Bailouts Likely to Result in Malaise

Published June 1, 2009

Given all the “reforms,” bailouts, and planned regulatory and monetary machinations adopted since January 2008, can we expect a return to robust economic growth over the long haul?

The answer hinges on how bailouts affect private incentives to save, invest, and innovate and thus jobs, production, and income.

We are concerned that the bailouts have created investment uncertainty, uncertain future tax burdens, and moral hazard that will result in economic stagnation, sluggish growth, and further crises.

Failed Plans

When the real estate bubble burst, large financial institutions and insurers found their balance sheets filled with “toxic” assets. The Federal Reserve provided interest rate cuts in 2007 and conducted discount rate auctions in early 2008.

The Bush administration and Congress created subsidies and loans of $700 billion to financial institutions “too big to fail.” Among the many bailouts and stimulus packages, Fannie Mae, Freddie Mac, and the Federal Home Loan Bank were effectively nationalized. Automakers General Motors and Chrysler also received bailout money.

Those actions failed to unlock credit or stabilize employment, so the Obama administration implemented larger but similar palliatives, such as a $787 billion stimulus package and massive budget deficits. More recently, Treasury Secretary Timothy Geithner initiated plans to rescue financial institutions by having private-public “partnerships” buy up toxic assets.

Temporary Bump

Massive injections of government spending can temporarily bump up gross domestic product statistics. Economists Matthew Shapiro and Joel Slemrod already have documented that the $100 billion of rebate checks in 2008 had “a noticeable effect” on GDP and growth in consumption.

But few economists argue this is the path to prosperity. Governments can pay people to dig ditches and other people to fill in those same ditches, and this does increase GDP, but it obviously does not result in a more prosperous society.

With the tab now exceeding $10 trillion, we believe taxpayers should actually prefer make-work projects over all the bailouts because the lingering effect of the latter could be disastrous for private investment and future economic growth.

Future Costs

Investment is the key, but it must be private investments based on secure and accurate market signals to ensure real and sustainable economic growth. Volatility and uncertainty created by “unprecedented” and erratic policies stifle private capital investment by creating an exceedingly cloudy view of future market conditions for investors. This is not the imagined uncertainty implied by Keynes’s “animal spirits,” but the very real uncertainty caused by government policy.

The bailouts are largely financed by government borrowing, which means the cost will be paid in the future. Anticipated higher taxes (of uncertain magnitude) have a negative impact on investors in the present, particularly when tax increases are expected to fall on highly productive, high-income individuals.

Disincentives to invest are buttressed by the aging of the population—Baby Boomers whose willingness to make equity-based and long-term investments will be attenuated. For these reasons, the huge increases in the national debt will certainly dampen investment.

Incentives for Recklessness

Bailouts also create moral hazard in the economy. Moral hazard refers to a change in incentives that encourages bad behavior. Bailouts renew incentives to “game the system” because rewards are funneled to non-creditworthy borrowers, imprudent lenders, and investors who are not forced to bear the full costs of their decisions.

As people clamor against improvident companies such as AIG, government is creating additional incentives for some future investors to be as reckless as possible. Therefore we should not be surprised to see some repetition of our current economic situation in the future.

Despite having allocated more than $10 trillion in spending, the new economic regime (the product of both Bush and Obama administrations) is clearly having difficulties fixing existing asset problems. Our concern is that they are also creating great uncertainty, higher future taxes, and moral hazard for investors.

This does not bode well for future economic growth. A lingering economic malaise is therefore probably in our future.

Robert B. Ekelund, Jr. ([email protected]) is eminent scholar emeritus in the department of economics at Auburn University. Mark Thornton ([email protected]) is senior fellow at the Ludwig von Mises Institute in Auburn, Alabama.