The Argument against Bailing out Banks

The House of Representatives voted against the initial $700bn bailout. Though some bailout is likely to go through in a different form.

The Problem with the bailout was:

  • Buying worthless assets, won’t solve the causes of the credit crunch. It won’t solve the problem of home repossessions, falling house prices and the fact banks have made too many bad debts
  • There was a danger financial firms would use the bailout as a way to get rid of their worst assets and seek to make profit at the expense of the taxpayers
  • It will cause moral hazard. If you bailout firms who fail, it encourages risky behaviour in the future. The financial crisis is indicative that there is a fundamental disequilibrium in the markets.
  • The Government was getting a poor return. It was going to buy assets nobody wants to buy at prices well above market prices. If the government is going to bail out firms who lost money to incompetence, at the least they should get a stake in the company. This means the taxpayer has more chance of getting a fair return in the long term.

Having said all that. There is some economic justification for government intervention at this stage.

You could argue that the market value of these mortgage assets is undervalued. Panic has gripped money markets and no-one wants to lend to each other. Away from subprime mortgages there are some assets which will get a reasonable part of their cost back. Therefore, although the plan appears to cost $700bn, in actual fact it won’t because some assets will not be defaulted on. A government intervention would maintain some degree of calm and stability and prevent a market rout.

The problem is that we don’t know how much a crisis in the banking system would affect the real economy. Some people feel that if banks do go under, we could face a great depression not seen since the 1930s. Others argue, that this is actually unlikely, because we would be able to prevent a collapse in the money supply like in the 1930s.

The problem is who wants to risk a great depression?