The Market Approach to
the Financial Crisis and Recession
The
market approach to the present financial problems is to let the failed firms go
bankrupt. Firms should go bankrupt when they
do not have enough revenue and cannot borrow to pay their bills. There is absolutely no reason for the
government to support any insolvent firm.
The fact that the firm fails means it made bad decisions.
Banks
are firms that can go bankrupt. Banks
make money by borrowing from lenders at a low interest rate and lending to
borrowers at a higher rate. If a bank
makes bad loans and borrowers quit paying, the bank goes bankrupt.
Insurance
firms can go bankrupt too. They help
avoid risk, collecting premiums from everyone and paying those who have bad
luck. If the premiums collected by an
insurance firm are less than what it has to pay out, it goes bankrupt. Insurance policies sold to stockholders that cannot
be paid results in bankruptcy for the insurance company.
Bankruptcy
is a normal part of economic life, covered by laws that guarantee debtors and
then stockholders will be compensated as much as possible. In bankruptcy, the firm can have the chance
to reorganize and learn from its mistakes.
More efficient firms can take over what is left of a bankrupt firm and pay
for what can be put to productive use.
These payments go to bondholders then stockholders of the bankrupt
firm. There is no crime in bankruptcy
and it causes minimal economic harm.
When the largest US energy company Enron went bankrupt a few years ago there
was not even a ripple in energy markets.
Banks
and insurance firms should be careful lend and sell policies on the constraint
that revenue will pay their bills. The
present government backing, however, provides a soft cushion for failure allowing
banks and insurance firms to be less careful.
Increased government involvement will not solve the crisis.
Government
sponsored mortgage banks and insurance companies created moral hazard and
contributed to the present financial crisis.
Fannie
Mae is an failed government firm that provides backing
to mortgage banks, encouraging them to make bad loans, and making subsidized
loans to mortgage companies when they are short of cash. Freddie Mac is a government mortgage bank
that sells mortgages without the usual worry of making a profit given its
taxpayer backing. The government subsidizes
and more or less manages these two bankrupt mortgage banks with losses will be
paid by taxpayers. They go bankrupt and
the government should get out of the mortgage business.
The
government provides subsidized mortgage insurance letting commercial banks
relax and make loans to that people will not be able to pay. Government support elevated housing demand
prior to the collapse. Rising prices
made home buyers confident they could buy a house they could not afford and
sell it soon for a profit as long as that “greater fool” came along. Realistically, people should only buy a house
when they plan to live in it and can pay for it. Speculating on the future price of a house
can involve large gains but also large losses as some people learned recently.
One
result of government meddling in the mortgage market is that people have bought
houses they cannot afford. When prices
quit going up, these people are left owing more on
their house than it is worth and simply default on their underwater mortgages. With defaults the mortgage banks are left
without income. The present mortgage
mess is a result of government meddling and was a fundamental cause of the financial
crash.
One
part of the financial bailout is the government helping people who have not
been able to pay their mortgage. The
government is taxing those who have paid their mortgages and transferring the
money to those who have not, rewarding uneconomic behavior.
As
another part of the bailout, the US Federal Reserve will now make short term
loans to firms to meet payroll and other bills.
The Fed’s job is to control the money supply by printing money or buying
and selling bonds. Bankrupt firms will
be first in line to borrow such short term funds. It is easy for the Fed to make loans since it
is in charge of the money supply.
In
the bailout the Treasury also plans to buy a stake in the failed firms and
become part owner of the failed firms.
No private investor would buy interest in these failed firms.
The
underlying goal of the financial bailout is to keep a few Wall Street firms, mortgage
banks, insurance firms, and a car company or two in business. If these firms had gone bankrupt the economy
would have recovered quickly. Other
firms would step in and buy them out.
Wall Street is much less important now than in the past due to national
and global financial competition. Detroit
has lost its dominant position in the automobile industry, even in the US much
less worldwide.
Profit
motives in business are clear but government has no profit motive and can
collect taxes, print money, and borrow against future taxes to spend. Mortgage and other financial firms will now
have to wait to see what else the government does in the market. Uncertainty about future policy will delay
business decisions. Little private
activity will begin until the government makes clear what it is doing in the
financial and other markets.
It
is not too late to let markets operate.
Inefficient firms should simply go bankrupt. The irony is that the government is stepping
in to solve the problems it created. The
solution might work but the underlying disincentives in the mortgage and
insurance markets will worsen. Now the
rescued firms feel confident the government will not let them go bankrupt. The failed firms more or less belong to the
government. Increased government takeovers
and management will only prolong the economic crisis.