The misguided call for intervention.

• Author: Gokhale, Jagadeesh
• Position: Economics

AS THE U.S. FINANCIAL crisis persists, policymakers feel compelled to act. They seek to counter the housing-wealth shock by extending the pool of risk-beating creditors. With oil magnates and other wealthy foreigners unlikely to provide sufficient capital injections to private U.S. firms, policymakers are turning to another group of prospective creditors: future generations, who can be "forced" to lend through a debt-financed government bailout plan. Intervention proponents can argue that future generations, were they around, should--and would--be willing to sacrifice some of their (eventually larger) resources to help current generations (and themselves) to dig out of a potentially prolonged economic downturn. However, future generations cannot extend this credit directly because they--and their wealth--do not yet exist.

This reflects a form of market incompleteness that prevents a solution to the current financial market failure. That failure provides theoretical justification for government to step in and effectively transfer resources from future generations to those alive today--assuming that this transfer will be effective in preventing or reducing economic harm from the financial crisis.

Supporters of Pres. Barack Obama's economic policy point to two reasons to believe that the bailout might help to resolve the financial crisis. First, they claim the current version of the bailout would recapitalize banks broadly and revive borrowing and lending activity. It is tempting to think that capital injections should be limited only to financial firms that made reasonable investments but suffered illiquidity because of a widening financial panic, not to those near insolvency because of high exposure to toxic mortgage-related securities. In general, this principle should be followed. However, judging which banks deserve help and which should be terminated is very difficult and lime-consuming, given the broad and deep penetration of housing-related asset failures. Separating the good from the bad would involve unwrapping many layers of complex derivative instruments and the imposition of arbitrary (nonmarket) asset valuations. It would create wasteful lobbying activity by financial firms, a strong incentive for corruption, and require intense public (congressional) scrutiny.

Second, direct capital injections by the Federal government may induce private wealth-holders and foreign savers to commit additional funds to U.S. financial institutions. That inflow of capital could prevent the credit crisis from developing into an economy-wide credit crunch. Such complementarities in alternative investment sources might occur simply because the commitment of future taxpayer funds could reduce foreign investors' perceptions of credit risks among U.S. financial firms and stimulate additional lending.

The foregoing discussion suggests that the government should tailor public policies to the causes and symptoms of particular recessions. Thoughtful proponents of government intervention would argue that recessions arising from shocks to input prices--such as oil prices--at are limited to nonfinancial sectors require restructuring by private firms through technological change. That is best achieved through an unfettered operation of market forces. In contrast, they contend, recessions involving a large wealth shock in this case, declining home values--that results in a broad financial sector collapse require a different approach. Given the crucial role of the financial sector in greasing the economy's wheels, and given the significant potential for market failure, the recapitalization of financial intermediary firms requires borrowing from abroad and from future generations. New government borrowing could induce more investment by foreigners, promoting a quicker restoration of bank capital and an eventual return to normal levels of financial intermediation.

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In short, bailout proponents have met a necessary condition for government...