My friend Brent Mattis (Finance Professional and student of Austrian Economics) wrote:
From where I am standing, it seems like leading up to and during financial crises, some Austrians seemed to be making contradictory statements. On one hand, several Austrians predicted that an imminent disaster was near, that nothing could stop the coming crash, and that any attempt to do so would lead to dire consequences (hyperinflation, dollar crash, Japanese-style “lost decades”, etc).
On the other hand, Austrians were against every action taken by the Fed and Treasury during the crisis. According to Austrians, all the Fed/Treasury predictions of calamity, cascading cross-defaults, and death spiral, were mostly scare-mongering to expand federal power.
Put another way, when the Fed and Treasury started saying “we need to take major action, because the end is nigh,” the Austrians said, “No, just allow the insolvent entities to fail and let the chips fall where they may, capital will move from weak hands to strong hands and we’ll be better off for it.”
Take one specific example: last Fall, a Money Market fund broke the buck when Lehman collapsed. It started a run on supposedly safe investment vehicles like commercial paper. The Fed arrested the run by backstopping all MMF’s. Suppose instead of bailing out AIG and backstopping all MMF’s and short-term paper, they’d followed the Austrian prescription of letting insolvent entities fail. In the ensuing run, the consequences would be difficult to predict, but would have likely gone beyond the Austrian idea of the ‘short but sharp recession.’ One can try to trace the linkages. In sequential order, the CP markets fail, corporate bond markets go crazy, businesses dependent on rolling paper fail, and banks fail en masse. This would be pretty traumatic. Would America be better off in the long run if we’d watched the majority of the banking, shadow banking, insurance, and other levered entities collapse? I’m not being facetious. I’m legitimately curious on this one.
Austrians can differ about the severity of the consequences if one firm or another were not bailed out. But I don’t think that the only good case for opposing a particular bailout would be to show that there would not be much pain involved if the bailout were averted. You might think that a serious downtown would occur without efforts to defuse it, and yet still be opposed to a bailout because the bailouts would only make things worse. If we’re not going to make an argument against all bailouts on ideological grounds, then lets compare all of the costs of a particular bailout against the benefits.
Some advocates of bailing out financial institutions (not necessarily Austrians) think that the credit crisis is the problem, and that by preventing firms from failing we can solve/avoid/fix the problem. If it were that simple, then those Austrian ideologues who are against all bailouts look pretty mean-spirited and narrow-minded.
Where Austrians differ is that we see the boom as the problem — where the price system was disrupted and capital was misallocated — and the bust as the way that the problem gets fixed. The only way to return the economy to sustainable growth is to go through a bust. The cost of bailouts in general is that, to the extent that they “work”, they prevent the price system from working to reorganize the capital structure and to prolong the period of waste. Because bailouts are an attempt to preserve fictitious prices.
One of the strongest arguments against bailouts is that they don’t fix anything, they only pushes the adjustment process off into the future. More or less the same adjustment process will have to occur sooner or later. Once firms have run out of their bailout funds, the price system will continue to put pressure on them to liquidate their malinvestments, write down their balance sheets, go bankrupt, or adjust by whatever means the correction needs to occur. By keeping a corrupt and inefficient system in place, bailouts may create moral hazard and attract more entrants into the race to waste capital.
Let it unravel now or let it unravel later? Political systems generally try to push pain off into the future, but the better choice might be to get it over with, return to a sound basis of savings-financed growth, and have a better future. But if a bailout can push the adjustment process off into the future, why not have a series of bailouts and delay the day of reckoning forever? This can’t be done: there will come a point where we don’t have a choice – we will have to face some kind of consequences. Either the economy will be progressively socialized, which amounts to a permanent depression, or something more dramatic will occur: hyperinflation, a currency crisis, or a systemic failure that is large enough that the enough resources simplly cannot be confiscated to paper it over.
Can we pick and choose among the bailouts, only implementing those that prevent some kind of domino-chain systemic crisis and letting other firms fail? I’m not sure that anyone knows how to tell which are which. However, a point that speaks in favor of a more moderate consequences is that the “collapse” of financial entities does not wipe them out of existence; if we had rule of law it would only transfer their good assets to the bond holders. The good parts of these firms still have their employees, their brand, their physical assets, and whatever parts of their balance sheet are worth owning. As Ben Stein told Peter Schiff, Merrill Lynch is an “astonishingly well run company”. He was right, that is, when talking about their retail business. … It was their entry into the mortgage securities market with excessive leverage brought them down. The other firms you mention – MMFs, CP, corporate bonds, all represent something real if you follow the paper trail far enough. These securities would not all disappear, they would only get repriced. A key to this process working would be the efficiency of the bankruptcy process in transferring assets and settling claims.