More generally, the government’s bailout will perpetuate the very incentives that caused the problem in the first place. A free market system is based on profit and loss. If corporate executives know that the government is always ready to step in and prevent an absolute meltdown, then those executives will take on too much risk. If the aggressive bets pay off, the private companies keep the profits. And if the aggressive bets blow up in their faces, then no worries—the taxpayers will eat the loss.
There are two distinct issues hurting the economy, and the government’s efforts are exacerbating both of them. First was the massive overinvestment in the housing sector. Here we can lay much of the blame on Alan Greenspan’s incredibly low interest rates following the dot-com bubble, as well as the efforts of politicians and community groups to promote the “American dream” of homeownership by lowering credit standards for mortgage applicants. Now that housing prices are falling, many unqualified borrowers are defaulting on their mortgages, leading to unexpected losses for those holding the loans.
However, our recent financial crisis is not just the fault of bad real estate bets. Besides the existence of billions of dollars worth of dubious assets tied to mortgages, there is the additional problem that banks and investors don’t know who is holding them. The “credit crunch” is due to banks’ reluctance to even lend to each other, since the counterparty might go belly-up the next day.
Here too the government has amplified, not helped, the problem. By promising ever more generous assistance—through lower interest rates, unprecedented “liquidity” programs, and now an outright bailout—the government set up a game of chicken. The institutions holding huge amounts of toxic assets had an incentive to drag their feet as long as possible, stringing their creditors and shareholders along, while hoping for a government miracle. And now Secretary Paulson has apparently delivered.
The free market is a superior economic system to central planning. This superiority demonstrates itself during normal times but especially during an economic crisis, when resources must be rearranged before regular growth can resume. By embracing massive corporate handouts and other socialist measures, the Bush Administration discredits capitalism and delays economic recovery.