The Bailout is Bad

Ten days after passage of its $700 billion bailout of the financial sector, the U.S. Treasury has announced that it will implement this program, in part, by giving banks $250 billion in return for shares of their stock.

In other words, the U.S. government will acquire a significant ownership stake in the banking sector...

If banks were fundamentally sound but temporarily in need of cash, they could sell stock on their own to private investors. Few investors now want bank stock, however, because they cannot tell which banks are merely illiquid -- short of cash for new loans because their assets are temporarily sellable only at fire-sale prices -- and which are fundamentally insolvent -- short of cash and holding assets whose fundamental values are less than the bank's liabilities...

Government ownership means that political forces will determine who wins and who loses in the banking sector. The government, for example, will push banks to aid borrowers with poor credit histories, to subsidize politically connected industries, and to lend in the districts of powerful members of Congress. All of this is horrible for economic efficiency.

Government pressure will be difficult for banks to resist, since the government can both threaten to withdraw its ownership stake or promise further injections whenever it wants to modify bank behavior. Banks will respond by accommodating government objectives in exchange for continued financial support. This is crony capitalism, pure and simple.

Government ownership of banks will not be a temporary expedient. Politicians can swear they will unwind the government's position once "economic conditions improve," but no one can enforce this promise. The temptation to use banks as a political tool will be permanent, not temporary, so government ownership will continue for decades, or forever.

Worse yet, government ownership of banks sets a precedent for ownership in every industry that suffers economic hardship. Some might argue that banking is "essential," but many industries -- autos, steel, computers or agriculture -- will make similar claims when it is their turn to demand a bailout. Thus banking will be only the first victim in an enormous expansion of the government's role. This again will have disastrous consequences for economic efficiency.

Last but not least, a government "injection of liquidity" is still a bailout in all but name...

It is time for the government to do the one thing it does well: nothing at all. This might mean serious economic pain in the short term, as more banks fail and the economy suffers through a recession. As for a cancer patient who has a tumor removed, however, the long-term benefit will more than compensate.

Jeff Miron's essay