The True Cost of Government Bailouts

Here, I explain why the government should not bail out failing businesses.*

[* Based on: “The True Cost of Government Bailouts,” Georgetown Journal of Law and Public Policy 11 (2013): 335-48. ]

1. Background

Periodically, large businesses are in danger of failure, and the government “bails them out” to enable them to stay in business and preserve jobs. A common rationale is that a business is “too big to fail”, meaning that it is so large that its failure would disrupt the overall economy, leading to further business failures, unemployment, etc.

Examples: They bailed out the Penn Central Railroad in 1970, Chrysler corporation (the auto maker) in 1980, a series of savings and loans in 1989, the airline industry in 2001, and the financial sector in 2008. The 2008-09 bailout also included bailouts for the auto industry, particularly GM and Chrysler.

What do these bailouts cost us? Typically, the news media will report a dollar amount, e.g., we hear of a “$15 billion airline bailout”. In 2008, we heard over and over about the “$700 billion financial bailout”. I suspect that most news consumers have no idea what those numbers are (the news stories almost never say). They probably think it means that the government just gave $700 billion of free money to a bunch of failing banks.

That of course is not what it means. Even the federal government isn’t that stupid. Usually, they give loans to the failing companies, which have to restructure and reform themselves to return to profitability, after which they have to repay the loans.

So the cost of the “$700 billion bailout” was not $700 billion. In fact, some say the government turned a profit on the whole deal (https://www.investopedia.com/articles/economics/08/government-financial-bailout.asp). (But others disagree: https://mitsloan.mit.edu/ideas-made-to-matter/heres-how-much-2008-bailouts-really-cost.)

What was the true cost? The main costs that should concern us are not the money that the government directly loses. The main costs are in terms of justice and overall, long-term effects on our economic and political system.

2. The Injustice of Bailouts

Like everything that the government does, bailouts are financed by taxation, which means that the government forces individuals (who were not responsible for the business’ impending failure) to pay to help save a failing business. Sometimes, the government loses money on the deal, which essentially means that money was stolen from taxpayers to help businesses that did a crappy job at running their business, or (more likely) to help the creditors of those businesses who did a crappy job of deciding how to invest their money.

Other times, the government makes a profit on the deal. But even so, many taxpayers simply do not want their money to be spent in this way. The 2008 financial bailout was particularly unpopular, and the auto industry bailout most unpopular of all. If you mismanage your business until it is on the verge of bankruptcy, other people who had nothing to do with your mismanagement should not be forced to spend their money on saving your business.

Bailouts are particularly unfair to competing businesses. By any notion of fair competition, the well-run businesses deserve to capture the market share of the poorly run businesses. For example, in the same year that GM was losing $31 billion and begging for government assistance, Toyota posted record profits of $17 billion (thus proving that the 2008 recession did not, in fact, make it impossible for an auto company to be profitable; GM was just doing a terrible job). Toyota deserved to reap the benefits of GM’s failure. They (including their U.S. employees) did not deserve to be forced to bail out GM.

3. Economic Costs of Bailouts

A. Moral Hazard

The moral hazard problem as usually stated: Bailouts encourage large companies to take big risks. If things go well, they keep the profits; if things go sour, they get to shift the losses on to the government.

No, that’s wrong. If you look at what actually happens in these bailouts, the executives of the companies usually lose their jobs. (Note: Often, they get ridiculous severance packages which insulate them from the consequences of their mismanagement, but that problem is completely unrelated to government bailouts; the bailouts do not increase these irrational severance packages, so they don’t increase the incentives for executives to act recklessly.) Equity investors (esp. stock holders) also lose a lot of money, so there’s no moral hazard for them either.

But there is still a problem: In government bailouts, counterparties of the large, failing company (people they did business with) are commonly insulated from losses. Ex.: When AIG was bailed out in 2008, its counterparties -- to whom it owed $62 billion -- were completely insulated from loss. Without the bailout, they would have lost close to the whole $62 billion.

What this means is that the government’s bailout policy creates incentives for other agents – individuals and companies – to keep doing business with a large company that takes excessive risks. Indeed, if a company is big enough (so it would be judged “too big to fail”), you can completely ignore questions of that company’s solvency when you do business with them. This makes it possible for such companies to continue reckless practices.

