The 2008 Tightrope Walk

My previous post “Balancing Classical Ideas and Active Policies” talked about why policy makers hold at least somewhat to classical ideals. This post hopes to continue this line of though by examining why the government decided not to bail out so many businesses but not others.

Without the Federal Government’s TARP money and the Federal reserve’s lowering of interest rates to practically 0% the economic recovery of 2008 would have been even slower. It is clear without these policies more businesses would have gone out of business and further economic destruction would have occurred. If large sectors of the economy go out of business and new companies have to start from scratch a huge amount of institutional knowledge would be lost. Once lost this knowledge may never be recovered or at the very least will take time to recover. The benefit of preserving the existing institutions is the preservation of this institutional knowledge. If companies are forced to start from scratch they spend time developing and regaining this knowledge; Whereas, if companies are saved after a crisis they immediately will resume improving their productivity.

Should every business be bailed out? In short, no. Classicals argue that the markets should be left alone and any business that goes out of business due to the financial crisis should. In the aftermath of financial crisis they are replaced by new more cautious companies who can weather any future storm. The trick then becomes for policy makers to walk the fine line between protecting the institutional knowledge of existing institutions and ensuring that these same institutions do not become excessively risky because of the government’s bailout safety net.

In 2008 the fine line was walked as Lehman brothers was allowed to go bankrupt but other institutions were saved. Lehman brothers was the sacrificial lamb serving as a warning to institutions that the government safety net isn’t all inclusive and will not protect every shareholder. The institutions the government choose to save were deemed too valuable and costly to restart from scratch as new institutions. In addition, if the government provided a safety net for all businesses it could have incentivized even riskier financial behavior in the future.

This entry was posted in Student Blogs and tagged . Bookmark the permalink.