Government Bail-Outs: How I see things

First, let me make the case that someone could make for the government to be willing to give bail-outs:

The government can and should act as an insurer against systemic risk and uncertainty to the economy. In particular, not only should the government provide assistance during times of natural disasters, but it should be willing to "bail out" certain financial institutions during times of financial panic. The argument here is familiar: some institutions are "too big to fail." If one of these institutions fails, then the resulting loss of liquidity and general panic (perhaps because that failure would signal to other market participants that some underlying economic condition is substantially worse than previously thought) would cause people to flee from their medium and long-term financial commitments, thereby putting a great strain on all other financial institutions. In essence, the failure of such a large institution can cause people to fear that other institutions are likely to fail, which becomes a self-fulfilling prophecy as people run to get their money.

*If* the government is to have this role as insurer, then the risk is that financial institutions will make excessively risky and poor investments so that when those investments work in their favor, they profit, and when the investments flop, taxpayers share the losses. This is the common moral hazard problem. If you insure someone against a risky event whose probability of occurring can be affected by the person's actions, then the person is less disinclined to take those actions, thereby making the risky event more likely to occur.

The "solution": if the government is willing to bail-out financial institutions, then it must regulate them properly to reduce moral hazard. Most importantly, the government must insist on complete transparency in the institution's dealings, so that investors can accurately gauge the level of risk that the institution is taking on. In addition, the government should probably insist on reasonably tight capital requirements (such as in the case of banks, which must retain on hand a certain percentage of deposits) to prevent excessive leverage.

What I personally prefer:

There are several disadvantages to having the government bail out individual private companies. First of all, unless there are explicit contracts between the federal government and any institution that it is willing to bail-out (basically, insurance contracts), then we have a two-pronged nightmare: 1) The government, being in principle willing to bail-out any firm that is "too big to fail," deems it necessary to heavily regulate the entire financial industry, and perhaps other industries, in order to prevent the moral hazard problem discussed above. Of course, in doing so it is inevitable that the regulation would be inefficient, politically tainted, and would reduce innovation and productivity in those industries, and 2) Big firms still manage to make investments that are unsound or excessively risky in nature while simultaneously being unable to make certain sound investments due to clumsy regulation, thereby spreading excessive risk onto the average investor along with sub-par performance. All of this leads me to oppose these sorts of government bail-outs.

Here is what we should do instead (subject to me learning more in the future)...

1) The government should require a drastic increase in transparency in our financial markets. The current asymmetries of information between investor, lender, and borrower are, in my opinion, the primary cause of the current credit crisis. In the mortgage market, many people were allowed to purchase homes without proof of income, and then their mortgages were repurchased by a Bear Stearns or Fannie Mae, bundled with other mortgages, and sold to third party investors. Normally, the initial bank would face the consequences of not knowing the buyer's private information about his or her ability to make payments on the loan. However, when the bank can then sell the mortgage to an unaccountable and huge government-sponsored enterprise like Fannie Mae, which has little incentive to manage risk since it knows that it is "too big to fail," the bank can shift the risk onto the eventual third-party investor who has no real idea just how much risk is inherent in many of the mortgages he just purchased (and, for that matter, does not really care since he too knows that Fannie Mae is too big to fail).

2) The government should cut loose Fannie Mae and Freddie Mac, and it should aggressively seek to ensure that our financial markets are as close to "perfectly competitive" as they can get. In essence, the government should do what it can to prevent, or at least minimize, the very existence of firms that are "too big to fail." The health and stability of our financial institution should not rely on a handful of firms, and instead of having firms that are "too big to fail," we should have firms that are "too little to matter." In principle, this does not actually mean that most financial firms would be small. Far from it. It simply means that the government should do what it can to lower barriers to entry into the financial industry, should reform and aggressively prosecute its antitrust laws, and should allow the process of creative destruction, unimpeded by monopoly or manipulation, to do its work.

3) The government should still in some capacity be lender of last resort. There are two main reasons for this. In the first case, the government as LLR can reduce the occurrence of what are called "sunspot equilibria." A sunspot equilibrium is where people in the economy have a belief that something will happen, react accordingly, and by reacting in that way actually cause the event to happen, even if it would not have otherwise occurred. A bank panic is a standard example of this. People fear, for whatever reason, that their bank will fail, so they run to the bank to withdraw their money, which in turn causes the bank to fail. If the government can credibly insure people against the risk of bank failure, then people will not run on the bank if they hear that it may fail, thereby making it less likely for the bank to actually fail. However, if the government is to do this, then it should also institute regulations to avoid the moral hazard problem that was previously discussed. According to economist Ricardo Caballero, "ex-ante policy recommendations typically center on prudential risk management. For example, in many analyses there are externalities present that drive a wedge between private and social incentives to insure against a financial crisis episode. Then, ex-ante regulations to reduce leverage, increase liquidity ratios, or tighten capital requirements are beneficial."

The second main reason for the government to be lender of last resort is to deal with economic situations of great uncertainty which are of a nature not previously seen. In these situations, people do not have any prior experiences or adequate models to reference, and are therefore more likely to react as if they are in a "worst-case scenario."

Once again, according to Caballero,

"an important dimension of the crisis is that there is uncertainty about outcomes. Agents cannot refer to history to understand how a crisis will unfold because the historical record may not span the event space. In such a case it is unclear whether any entity, either private or public, can arrive at the appropriate ex-ante risk management strategy, calling into question the feasibility of these policy recommendations. Instead, in our uncertainty model, the most beneficial ex-ante actions are ones which help to reduce the extent of uncertainty should a crisis occur. In some cases, this may simply involve making common knowledge information that is known to subsets of market participants – for example, making common knowledge the portfolio positions of the major players in a market."

To read Ricardo Caballero's paper titled "Collective Risk Management in a Flight to Quality Episode," go here.