The Cult of Bailout

What single word best characterizes policy responses in this on-going financial crisis? "BAILOUT".

Yes, this applies to Canada too. We just threw $9.4 billion into the European bailout plan via our role in the IMF.

It goes something like this. You take a lot of risk and reap lots of rewards (be it in pay, bonus, or social programs). You get into trouble. The government bails you out.

How often have we seen this same story repeating? It seems like we are in an infinite loop.

But we aren't. This cannot last forever. The bailouts have many implications - some seen immediately and some will play out later.

On the positive side, bailouts buy time and short-term stability. Importantly, we see the results immediately. A good example was the big jump in world stock markets when the EU announced its 750 billion Euro bailout.

On the negative side, the list is longer. Also importantly, you do not see the results immediately. Here are a few of the implications:

1. Moral hazard. When you reward people for taking risk or going beyond their means, you will perpetuate this type of behavior in the future. That is, the cost of the bailout is not just the immediate cost but also the cost of new future bailouts that become more likely as a result of the current bailout.
2. Throwing good money at bad. We tax the productive assets to support the failed assets. Whether it is the U.S. government throwing away money on GM, Fannie or Freddy, or the German people paying for unrealistic social programs in Greece, the effect is identical. This reduces future growth opportunities in the productive economies. Think of it this way. Would you prefer to invest in a U.S. tech start up that is risky or buy some overpriced Greek assets.
3. We have to pay for it. It is naive to think that we can simply roll over debt forever. This is exactly what Greece thought. Please note that the size of the U.S. government deficit to GDP is not much different than Greece's. [However, to be fair, the U.S. is in a much stronger starting position - but does face some similar risks.] Government debt financing competes with corporations trying to raise money. Corporations are forced to offer higher yields as more and more government debt floods the market. Increased borrowing costs means that fewer investment projects are viable. Less corporate investment leads to lower growth opportunities and lower long term growth for the economy in general. Lower growth means a smaller number of jobs.
4. Who are we really bailing out? Yes, the EU package has drastically reduced the cost to the Greek government (and other peripheral countries) of financing their debt. However, the main beneficiary are the banks and investment funds that hold the sovereign debt. They foolishly overpaid for this debt. Effectively, they thought Greek sovereign debt had the same risk as German debt. That was their mistake. However, the bailout makes them whole. That does not make any sense to me. They made a mistake and they are made whole. Remind you of AIG? Yes. It is the same thing. People that did business with AIG misestimated the "counterparty risk". But no big deal. The government will make you whole.

I have some other thoughts.