When facing a major financial problem, it is not uncommon to face the temptation to do something foolish at best or something evil at worst. Our elected officials and un-elected monetary and financial authorities are on the brink of doing both. Although the House of Representatives defeated the initial proposed $700 billion bailout of the American financial sector on Monday, Treasury Secretary Paulson vowed to work with Congress to save the bailout plan.
The financial bailout is a gigantic rip-off and must be stopped. All U.S. taxpayers are on the verge of being looted to bail out financiers that made a bunch of bad investments. This bailout is morally wrong and in the long run will only harm the prospects of economic prosperity.
The economic problem we are in is ultimately due to capital malinvestment encouraged by government intervention in the money and banking system, including a Federal Reserve that has engaged in irresponsible inflation via credit expansion after the tech-stock bubble burst and after the terrorist attacks of 9-11.
In order for our economy to return to sound footing, the bad investments already made must be liquidated. In other words, firms that cannot survive financially must be allowed to go bankrupt. This is what happened after the recession of 1921-22, which was sharper and deeper than the recession of 1929-30. However, we don’t read of the Great Depression of the 1920s because markets were allowed to adjust, bad investments were liquidated, and the economy recovered in about a year. Later, Presidents Hoover and then Roosevelt did not allow this to happen in the 1930s and the agony was prolonged, turning a recession into the Great Depression.
The same story played out in Japan during the 1990s. There they had the roaring 1980s, much of which was financed with inflationary credit expansion. The malinvestment chickens came home to roost in 1990, but the Japanese government and the Bank of Japan did not allow the liquidation process to take place and loads of bad debt were frozen in place on bank balance sheets, so they experienced their own Great Depression of the 1990s.
If a bailout proposal manages to go through, the bad debt held by American banks will be bought up by the state at artificially high prices and it will be up to government bureaucrats to liquidate the bad debts and sift the financial wheat from the chaff. There is no reason in the world to think that a state bureaucrat can value assets more correctly than entrepreneurs who are risking their own capital. Remember, the government that now claims almost Gnostic wisdom regarding asset values is the same government that created the mess to begin with through intervention in the financial system.
Additionally, any bailout adds to the moral hazard problem in financial markets by verifying again what people only assumed might be the case before: Commercial banks and investment houses can issue as many loans of whatever dubious quality they want, because if things go bad, the government will bail them out. So much for the free-enterprise system.
We should also ask, just where is the $700,000,000,000 going to come from to pay for this bailout? When the government spends money, it has only three options for financing: The U.S. government would either have to increase taxes to pay for the whole $700 billion (which directly impinges on capital accumulation, worker productivity, and standards of living), borrow the $700 billion (which takes that much investment capital out of the hands of productive entrepreneurs and foists the payment burden on our children), or inflate the money supply by that amount (which will further raise prices, decrease the purchasing power of the dollar, and set in motion another phase of the business cycle). Or, as another option, the goverment could do some combination of the three.
None of these are good options. The best thing to do is let the firms that are in trouble because of bad investments go bankrupt and allow the market to adjust. There will be pain for sure, but the world will not end, and no one would be robbed. Productive assets would find their way into the hands of wiser entrepreneurs. The economy would get back to a firmer foundation and on the way to building prosperity.
Dr. Shawn Ritenour is an associate professor of economics at Grove City College, contributor to the Center for Vision & Values, and adjunct professor at the Mises Institute in Auburn, AL.