A quick note on corporate bankruptcy and bailouts

Bankruptcy is a necessary part of a free market.  I certainly believe this to be so. Rick Newman, who writes the blog “Flow Chart” over at U.S. News, is putting forward the provocative idea that failure is exactly what we needed more of in 2008 and what we should want in 2009.

The idea is that  propping up bankrupt companies artificially constitutes a dead-weight loss to society and fosters a pernicious sense of invulnerability at many large companies. I tend to agree with these sentiments and this is one reason I do not support the bailouts of the automakers and why I did not support the way other bailouts like Citigroup, Fannie Mae, and Freddie Mac were handled.  However (and this a big however), systemic risk must always be kept in check.  Newman says as much.

OK, so maybe all those bailouts have collectively served the national interest, by preventing a panic and dampening the effects of a nasty recession. But at some point—which we might have passed already—preventing failure does more harm than good. Here’s why we should be more tolerant of failure in 2009:

Bailouts perpetuate the problem instead of solving it. We’re probably about to learn that bailouts are an open-ended—and extremely expensive—proposition. AIG and Citigroup have both asked for one infusion of federal money, then another. Are they done? Or will they come back for even more? The $15 billion in federal loans for General Motors and Chrysler is almost certainly just a down payment on a bailout that could easily total $75 billion or more. And there’s no evidence at all that it will compel more people to buy their cars, which is the real problem. In the end, we might still be stuck with too many automakers building too many uncompetitive products.

So while systemic risk must always be addressed — and that is why I believe the Lehman bankruptcy was a major mistake — failure is part and parcel of the free market.  The government is not there to bail out companies that made poor decisions.  It is there to protect citizens from the ill effects of those poor decisions.

Sources
Needed in 2009: More Failure – Rick Newman, U.S. News
Best Move of 2008: Letting Lehman Fail – Rick Newman, US News

6 Comments
  1. Mark Wadsworth says

    Ed, nobody wants to see viable businesses go bankrupt, but on the other hand, nobody (in his or her right mind) wants to see government bail outs. There is a middle way in all these things, of course (which applies to banks as much as The Big Three as anybody else like Revlon) it's called a 'debt-for-equity-swap'. (click link for a few examples)

  2. Mark Wadsworth says

    BTW, the left and right hand edges of your fine new 'blog still get chopped off.

  3. Edward Harrison says

    Thanks, Mark. You're right about the debt-for-equity swaps. Why are we bailing out bondholders when they should be taking a haircut? In the case of Fannie and Freddie it was because of the Sovereign Wealth Funds and central banks, but at GMAC, I wonder.

    You have some pretty good ideas. I'd love you to forward me a fleshed out version of your ideas regarding the Land Value Tax as a way to prevent property bubbles. It would be a great idea to put forward for debate.

    The edges thing is annoying. I am using Firefox and don't see it at my resolution, but I reckon it could be a problem at a lower resolution screen. thanks for the feedback.

    Cheers.

    Edward

  4. Mark Wadsworth says

    Dear Ed, I've never had an original idea in my life, greater minds than mind beat me to all this by centuries.

    As to LVT, I see this in a UK context. We have incredibly strict planning laws here (unlike some US towns who had little or nothing in the way of property price bubbles because of liberal planning laws) which stokes the bubble as well. Sensible banking supervision is important as well (in which the USA has been just as dumb as the UK).

    Within the LVT community, most of them believe that having a tax on annual rental values would prevent bubbles. On the basis of a real life example of Business Rates in the UK (which is a flat tax on the annual rental value of commercial properties) I don't think that this is true (click link). Property price bubbles are just bubbles in capital values (it is impossible to say for sure whether the bubble is in property values or land values), therefore to dampen bubbles, the tax would have to be on the capital value.

    1. Edward Harrison says

      Somehow your link went missing, Mark. Would you re-post with the link. Cheers.

      Ed

  5. Mark Wadsworth says

    You have to click where it says 'Mark Wadsworth' above the comment. Or use this:

    http://markwadsworth.blogspot.com/2008/12/taxes-o

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