Fed study: Bailouts and stimulus plans can recessions into depressions

July 9, 2009

Some interesting conclusions from a Minneapolis Federal Reserve Bank study of how country’s deal with financial crises. The White House might want to take a peak at the whole thing. Here is a bit of it (bold is mine):

1) Governments are now spending huge sums of public money to bail out financial institutions that had not been previously regulated. … Labor and capital will stay employed in unproductive uses. Incentives for future investment will be distorted by moral hazard problems.  …  Indiscriminate bailouts in the financial sector will reward many of those who made bad decisions and make it even more difficult to assess risks in the future. Understanding the moral hazard problems created by bailouts, many citizens and politicians will call for massive regulation of all financial institutions. Directly and indirectly, massive and indiscriminate bailouts of the financial system will create inefficiency and low productivity.

2) What do we need to do now? The central banks in the countries that are in crisis should lend to banks to maintain liquidity.  … The bailout should not be used to maintain high returns either to the equity holders or to the bond holders in these institutions. Investors who made risky investments should not be rewarded when these investments have  gone bad. Any public spending on investment in infrastructure should be justified on its own merits, especially in terms of its potential for increasing productivity. Otherwise, we should let the market work in letting unproductive firms go bankrupt and reallocating what remains of their resources to more productive firms. Reforming bankruptcy laws in some countries could make this process more efficient.

3) Studying the experience of countries that have experienced great depressions during the twentieth century teaches us that massive public interventions in the economy to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead to a great depression. Those who try to justify the sorts of Keynesian policies implemented by the Mexican government in the 1980s and the Japanese government in the 1990s often quote Keynes’s dictum from A Tract on Monetary Reform: “The long run is a misleading guide to current affairs. In the long run we are all dead.” Studying past great depressions turns this dictum on its head: “If we do not consider the consequences of policy for productivity, in the long run we could all be in a great depression.”

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