The Legacy of Bailouts
From Greg Mankiw's Blog:
Sunday, May 04, 2008
The Legacy of Bailouts
Alan Blinder make the case for more regulation of financial institutions. The key passage:
It will, for example, substantially reduce the profitability of investment houses and, therefore, reduce their scale. But that’s the price you pay for access to a publicly financed safety net.
That is why some economists cringe when Wall Street firms are bailed out. Beyond the obvious equity issues about risking taxpayer money to help rich guys, there is the problem of efficiency. If you start bailing the firms out when they lose, you have to regulate the gambles they take. You can no longer count on the creditors to limit the firms' leverage, as the creditors are counting on Uncle Sam if things go wrong. But the more regulated these firms are, the lower their productivity will be.
The bottom line: The Bear Stearns bailout may have saved the economy from an episode of financial contagion in the short run, but in the long run it will likely leave us with a more regulated and less vibrant financial system.
It is important to keep both sides of the argument in mind. What about the legacies of financial crises? A short term episode can lead to negative, long-term effects on the real economy so I don't think it is fair to imply that the Fed's decisions simply traded long-term growth for stability in the short-term.
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