The Economics of a Bailout

A federal rescue raises huge moral hazard issues.

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Economist Tyler Cowen comments on the "economics of bailouts" and tells the critics to quit worrying:

If you're a critic of bailouts, you can't have it both ways. If the Fed or Treasury is guaranteeing loans, yes that does put taxpayer dollars on the line. But if you think the system can hold up, as do most bailout critics, those guarantees are unlikely to cost very much. The Fed or Treasury may even turn a profit. If you think the system cannot hold up, the bailout is probably necessary even if costly. So you can't claim: "The bailout isn't needed" and also "The bailout will burden taxpayers."

But what about the day after tomorrow? How many bailout proponents are pointing to previous bailouts, from the S&L bailout to the bailout of Chrysler, as applicable precedent? I know the idea of moral hazard may seem abstract at a time like this, but it should be taken seriously by policymakers. As jurist Richard Posner points out at the blog he cowrites with economist Gary Becker (boldface mine):

Moral hazard is thus not a defect of the will, but a rational response to one's opportunity set. If one has medical insurance without deductibles or copayments, the marginal cost of medical care will be low (even zero), so one will consume more of it. If one is confident that in the event of a flood or an earthquake there will be a government bailout, one will buy less or no flood or earthquake insurance. The government's bailing out of investment companies, banks, and mortgagors will induce those entities to take more investment risks in the future than they otherwise would, and so will increase the risk of future housing bubbles and credit crunches.