Monday, September 8, 2008

The Economics of Random Stuff: Bail-Outs

The following was written by EPJ contributor Christopher Espinal.

When a kid does something wrong, the worst response for a parent is to just “let it go.” The same logic follows here: when a grownup makes a mistake or an idiotic decision, the worst response for a parent is to intervene and bail them out. The reason follows from the same methodology as the previous articles of series, The Economics of Random Stuff. For the billionth time, the law of demand exhibits the idea of the incentive. It outlines the concept that there is an inverse relationship between price and quantity consumed. When the price of a good drops, expect consumption of that good to rise – elasticity will determine by how much.

That is exactly what happens in a bailout – some intervening force artificially lowers the cost associated with the occurrence of some event that had a negative impact on the subject. That price drop will only provide an incentive to consume that good, or in plain English, to do it again. Thus, we have a problem called moral hazard. Due to this artificial reduction in cost, in the future the kid rationally expects the parent to “let it go” again, and the grownup rationally expects his or her parent’s assistance in response to a costly event.

The chain reaction begins. Now the kid’s siblings will take advantage of Mom and Dad’s lack of disciplinary action.

Just as I once argued that individual market trade theory applies at the international level, I believe the energy of the family argument on bailouts is conserved on the economy-wide scene.

It seems that during a time when people are betting on widespread economic disaster, everyone wants a bit of security – including investment banks and other financial institutions such as Fannie Mae and Freddie Mac. To provide that bit of security the Federal Reserve makes history by intervening in markets outside of commercial banking. To piggy back on the Fed, Paulson’s Treasury makes history by nationalizing two of America’s largest mortgage creditor institutions. As far as Fannie and Freddie are concerned, there is a case to be made that they had a special privilege as government sponsored enterprises.

Regardless, financial markets now lay on the horrifying risk that the Fed and Treasury made the wrong signals to the remainder of the financial community. Just as the kid’s siblings knew they can take advantage of Mom and Dad, the financial community may believe that they are insured by the Fed and Treasury.

The remaining question that I just don’t know how to answer is: ultimately, how will the financial community perceive the artificially reduced cost of risky or bad corporate management. Let me ask a more refined question: has the cost been reduced to a degree that surviving financial institutions will continue risky security deals?

Christopher Espinal is an economics student at the University of Chicago. He can be reached at

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