. Miron argues that Bankruptcy, not bailout, is the right answer to the current problems in the US financial markets. Miron is senior lecturer in economics at Harvard University ands one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan. In this article Miron explains why the plan is a bad idea.

He opens his piece by noting

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

Miron argues that any response to the crisis should eliminate the conditions that created the problems in the first place. What such a response shouldn't do is attempt to fix bad government with even more government. He writes

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

But keep in mind that bankruptcy doesn't mean the company disappears. What happens is that the firm is now owned by someone new. Importantly bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable. Contrast this with the bailout plan which transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending.

Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

Many of the more thoughtful advocates of the bailout will concede the moral hazard point, but will still argue that a bailout is necessary to prevent economic collapse. Their argument is that lenders are not making loans, even for worthwhile projects, simply because they cannot the capital to do so. Miron accepts that there is a grain of truth in this and that if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time. He goes on to note, however, that

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Miron further notes that the current credit freeze may well be due to Wall Street's hope of getting a bailout. Bankers will not sell their toxic assets for 20 cents on the dollar if the government might pay more than that.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should be done? Miron's answer is,

Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

He ends by saying,

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.