In Praise of Bankruptcy

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An MP3 audio version of this article, read by Dr.
Floy Lilley, is
available here
.

In one word, the market approach to the financial problem is bankruptcy.
Firms go bankrupt when they do not have enough revenue to pay their
bills. Banks make money by borrowing from lenders at a low interest
rate and lending to borrowers at a higher interest rate. If banks
make bad loans and borrowers quit repaying, banks go bankrupt.

Insurance
firms help people avoid risk, collecting premiums to pay those who
suffer bad luck. If the premiums collected by an insurance firm
are less than what it has to pay, it goes bankrupt. AIG sold insurance
policies to stockholders that banks and other firms would not go
bankrupt and could not pay the policies when that happened.

Bankruptcy is a normal part of economic life, covered by laws that
guarantee stockholders will be compensated as much as possible.
More-efficient firms move in to take over what is left of bankrupt
firms, buying what can be put to productive use. There is no crime
in bankruptcy and, if handled quickly, little economic harm. When
the largest US energy company, Enron went bankrupt a few years ago,
there was not even a ripple in the energy markets, much less the
economy. Bankruptcy is not criminal and should not be a surprise,
but it can be unnerving if large, well-known firms go bankrupt.

Banks and insurance firms are careful when lending or selling policies
because they want to ensure their revenue will pay their bills.
Government involvement, however, provides a cushion for failure
and allows banks and insurance firms to be careless. This carelessness
occurred with the government-sponsored mortgage bank, the Federal
National Mortgage Association.

Fannie Mae provides backing to mortgage banks, more or less encouraging
them to make bad loans. Fannie Mae makes 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 has taken over
these two losing mortgage banks, and losses will be paid by taxpayers.

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the rest of the article

October
30, 2008

Henry
Thompson [send him mail]
teaches economics at Auburn University.

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