I have already explained the root cause of why we are in a financial crisis. I have explained why talking heads talking about this being a liquidity problem are speaking bunk. Now, I am going to explain why the current actions of governments around the world are making things far worse.
The last few weeks have been filled with government announcements that they will guarantee one form of debt, or another. They think they are helping, but in fact they are doing two things:
- They are destroying otherwise healthy parts of the world financial system.
- They are putting other governments in a position where they have no choice but to do the same thing.
Generally, big governments are considered a good credit risk. For example, people generally assume that if they lend to the US Government, they will be paid back. So, imagine an otherwise normally functioning market in today’s panicky times, in which various forms are debt are bought and sold. The government announces that they will be guaranteeing a particular form of debt.
At that point, rational market participators sit back and consider their options. They can continue trading in the debt they are used to, but these are tricky times, and the government guaranteed debt is safer.
So, they very quickly move their money in the guaranteed debt. Besides meaning that a government is now on the hook for much more debt than they thought, this also means that otherwise healthy debt is suddenly difficult to sell.
The government backstop stole buyers away from similar debt. At that point the market for that other debt is distressed, and previously healthy entities start teetering. In desperation, governments announce they will backstop the newly distressed market. This then causes money to be sucked out of some other market, and that market becomes distressed.
In the end, everything is distressed, and the government is backstopping everything.
But, governments don’t have infinite resources. At some point they either refuse to guarantee something, or they default on their own debt. And then, a much larger problem that they have created unravelles in a way out of anyone’s control.
(For one example of what I am talking about, have a look at what Mr Practical has to say at Minyanville.)
{ 1 trackback }
{ 2 comments… read them below or add one }
Elizabeth Barrette 11.20.08 at 12:25 pm
Hm … I had a different rationale for why this is stupid: It rewards failure. Businesses demand money from the government to rescue them from foolish and selfish financial decisions. At the same time, they scream against any kind of oversight or regulation. So the taxpayers are simply *robbed* — their money is forcibly taken and handed to others, and a lot of it goes not to saving businesses but into the pockets of rich executives. The businesses fail anyway, and the rich executives sail away on their golden parachutes. They don’t care about the damage done, because they don’t have to care. They’ve got what they want, and everyone else can go hang. And then the government “can’t afford” to fund vital things like education, infrastructure, health care, etc.
If a business makes bad decisions and runs out of money, it must be allowed to fail. The capitalist system requires that; otherwise it doesn’t work. Socializing risk and privatizing loss is a disaster — which is exactly what’s happening now.
Ray 11.20.08 at 4:21 pm
I agree with you 100% I’ve just chosen not to explain all of the reasons why I think a bailout is a terrible idea.
I have been trying to point out things that people may not know about, while avoiding topics that may degenerate into meaningless arguments over what some people would argue are elements of relative morality.
My experience is that people who want to find an argument for a bailout will treat your argument as a moral argument rather than a practical argument about consequences and the actions of rational actors. So, I try to stick to things that describe existing practical consequences.