100% Reserves Now

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economic policymakers stand at a crossroads. Crises like the one
we face now present unique opportunities for governments to try
new things, and to choose the path of the economy in the years ahead.
Today, we have the opportunity to adopt policies that will encourage
either future stability or future crises like the one we have now.

Government has chosen the latter: a policy of bailouts, which will
only create further incentives to take those same actions that led
to the current crisis in the first place. In doing so, they have
ignored sound economic analysis, and even the original designs of
the government institutions they are using to carry out these bailouts.

The Investment Decision and the Impact of Bailouts

All investments are speculative; that is, there is some possibility
that the future will not turn out as the investor hopes, and he
will take losses. Generally, when examining various investment possibilities,
an investor has the option to invest in low-risk, low-return investments,
which are likely to pay something, regardless the circumstances
(for example, typical savings accounts). There are also high-risk,
high-return investments, which are relatively likely to fail, but
will pay very high returns if they succeed. (Think of investing
in developing cancer drugs: odds are good that the formula will
not work, or that it will not be approved by the FDA. However, if
it does work and is approved, then the return will probably be very
large.) Facing a menu of options that differ in terms of risk and
reward, the investor will choose that which has the right mix of
risk and reward for their preferences.

The possibility of bailouts changes the structure of the decision
by decreasing the risk involved for certain projects. Consider a
very simple "investment." Say that I offer you a bet.
I will flip a coin. If it lands heads up, you give me $1. If it
lands tails up, I give you $1. Now, as a mathematically-savvy person,
you know that you don’t really expect to get anything out of this
deal. The odds of winning and losing are identical, and the size
of the loss and reward are identical, so everything "cancels
out" a priori. In short, when you take the bet, you’re doing
it for kicks. You would certainly not consider this to be an "investment"
in anything like the normal sense of the term.

However, say that the government knows that your losing a dollar
would disrupt the economy. After all, that’s $1 that you don’t spend
on a highly nutritious
Wendy’s Frosty
™. (Henry
has something to say about this reasoning.) In fact,
the government has seen these disruptions for a long time, and has
a history of paying for 90% of losses on such bets. In that case,
you’d have to be taking a very principled stand against gambling
not to take the bet. You have the potential to gain $1, though you
may lose $0.10, and the probability of each outcome is equal. The
potential loss is very small compared to the original case, and
compared to the reward. I’d expect that, if I made this offer to
lots of people, and the government made that bailout guarantee to
lots of people, I’d have lots of people making this bet. If I offered
the simple case with no bailout, significantly fewer would take
it. As noted by Guido Hülsmann, "the very possibility
to bail out some people brings about situations in which bailouts
are dearly needed."

the rest of the article

10, 2008

M. Engelhardt is a fourth-year graduate student in economics at
Ohio State University.

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