When Governments Attack ! (Or At Least Cause Depressions)

Good new overview paper out on how governments can cause depressions through ill-thought policy. Lots of historical frisson, especially given the current TARP 2/stimulus rancor, so I’ll just turn to the paragraphs on the ongoing crisis:

The fall in housing prices has exposed an even more fundamental problem in the financial system. Some investors and policy makers have come to regard some financial institutions, and even some manufacturing firms, as being too big to fail. In the banking system, a tension exists between the government insuring depositors in banks and in regulating the banks. The fundamental principle involved in efficiently allocating risk is that any insurance should be accompanied by regulation. Any institution that is too big to fail needs to be regulated.

Governments are now spending huge sums of public money to bail out financial institutions that had not been previously regulated. Even aside from the costs of generating the need for more taxes, these bailouts will create difficulties for the future. Risky investments will pay returns in spite of bad outcomes. Labor and capital will stay employed in unproductive uses. Incentives for future investment will be distorted by moral hazard problems. We got into the financial crisis that we are in now because of poor assessments of risk. Indiscriminate bailouts in the financial sector will reward many of those who made bad decisions and make it even more difficult to assess risks in the future. Understanding the moral hazard problems created by bailouts, many citizens and politicians will call for massive regulation of all financial institutions. Directly and indirectly, massive and indiscriminate bailouts of the financial system will create inefficiency and low productivity.

What do we need to do now? The central banks in the countries that are in crisis should lend to banks to maintain liquidity. Any bailouts of nonbank financial institutions should be accompanied, at least temporarily, by strict regulations. The bailout should not be used to maintain high returns either to the equity holders or to the bond holders in these institutions. Investors who made risky investments should not be rewarded when these investments have gone bad. Any public spending on investment in infrastructure should be justified on its own merits, especially in terms of its potential for increasing productivity. Otherwise, we should let the market work in letting unproductive firms go bankrupt and reallocating what remains of their resources to more productive firms. Reforming bankruptcy laws in some countries could make this process more efficient.

And it closes with this appropriately cautionary reversal:

Those who try to justify the sorts of Keynesian policies implemented by the Mexican government in the 1980s and the Japanese government in the 1990s often quote Keynes’s dictum from A Tract on Monetary Reform: “The long run is a misleading guide to current affairs. In the long run we are all dead.” Studying past great depressions turns this dictum on its head: “If we do not consider the consequences of policy for productivity, in the long run we could all be in a great depression.”

More here.