The government’s proper role

There is a real question about the government’s proper role in helping people recover from disasters. Two events in recent days bring this issue to mind: the devastation in Galveston, Texas and the devastation among investment banks on Wall Street.

In both cases government policy, some local and some federal, led people to do very unwise things. Galveston City actively encouraged people to build million-dollar homes right on the waterfront (it increased city tax revenues and provided a building boom). And on Wall Street a conservative administration resisted attempts to impose more regulation on the banks, who were chasing huge paper profits by lending money to poor credit risks and highly leveraged buyers (that’s what a ”subprime mortgage” is).

Now we are pouring hundreds of billions of taxpayer dollars into recovery efforts on both these disasters. It may seem heartless to say we ought to let people (and businesses) suffer the natural consequences of their own folly, especially if the government has been encouraging that folly. On the other hand, if the government will rescue everyone who takes an unwise risk and loses, then why should we not all take more big risks? If we win the profit is ours; if we lose the loss is the government’s (actually the taxpayer’s).

For places subject to natural disasters, like river flood plains and vulnerable seashores, forests subject to frequent fires, earthquake fault lines, etc., it seems to me people ought to build there at their own risk, and if they can’t find anyone willing to insure them, then they simply have to take the risk with their own money. For established communities in such a disaster, it might be appropriate for government to help them relocate their community or town to a safer place, like the bluffs well above the floodplain that floods every few years. But it certainly doesn’t make sense for government to shell out taxpayer money to help people build right back on the same unsafe spot. The billions being poured into New Orleans is probably largely wasted money – much of New Orleans is already below sea level and still sinking, and it doesn’t take a genius to see that there will be more devastating hurricanes over the coming decades and it will almost certainly flood again. The same is true of the vulnerable shoreline and islands in Galveston Bay.

For businesses that make unwise decisions, we risk creating a real moral hazard if everyone thinks the government will bail them out. The Federal Reserve seems to be (finally) realizing that, which is probably why they declined to offer Federal money to bail out Lehman Brothers last weekend. There were powerful arguments for saving AGI – its collapse would probably have sent markets all around the world plummeting. And the government drove a hard bargain (11.5% interest on the loan and 80% ownership of AGI) on the deal, which is probably proper, considering the risk they are assuming. Still, as a general principle, it is probably unwise for governments to save businesses from their own unwise decisions, however strong the political pressure is. Foreign countries that have done that in the past, such as Japan, have generally had much worse economies in the long run, because the market’s natural selection process hasn’t been allowed to prune out the less fit businesses and the unwise managers.

Now the administration proposes to spend about three quarters of a trillion dollars to buy bad loans from banks. If they drive a hard enough bargain (say buy the loans at 20-25% of their face value, this might turn out to be at least revenue-neutral. If they buy the loans at, say, 90% of their face value, they will have simply given the managers and stockholders of these banks a free gift – assuming the risk but leaving the profits to the banks. That certainly would create a moral hazard. In fact, one might be forgiven for the cynical suspicion that this arrangement is simply a way for well-paid bankers to recover from their poor judgment, and keep their high incomes, at the expense of the ordinary taxpayer who will pay the bill.

It’s a hard problem, and requires a delicate balancing act. But in general I think the government should not act to save people or businesses that have been unwise. It is appropriate beforehand for the government to give loud warnings, but if people or businesses ignore those warnings, they ought to assume the risk and the consequences.