Europe has created a $1 trillion bailout fund. The United States Federal Reserve Bank has apparently agreed to unlimited currency swaps to support the bailout effort. By comparison, Freddie Mac’s request for another $8.4 billion looks pretty small, but they are all symptoms of the same disease.
Let’s call the disease bailoutitis. It is not fatal, but it leads to an extended period of serious constipation, near-death experiences, and eventually, a painful hangover.
Bailouts, as we are currently performing them, amount to free insurance. You don’t see free insurance offered very often, for good reason. It doesn’t matter how much money you start with, you eventually run out of money offering free insurance, even without a moral hazard problem. The math just doesn’t provide for any other outcome.
Then what? Well something fails and we have a collapse, something like what followed Lehman Brothers collapse, only worse, something like what the bailouts are intended to avoid, only worse. By propping up countries, states, and companies, we are only postponing our problem, a problem that will be much larger because of our postponement.
There are other issues. With every bailout we are rewarding a bad player by taxing a good player, creating terrible incentives and diverting funds from beneficial uses.
Now, we’re in a Catch 22 situation. We’ve created the expectation of bailouts, and the incentives have had their effect. There will be failures and financial crises if we stop bailing out bad players. There will be failure and financial crises if we don’t stop bailing out bad players. The lower-cost option is to stop bailing out the bad players now.