I have been consistent in opposing the “bailouts” that have been cropping up since about August of this year. I opposed the bailout of Bear Stearns, AIG, the auto industry, and the $700 billion bailout bill. One of my arguments against such a bail out is that we will set ourselves up for the next round of bailouts down the road. The logic goes something like this:
- Some firms are deemed to big to fail.
- The government, worried about the economy bails out these firms.
- The upper management of these firms now have less incentive to be prudent in their risk taking.
- Some time in the future, these firms will find themselves in a bind again due to their imprudent risk taking and expectation that the government will bail them out.
- Go back to step one.
Now some might argue, sure Steve, but who the heck are you, just some guy writing on a blog. Fine. How about George Akerlof, Nobel Prize winner in economics, and Paul Romer, a good candidate for a future Nobel Prize? Just a couple of guys writing on some blog?
Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.
Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values…
Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters’ current extractions with no regard for future losses….–emphasis added
Now some could argue, “Okay, good point, but if we don’t do something there will be lots of pain, so how about we do it this once then promise not to do it ever again?” Sorry, for this we can turn to the work of two other Nobel Prize winning economists, Edward Prescott and Finn Kydland who put forward an idea called time inconsistency. The idea here is that the optimal plan at the current time is no longer the desired plan at some future date. Now that sounds kind of odd, so here is an example from monetary theory/economics regarding the inflation/unemployment trade off:
Back in the 1960s and 1970’s economists (most notably Alban William Phillips, for whom this curve/relationship is named after) noted a relationship between unemployment and inflation. When inflation increased, unemployment went down. So the Fed would engage in counter-cyclical policy by tweaking the inflation rate via its various instruments controlling our money supply. However, eventually people figured out the price increases they were seeing were simply inflation, that is there was no real price increase.1 Once consumers and firms figured this out, the Phillips curve went vertical and increasing inflation left you simply with both high unemployment and high inflation…stagflation anyone?
So, if inflation is undesirable then the optimal policy is to set inflation to zero. However, if consumers and firms believe this policy, then at a later date the policy maker can increase inflation, reduce unemployment and make everyone better off. Sounds good right? Well, Kydland and Prescott pointed out that people (consumers and who run firms) are forward looking. As soon as they anticipate this kind of policy deviation, and they should since it is in the policy makers best interest2, then the improvement the policy maker wants to attain wont be attainable and neither is the zero inflation outcome either. We are in a sub-optimal situation.
Now we can apply the above reasoning to our problem with bailouts. If the government announces that there will be no more bailouts, forward looking and reasonable agents will not find this policy credible. Why? Because in the face of a similar crisis they know the government, even with a wonderful, kind and caring elected leader, will have an incentive to deviate from the initial stated policy in favor of bailouts. Lets return to Akerlof and Romer,
The S&L crisis in the United States leaves us with the question, why did the government leave itself so exposed to abuse? Part of the answer, of course, is that actions taken by the government are part of the political process. When regulators hid the extent of the problem with artificial accounting devices, when congressmen pressured regulators to go easy on favored constituents and political donors, when the largest brokerage firms lobbied to protect their ability to funnel brokered deposits to any thrift in the country, when lobbyists for the savings and loan industry adopted the strategy of postponing action until difficulties were so large that general tax revenues had to be used to address the problems instead of revenues raised from taxes on successful firms in the industry — when these and many other actions were taken, people responded rationally to the incentives they faced in the political process.
The S&L crisis, however, was also caused by a misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it could be. Thus, the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself.
Whoops, guessed they missed that one. We did repeat history. Will we repeat it again? Absolutely. Why? Because we have a government that utilizes discretionary policy that Kydland and Prescott noted is pretty much assured of repeating these problems.
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1More rigorously, the Phillips curved rested on the notion that people suffer from money illusion; an equal increase in all prices and incomes didn’t make people better off. That is, if we double all prices and double income people still have the same budget constraint. Suppose our initial budget constraint is,
P*X + Q*Y = I.
Where P is the price of good X, Q is the price of good Y and I is income. And suppose we double all prices as well as income.
2*P*X + 2*Q*Y = 2*I.
Which can be re-written as,
2*(P*X + Q*Y) = 2*I.
And now we can cancel to the 2’s to get back to our initial budget constraint,
P*X + Q*Y = I.
In other words, there is no reason for people to change their behavior and buy more goods because their income has doubled because prices have doubled too.
2Kydland and Prescott assumed a benevolent social dictator, hence this isn’t simply a problem of “getting the right guy” or political wheeling and dealing or having a bad elected leader.
