I have resisted commenting in detail about the wisdom of the federal government's massive bailout of various financial institutions because most of the issues involved are far outside my area of expertise. For this reason, I have resisted using my perch at the VC to criticize what I consider to be a horrendous error by the administration that we will all pay for dearly over the coming years; in my view, the federal government should have allowed AIG, Bear Stearns, and other firms to fail, without any bailout whatsoever. I suspect (though of course I cannot prove) that any short-term damage from their failure would be more than outweighed by the longterm benefits of signalling that firms cannot rely on government handouts to compensate them for their mistakes. They will then have strong incentives to avoid overly risky investments and speculative bubbles in the future. Like co-blogger David Bernstein, I also fear the public choice effects of giving the executive a blank check to spend billions of dollars bailing out whatever firms they consider to be deserving of such largesse. There is an obvious risk of favoritism here, along with an even more severe risk that major firms will become dependent on government handouts over time.
Be that as it may, it turns out that Nobel Prize-winning economist Gary Becker has some of the same concerns as I do; and he surely has relevant expertise that I just as obviously lack. Although Becker has "reluctantly concluded that substantial [government] intervention was justified to avoid a major short-term collapse of the financial system," he criticizes the federal government bailout effort as follows:
Still, we have to consider potential risks of these governmental actions. Taxpayers may be stuck with hundreds of billions, and perhaps more than a trillion, dollars of losses from the various insurance and other government commitments....
Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.
The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.
Various other mistakes were made in government actions in financial markets during the past several weeks...
As they say, read the whole thing.