Monday, September 21, 2009

Subprime Bailouts and the Predator State

I finally finished "Subprime Bailouts and the Predator State," and posted it on SSRN. The conclusion will not surprise any visitors to this blog. The abstract sums it up:

Recent bailouts in response to the subprime crisis evince an ad hoc government response that benefited general unsecured creditors and managers within the financial sector, while inflicting great loss upon taxpayers. The bailouts violated notions of the rule of law and sound macroeconomic science. In fact, the bailouts were followed by restricted lending and capital hoarding. This paper argues that such bailouts should be powerfully discouraged by imposing a legal framework including civil, criminal and administrative sanctions designed to discourage CEOs and other senior managers from flirting with too-big-to-fail status. Specifically, such managers would face near-automatic termination, discharge of employment agreements, the loss of protections under the Private Securities Litigation Reform Act, civil fines for causing losses to TBTF firms through unsafe and unsound practices, criminal sanctions for recklessly causing a loss to TBTF firms, and the prospect of administratively ordered prudential divestitures of operating units when a regulator identifies a firm as being TBTF. The goal is to eliminate the attractiveness of TBTF and thereby avert the huge costs implicit in TBTF. This should assure that bailouts are not a function of political power rather than sound economic science.

The only comment to add here is this: the resources at stake with this issue are mind boggling. We are talking trillions. It is hard to imagine how much “trillions” really is. If things go well the entire fiasco will cost a mere $1 trillion. But the collateral damage to the economy is at least that much. Frankly, I predict the final tally will be closer to $10 trillion than $2 trillion. Assuming the conservative guess of $2 trillion: that is still $6000 for every man, woman and child in the US. So, for a family of four think $24,000 if we are lucky. The next time anyone suggests this nation cannot afford social justice (from reparations to universal health care to better education) it will be because of these obscene bailouts.

And, now the Obama Administration seeks to codify the Bush/Paulson approach, with relatively minor modifications. The perverse incentives from this approach will cost even more in the future.




  1. i enjoyed the cartoon dude!

  2. The officials who developed and implemented the recent financial bailouts in the United States forgot or refused to remember a critical tenet of capitalism, and that is, that the entrepreneur, not the taxpayer, bears the risk of business failure. If an entrepreneur behaves recklessly (e.g., takes unnecessary or uninformed risks with his or her capital resources and chooses investments that are highly risky; or produces products which consumers do not want; or provides his or her customers with extremely poor and unreliable service; failure is the most likely outcome. When (and if) the government uses taxpayer money to reward such reckless and unproductive behavior in the marketplace, an important function of investor/entrepreneur failure--notice--is defeated. Where the government provides an enabling institutional environment for capitalism to operate effectively, failure, on the part of investors/entrepreneurs who behave recklessly and unproductively (including unlucky ones), provides notice to subsequent actors in the marketplace not to behave likewise. However, if the government uses public funds to reward the type of reckless and opportunistic behaviors that have been exhibited by many executives in the financial sector, it creates perverse incentives in the marketplace and seriously undermines the very foundations of the nation's capitalist economy.

    - John Mukum Mbaku

  3. An excellent paper. I approach this topic from a government ethics perspective in another paper and condlude that bailouts of particular companies and government ethics do not and probably cannot mix.

    See Bailouts: An Essay on Conflicts of Interest and Ethics When Government Pays the Tab

    Richard W. Painter