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.

Economist Steven Landsburg, writing for the Atlantic, presents what seems to me a simple, but powerful argument against the bailout. I don't know enough about finance economics to be sure whether it's right. But I thought that it's at least worth passing along to our readers. Even if it doesn't succeed in proving that no bailout at all was necessary, it at least casts doubt on the need for a plan as massive as the $700 billion monstrosity that the administration is trying to ram through Congress:

What's clear is that a bunch of financial institutions have made mistakes and lost money. What's unclear is why anyone (other than the owners and managers) should care. People make mistakes and lose money all the time. Restaurants fail, grocery stores fail, gas stations fail. People pick the wrong stocks, they buy the wrong cars, and they marry the wrong spouses without turning to the Treasury for bailouts.

So what's special about banks? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt.

Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.

That's one reason I feel squeamish about the official pronouncements we've been getting. They tell us bank failures will make it hard to borrow but never that bank failures will make it hard to lend. But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically. This makes me suspect that the official pronouncers have not entirely thought this thing through.

In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent. Second, as any user of match.com can tell you, the technology for finding partners has improved since then. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad?

Ultimately the key question is this: why shouldn't these banks be treated like any other business whose management has displayed bad judgment and lost a great deal of money as a result? Capitalism works because we insist that businesses bear the cost of their own losses, a process that gives them strong incentives to make good decisions and transfers their wealth to others with better judgment if they persist in screwing up anyway (as the big banks have done in this case). Perhaps really big banks are somehow special and deserve bailouts that we would deny to other businesses. But there is a heavy burden of proof on those who claim that this alleged specialness really exists and that it justifies hundreds of billions of dollars in public expenditures, unchecked executive power, and unprecedented control of the economy by the federal government. Like Landsburg, I am skeptical that the burden has been met.