B. Misallocation of Resources

Q: What does it mean when a business is losing money?

A: Fundamentally, it means that that business, as a whole, destroys value.

Every business takes certain scarce inputs (labor, land, natural resources, capital), and turns them into goods and/or services. The reason for doing this is that the goods and services produced are normally worth more than the inputs used to produce them.

If a business is losing money, that means that it is selling its goods and services for less than the cost of the inputs. That means, in general, that its products are worth less than the resources it is using up to produce them – i.e., it is destroying value. The market has a natural solution to this problem: if the business loses money long enough, it goes out of business and is forced to stop destroying value.

Government bailouts stymie this mechanism and thus allow a business keep destroying value. Even if the business later returns to profitability, the bailed out business will still typically be making a less efficient use of its resources than other businesses that didn’t need bailouts.

Capital is a scarce resource. When the government bails a business out, they are taking capital that could have gone to other uses and allocating it to save that business. Normally, the government raises the money by selling Treasury bonds, which means they are using money that investors probably would have put into some private-sector investment. The fact that the business needed the government to bail them out means that no private sector investors were willing to put their money into that purpose. And that means that the judgment of the community of investors was that such would not be an efficient use of capital.

So, even if the government ultimately saves the business and it returns to profitability, this was probably a misallocation of resources.

C. Macroeconomic Risk

Usually, companies begging for a bailout claim that the failure of their company would result in some kind of economic catastrophe. We would be foolish to trust in such self-serving speculations.

In 2008, people claimed that the bankruptcy of the auto makers would lead to economic Armageddon; hence the need for a bailout. They got the bailout. But it turned out that GM and Chrysler were so insolvent that they had to file for Chapter 11 bankruptcy in spite of the bailout. We thus had a chance to test the speculations people had made earlier. It turned out that no Armageddon happened.

Anyway, bailouts increase macroeconomic risk in the long run. They enable huge but badly-run companies to persist. Even when the senior management is replaced, it is unlikely that all problems at these companies will be fixed. For example, if one of the problems at GM was that its cars are simply worse than Toyota’s cars, that problem probably hasn’t been fixed.

As mentioned above, bailout policy leads other people and businesses to be more willing to do business with huge, “too big to fail” companies, without worrying about whether those companies are solvent or are taking excessive risks. Huge companies are thus able, e.g., to borrow more money at more favorable rates than would be true for smaller companies. All this encourages greater concentration of industries in the hands of huge corporations and enables them to take more risky strategies.

That is to say that government bailouts preserve and exacerbate the very conditions that create the need for bailouts. They cause industries to be dominated by just the sort of companies that create risks of triggering major recessions.

4. Political Corruption

There is evidence of corruption in government bailouts. One study found that companies with close ties to government officials were two and a half times more likely to get a government bailout than companies without such ties. In the 2008 financial sector bailout, Congressional Representatives who supported the bailout had received 54% more campaign contributions from banks and security firms over the preceding five years than the Representatives who opposed the bailout.*

[ *Sources: Mara Faccio, Ronald W. Masulis, and John J. McConnell, “Political Connections and Corporate Bailouts,” Journal of Finance 61 (2006): 2597-2635. Pamela Behrsin, “Financial Bailout Vote: House Members Voting ‘Yes’ Received 54% More Money from Banks and Securities,” Maplight, Sept. 29, 2008, http://maplight.org/financial-bailout-vote-house; accessed 9/272012. ]

Bailouts probably contribute to corruption in at least two ways: (a) they enable firms with problematic connections to public officials (that create conflicts of interest) to survive, while otherwise similar firms without such connections are less likely to survive; (b) they create incentives for firms that don’t yet have such connections to develop them. Once these connections exist, they are likely to be used for rent seeking, even if the firm doesn’t need a bailout.

5. Conclusion

The general reasons against bailing out failing businesses are clear and powerful: bailouts are unjust both to taxpayers and to competing businesses, they create a moral hazard problem, they perpetuate resource misallocations, they increase long-term systemic risks to the economy, and they exacerbate political corruption.