Our 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 Hazlitt 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."
December 10, 2008
Lucas M. Engelhardt is a fourth-year graduate student in economics at Ohio State University.
