The Power of Ideas

Guilty Even If Innocent

Over the last few years, we have been treated to the consequences of poor financial decision-making.  The propensity to make these choices has been fairly widespread. Homeowners over-indulged in homes that were too large and too expensive. (Why not, prices never drop).  Investors bought arcane securities that were too complex to evaluate.  (Why not, they were given investment grade status by rating agencies who must have known what they were doing or were backed by financial guaranties from insurance companies carrying AAA ratings from those same rating agencies).  Finally, many of our major financial institutions did just about everything wrong.  (Why not, if you make money you get paid a big bonus and if you lose, someone else bears the cost).

So, what is the Government’s proposed solution to this widespread error in judgment; a mass subsidy to those who are suffering the consequences of their own poor choices.  Unfortunately, there is a cost to this subsidy; and a significant part of this cost will be borne by people who did not bury themselves in bad debt, bad investments or both.  We have been through this before, and it is bad policy.  It encourages the very behavior that now threatens the entire economic system and penalizes those who are prudent.

I am sorry, but this is wrong.  If you want to help, fine. But the cost of the solution can not be charged to those who made proper choices.  (I am fairly certain that none of the risk-takers would have voluntarily given up their gains).  This means that the general obligation to repay the Government’s largesse must be retained by the people receiving it.  In the case of individuals, refinancing must be done at fair rates of interest.  However, a significant portion of the repayment obligation can be deferred.  The Government should be given a security interest in the homes to insure repayment in full.  In the case of our financial institutions, the special financial arrangements provided by the Federal Reserve are saving these institutions enormous amounts of money.  The benefit of low funding costs should not inure solely to the benefit of the shareholders of these institution and their employees; it should revert to the people taking the risk. If saving a large financial institution is justified by public policy considerations, the public should retain the future benefits derived from its capital injection.

Over the years, our financial system has been encouraged to make poor risk-return judgments.  The term “Greenspan Put” has been attached to this behavior; both on the private behavior and the public response.  Over time the risks associated with such decisions have grown. So have the systemic consequences which now border on the catastrophic.  It is time for this to stop.  Capitalism encourages risk taking.  It also requires that the risk of both gain and loss attach to the decision-maker. Taking away either side leads to bad choices, inappropriate expectations, misallocation of resources and ultimately poor results.

In the current environment, it is clear that financial bail-outs are a fact of life.  However, they should be tailored to leave the burden with the original risk-taker.  Furthermore, we should leave no doubt that risk-taking allows the possibility of both gain and loss.  It is neither the Government’s responsibility to ensure the former nor prevent the latter.


February 26, 2008 - Posted by | Economics, Finance, General Interest, Markets

1 Comment »

  1. […] Read the rest of this great post here […]

    Pingback by Bad Debt » Blog Archive » Guilty Even If Innocent | February 26, 2008

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