Friday, October 03, 2008

The Government Bailout: Are We Replacing Market Failure With Government Failure?

President Bush has signed the bailout bill. So the government will start buying assets from the banks. These assets are hard to value. They include mortgages that may or may not be good (they might not be paid back). How likely they are to be paid back is not clear, so we don't know how risky they are and therefore what price to pay for them. Will the governmnet pay too much for them, costing the taxpayers too much money or will the government pay too little in which case the banks will still be in trouble?

The plan is to get the banks into better financial shape so they can resume lending again, which is very important to the economy. Some say not acting will be worse than what is being done. But how will the government figure out the right price to pay for the assets? That will be the big question.

We could say that we have or are having market failure. That is when the market allocates too many or too few resources to some good, service or activity. Then we get too much or too little of a certain good or service. Pollution (a negative externality in economic jargon) means that too much of some good is produced, like steel. We have too little lending right now. Banks don't want to lend to businesses or other banks because they can't be sure how risky the lenders are or the value of assets they might put up for collateral.

It might be instructive to recall that the lack of this kind of information led Nobel Prize winning economist Milton Friedman to warn us that a government program might simply replace market failure with government failure. So we might be no better off or even worse off as a result of the government program. If lack of information is what caused the problem in the first place, the government can't necessarily find the right solution.

I think an article by Harvard economist Kenneth Rogoff called Significant reasons to doubt wisdom of bail-out expresses this market failure/government failure issue. Here is an exerpt:

"This brings us back to the US treasury’s plan to spend hundreds of billions of dollars to unclog the subprime mortgage market. The idea is that the US government will serve as buyer of last resort for the junk debt that the private sector has not been able to price. Who, exactly, does the treasury plan to employ to figure all this out? Why, unemployed investment bankers, of course!

Let’s ponder this. Investment bankers have been losing their cushy jobs because they could not figure out any convincing way to price distressed mortgage debt. Otherwise, their firms would have been able to tap the trillions of dollars now sitting on the sidelines, held by sovereign wealth funds, private equity groups, hedge funds, and others. Now, working for the taxpayer, these same investment bankers will suddenly come up with the magic pricing formula that has eluded them until now."

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