Editor’s note: Jeffrey A. Miron is senior lecturer in economics at Harvard University. A Libertarian, he was one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan. Economist Jeffrey Miron says the bailout plan presented to Congress was the wrong solution to the crisis CAMBRIDGE, Massachusetts (CNN) – Congress has balked at the Bush administration’s proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the “troubled assets” of financial institutions in an attempt to avoid economic meltdown. This bailout was a terrible idea. Here’s why. The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk. Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared. This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle. Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets. Don’t Miss Bailout plan rejected Financial rescue 101: the bill Commentary: Financial crisis a disaster In Depth: Commentaries The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government. The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company. Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable. In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy’s allocation of its financial resources. Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time. Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen. Further, the current credit freeze is likely due to Wall Street’s hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents. The costs of the bailout, moreover, are almost certainly being understated. The administration’s claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion. If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth. The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients. Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets. So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending. The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.
Pffff… another nutjob from a podunk university spewing villanous lies and innacuracies.
virgin: keep up the good work…your commentary is one of the only reasons I still occasionally visit this place…just thought you could use a little appreciation.
Yeah, well it is a bogus article by someone who thnks we’re stupid. a) The gov’t bears responsibility because of the way it handled FNM and FRE in 1977 and then in the 1990’s, and thus can’t be trusted for a solution? My father who bears my last name has wrecked untold numbers of cars and spent more on speeding tickets than my education. Does that mean I can’t be trusted to drive? (Ans: No, but I still can’t be trusted to drive). b) “Bankruptcy does not mean the company disappears” but it sure destroys wealth at frightening rates and diverts wealth to fairly unproductive places like lawyers. c) “Talk of Armageddon, however, is ridiculous scare-mongering” Nice strawman. The only person I have heard use the term Armageddon to describe this is him. d) “If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.” Gouman wants to buy them. They won’t let him because he doesn’t have the money. Try this out at your next investment committee meeting “They are getting crazy high prices right now for CDS on Alt-A CDO tranches. Those mortgages suck, but the default rate is nowhere near as high as the CDS implies. We should sell some”. e) " The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients. " The piece voted on by Congress didn’t. I suggest that we not say that we won’t do a bailout because Washington can’t do legislation without riders. f) “abandoning the goal of home ownership independent of ability to pay” Whose goal is that? Another stupid strawman g) “The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that.” Even Sarah Palin knows that.