The Problem with Bailouts

“Just like natural organisms, the financial system must have death to evolve into a better form…”

NOW THAT HE’S WEARING some sort of do-good government hat, even Hank Paulson is not thinking straight.

Regulate in New York and finance goes to Toronto. Regulate in London, it goes to Frankfurt or Paris — and since Toronto, Frankfurt and Paris are run by the same nervous bureaucrat-types, we can reckon soon enough that the entire financial markets will be hosted out of Singapore and Shanghai.

There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms, the financial system must have death to evolve into a better form. Of course, this sounds like a callous statement, but it may be the only way to avoid the moral hazard that Paulson is seemingly creating.

Paulson’s plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise. When will they learn their lesson? If reckless behavior is continually bailed out, when will we ever see a reversion to more risk-averse times? Sometimes a sound and safe bet is the correct one.

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson’s plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

Where Goldman Sachs should be duly rewarded for its safer bets, Bear Stearns should be given its due punishment for its uncontrolled risk. If the stock needs to fall all the way to zero, that’s how Bear’s cookie should have crumbled. Instead, the company has been rescued and placed in the safe, strong arms of JP Morgan. Where is the justice?

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York and London’s continued dominance of the world’s future financial system is government regulation itself.

Mr. Paulson should read F.A. Hayek’s classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top-down rules remove society’s flexibility until one day we all wake up in a paralyzed “command” economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism’s economic successes. It won’t take him long.

Paul Tustain
April 1, 2008

The Daily Reckoning