Saturday, October 10, 2009

Why Will the Next Economic Crisis Be Worse

The spate of economic data revealing the supposed economic recovery is merely covering the massive capital misalignment that still plagues the U.S. Bad debt and toxic assets continue to clog the balance sheets of financial firms, many of which would have gone under had it not been for the massive intervention provided by the government. Many economists and armchair pundits hailed the apparent success of the interventionists, I suppose, like the admirers who hailed the survival miracle of Annie Taylor’s daredevil stunt at the Niagara Falls.

Government intervention and its failure to prevent the dissolution of insolvent firms have magnified the problem of asymmetric information. The reasoning of their intervention, of course, ran along the logic that these firms are “too big to fail.” In other words, these companies are deeply embedded in the economic landscape that one bankruptcy would have triggered a cascade of other failures, causing the economy to come to a grinding halt and ultimately a collapse. Of course, politicians and government bureaucrats never let a crisis of this magnitude go to waste for their own purposes. There are always votes to win for the next election.

That being said, the problem of “saving” these so-called “too big to fail” firms is that it helps foster and promote moral hazard. Moral hazard is the idea that individuals will act different than they otherwise would in the presence of insurance. For example, a person might drive more recklessly, which increases the likelihood of an accident, if he knew he has full-cover car insurance. Similarly, for many years financial firms and investors understood that should a major crisis occur, the government would bail them out. And bailed out they indeed were. Let’s take a brief look into the annals of recent bailout history: In the early 1980s, banks received help from the government which curtailed looses stemming from the emerging market debt crisis. In the late 1980s, the government stepped in to help the financial industry from the saving and loans debacle. In the late 1990s, the Federal Reserve orchestrated a bailout of a prominent hedge fund. From 2005-2009, the government has become a shareholder in industries where constitutionally they have no business to be in. Of course, this has been spun in such a manner that glorifies the behavior of the market interventionists.

Moral hazard is a hidden action in the sense that it cannot be seen publicly: that is, only those holder of toxic assets—to use an example—know with almost full assurance the type and quality of assets they hold in their balance sheets. The government and other outsiders do not. Since the firms know the government will intervene in the case of a crisis, companies will be more conducive to take on higher riskier. Given the massive amounts of unprecedented money printed during the most recent crisis, government is laying the foundation for further capital misallocation. The “money” (which really is just paper printed with green tint) is being spent on things that are not productive. The risky behavior feeds on itself to the point of speculation. When we reach this transition, it is just a matter of time before the economy collapses again.

No comments: