Economy Bailout Solutions

And so economic turmoil continues around the world. My own investments are no exception - my US stocks have averaged a 33% loss this month, though I am better off than some of my friends who have lost almost everything. Iceland is broke (though that's just bad news for incumbents; for everyone else, that means there's plenty of opportunity there), and Argentina is on its way.

Recently I have heard some more discussions of how the government should help the economy turn the corner. Most of these are one kind of bailout solution or another to improve liquidity and ease the credit crunch. Ideas include:

1) Bailing out the financial institutions' bad investments by buying up bad assets.

This obviously is bad for taxpayer, as there is no reason any asset which will not sell above market price while in the bank's hands will now sell in the government's hands. Maybe prices will go back up, but there is no guarantee, and they certainly will not go up to the prices at the top of the bubble, so a loss is expected regardless. The government tries to paint this as an investment, not an expense; that is true, but a bad investment (which is what this is for certain) is almost as bad as an outright expense. Finally, there is no guarantee that this will improve liquidity, as the banks see no reason to lend out any more money to help out homeowners in this environment even if it has the money.

2) Loaning financial institutions the money to cover temporary cash shortages.

Once again, there is no guarantee here to improve liquidity. Furthermore, given the trouble some of these institutions are in, there of course is some risk of default.

3) Taking an ownership position in financial insititutions, forcing them to loan out money.

This of course might work, but it isn't clear how good a job a government can do to run a bank. Also, the reason financial institutions are tight on credit is valid, and it is likely that many of the loans they would make, while sensible in a normal environment, may be bad in the current environment. Thus, the risk of default is higher, and thus to force financial institutions to do so regardless will inevitably cause such institutions to lose money and shrink in size.

4) Helping homeowners directly by making loans available to them at low interest rates.

Of course this is the most direct and easiest way to help the homeowner, but the policy will have unintended consequences. Homeowners, seeing a source of liquidity available, may rush over to refinance and take advantage of the lower interest rates. This eases the credit crunch and ameliorates economic woes by temporarily stimulating the economy, but results in the start of another bubble, as you'll once again have people who take loans out and live beyond their means, etc. Soon the cycle will start again only it will be even worse the next time.

So in fact, I don't believe there is a way the government can help The best thing is to do nothing and let the markets ride it out. The recession in fact is much needed, and the restructuring that happens then will be the best thing in the long run. Bad banks will fail and better ones will grow and take its place. Credit will tighten, but the best investments will still be worthwhile projects to finance. The invisible hand of the market really works, and government should stop meddling with it, wrecking havoc, and then blaming the free market economy for problems it has caused, giving it more justification to nationalize and further regulate the economy. Keynesian policies advocating government intervention may have their place and time, but right now clearly is not one of them. Mainstream economics have mostly followed Keynesian thought in the past few decades, and that has led us to the crisis we have today.