Why the Stock Market Drop Doesn't Prove that Congress was Wrong to Reject the Bailout:

The stock market's record 778 point drop today will no doubt lead many people to conclude that the House of Representatives was wrong to vote down the bailout plan backed by both the Bush Administration and the Democratic leadership. Indeed, Senate Majority Leader Harry Reid has already made that argument. Here's why I think such claims are wrong.

What is good for stockholders isn't necessarily good for the economy as a whole. Normally, I'm not much moved by populist rhetoric about how the interests of "Main Street" are at odds with those of "Wall Street." This, however, is one of the rare cases where such cliches have a measure of truth. If Congress were planning to pass a bill providing, say, a $100 per share subsidy to stockholders at the expense of taxpayers, no doubt stock values would rise in anticipation and then fall precipitously if the plan were unexpectedly voted down. That is essentially what happened here. Many stockholders owned shares in firms that expected to be bailed out. In addition to the financial firms that would have been the immediate beneficiaries of the bailout, shareholders in many other industries could foresee a "slippery slope" under which their firms could expect an increased chance of a bailout for themselves. At least for the moment, this slippery slope has been forestalled. Naturally, shareholders are disappointed, and their stocks are falling in value. But the outcome is good for the larger economy because we will not have a massive orgy of wealth transfers from successful industries to failing ones, nor will we create a serious moral hazard by signalling that firms that make overly risky investments that fail can expect to be bailed out in the future.

Past history shows that stock market drops, even big ones, don't necessarily cause longterm damage to the economy. Today's drop in stock values, while the largest in absolute terms, is not even in the top 10 relative to total shareholder value. The 1987 stock market crash was much more severe - a 22.6% loss in share value on the Dow Jones in one day - three times today's 7% drop. Yet the economy recovered swiftly, in part because policymakers were wise enough to let failing firms go bankrupt and free up their resources for use by more efficient industries.

Even in the Great Depression, most economic historians agree the harm caused by the stock market crash of 1929 was not by itself enough to cause a severe economic downturn. Rather, the Depression got as deep and prolonged as it did because of a wide range of failed government policies, including a massive currency deflation, the Smoot-Hawley Tariff of 1930, and gargantuan boondoggles such as the National Recovery Act.

I'm not a macroeconomist. So I can't be certain that no government action is required by the present crisis. Perhaps a modest and narrowly-targeted intervention would be desirable. I do, however, have some expertise in political economy and public choice problems, and the just-defeated bailout has all the classic indicators of a massive interest group power grab in the guise of an "emergency measure." I also draw some reassurance from evidence showing that numerous prominent economists across the political spectrum also believe that the bailout is ill-advised and likely to cause more harm than good to the economy in the long run. What makes the present situation different from many past crises is that the power grab has - so far - failed.

UPDATE: University of Chicago economist Casey Mulligan provides a helpful summary of the reasons why the performance of Wall Street generally and finance firms in particular isn't a good predictor of the condition of the economy as a whole.