By Daniel Mitchell - October 1, 2008

The proposed bailout of the financial system is a misguided scheme that will hurt the U.S. economy in the short run and long run. The economy currently is stumbling as a consequence of a government-created housing bubble, but a bailout of companies, executives, and shareholders that made unwise decisions would, at best, extend the economy's adjustment process. More likely, the bailout would impose considerable additional economic damage because political factors would at least partially supplant market forces in determining the allocation of resources.

Some politicians and government officials are making reckless charges of greater financial turmoil in the absence of a bailout. These grossly irresponsible statements may cause short-term market losses as investors try to second-guess how other investors will respond, but the assertion that the stock market's health - especially in the long run - depends on bigger government is belied by real-world evidence. Japanese politicians made many of the same mistakes in the 1990s that American politicians today are considering, and the Nikkei suffered a lengthy period of decline - and remains today far below its peak level.

Proponents of a bailout also are trying to rattle credit markets by arguing that inaction will cripple commercial and household lending. Fortunately, there is little evidence of a freeze in credit markets, thought the Administration's rash rhetoric and the specter of a bailout doubtlessly are causing needless uncertainty and temporarily higher interest rates. Once the issue is resolved, one way or the other, credit markets will resume normal operations. The only question is whether capital allocation will be distorted - and long-run growth hindered - by government intervention.

Providing government with enormous - and opaque - new powers is likely to exacerbate economic uncertainty and increase system-wide risk. There is no need to incur this additional risk when the Federal Reserve and Federal Deposit Insurance Corporation have been able to deal with several major institution insolvencies (Washington Mutual, Wachovia, Bear-Stearns, Lehman Brothers, and AIG) with existing authority.

Why the Bailout is Bad for America

• The bailout is bad for the economy. The unfortunate truth is that bad government policy has resulted in excess investment in the housing sector, and the inevitable reallocation of labor and capital is going to cause some economic dislocation. The good news, though, is that this process - if not hindered - will create a stronger and more vibrant economy. A bailout, however, will discourage this process and reduce economic efficiency. This may not seem important in the short run, since modest changes in the rate of economic growth are difficult to perceive. But in the long run, because of compounding, even small changes in the rate of growth can have a significant impact on living standards. Small differences in annual growth rates are why disposable income in the United States is substantially higher than disposable income in nations that practice economic interventionism, such as France, Germany, and Japan.

• The bailout repeats the mistakes Japan made in the 1990s. There are several historical episodes that indicate the dangers of government intervention to prop up a bubble. Japan faced a similar situation at the end of the 1980s, with real estate prices rising to absurd levels. The bubble then burst, but rather than let market forces operate, Japanese politicians sought to prop up both insolvent institution and asset prices. This interfered with the orderly reallocation of labor and capital, created considerable uncertainty, and contributed to a "lost decade" of economic stagnation. Another worrisome parallel is what happened during the 1930s. Policy mistakes such as protectionism (Hoover), higher tax rates (Hoover and Roosevelt), increased government spending (Hoover and Roosevelt) and increased intervention (Hoover and Roosevelt), helped turn a stock-market correction into the Great Depression.

• The bailout will increase corruption in Washington. When politicians have more power over the allocation of economic resources, people have an incentive to play the "rent-seeking" game of exchanging campaign contributions and hiring lobbyist in hopes of obtaining unearned wealth (or, more honorably, taking the same steps in hopes of protecting themselves from those seeking unearned wealth). The squalid mess at Fannie Mae and Freddie Mac was made possible in part because politicians received enormous amounts of money from advocates of the two government-sponsored enterprises. If the government obtains power over financial markets, including the ability to steer money to particular firms, it will create a feeding frenzy of lobbying and influence peddling.

• The bailout rewards executives and companies that made poor choices. Unfettered markets are the best generator of prosperity because people have incentives to make wise decisions. If an entrepreneur figures out a way to provide a valued good or service to others, he can become wealthy. But if that entrepreneur makes a mistake, he will suffer losses and maybe even bankruptcy. If investors put money into a well-run company, they can increase their wealth. But if they put their money into a poorly-run firm, the opposite can happen. In other words, market forces encourage people to make smart decisions so they can prosper. But it is equally important that people bear the consequences when they make wrong choices.

• The bailout will encourage imprudent risk in the future. The debacles at Fannie Mae and Freddie Mac, as well as the savings & loan failures from the late 1980s/early 1990s, are compelling examples of the negative economic consequences that occur when profits are privatized but losses are socialized. Faced with this perverse incentive structure, people engage in riskier behavior (analogously, if you are in Vegas, and somebody else is going to cover your losses, you obviously have an incentive to make bigger bets). A bailout would extend this risky behavior to the whole financial system, if not the entire economy.

Government Caused the Turmoil in Financial Markets

One of the ironies of the bailout debate is that supporters think that more government intervention is the solution to problems caused by bad government policy. The main mistake was probably the Federal Reserve's easy-money policy. By creating too much liquidity and by driving interest rates to artificially low levels, the Fed set in motion the conditions for a housing bubble.

But this housing bubble is particularly severe because another government mistake - the pernicious and corrupt policies of Fannie Mae and Freddie Mac - lured many people into mortgages that they could not afford. When a housing bubble bursts, that can have a negative effect on economic activity because people lose wealth (or lose the perception of wealth). But when people have been lured into homes they cannot afford and a bubble bursts, the economic consequences are more severe when a bubble bursts because people not only lose wealth, they also lose their homes. .

Other mistakes include policies such as the Community Reinvestment Act, which extorted banks into making loans to consumers with poor credit. There are also many other policies that have encouraged economically inefficient levels of housing investment, such as the mortgage interest deduction in the tax code.

Short-Term Swings in the Stock Market Should not Determine Policy

Supporters of the bailout breathlessly watch the Dow Jones Industrial Average and interpret any downward movement as evidence that a bailout is necessary. This is a rather odd benchmark, particularly since it almost goes without saying that a $700 billion transfer from taxpayers to the financial industry is going to increase - at least in the short run - the value of financial assets. A $700 billion transfer from taxpayers to the auto industry would increase the value of auto companies, but that is hardly an argument for such a handout.

Moreover, short-term stock market performance is a bad indicator of good government policy. The Dow Jones Industrial Average rose substantially in the weeks following the imposition of wage and price controls by Richard Nixon in 1971. Yet Nixon's policy caused considerable economic damage by hindering market forces. And since it did not address the real cause of rising prices - an easy-money policy by the Federal Reserve, Nixon let the problem fester and worsen, which unavoidably was a major reason for the relatively deep economic recession in 1974-75.

One of the reasons why short-term stock market performance can be misleading is that investors sometimes care more about what other investors think than they do about the underlying fundamentals. This is known as the "Keynesian beauty contest," and though it is not a sound approach for long-term investing, it a perfectly reasonable strategy for speculative short-term investments. And in today's volatile environment - particularly with the reckless comments by Administration officials and Members of Congress, many investors will assume lower stock prices because they think other investors assume lower stock prices.

When government tries to redistribute wealth from rich people to poor people, it causes economic damage by discouraging productive activity by the most successful and by discouraging productive activity from those who are lured into government dependency. The proposed bailout is even more pernicious. It would redistribute wealth from poor people to rich people, and simultaneously encourage reckless behavior by recipients and impose an immoral burden on those that behaved responsibly.