The government is not the answer to financial failures
By Owen Kamphuis
web posted September 23, 2024
Is any company too big to fail? In the past 20 years, companies from all sectors that many would have thought too large to fail have closed their doors or been bought out. ToysRus, General Motors, Lehman Brothers, and many other corporations failed, shocking consumers. In his article, "How the Tricks that Crashed Wall Street can Save the World," one of the claims that Harvard Professor and Nobel Prize winner Oliver Hart makes is that what caused the 2008 financial crisis was the financial sector's "distorted incentives."
Hart's first suggestion, that the safest way to earn money on Wall Street is to take chances, begins to show the "distorted incentives" that he mentions earlier. Hart claims that, "For the past three decades, the most fail-safe way to make money on Wall Street has been to take on risk, borrow, and bet… Either you are lucky and you make a bundle, or you are unlucky and you walk away." Of course, this theory seems accurate. When an investor borrows and then makes a profit of 200 million dollars, they pay off their loan and take the cash home. However, when someone cannot pay back a loan on an investment that fails, the question remains of how to prosecute them. The average borrower does not keep tens of millions of dollars in the bank to pay off failed loans. Hart says that borrowers partially figured out how to manage this themselves by imposing covenants and keeping an eye of the borrower's use of money. This caused wildly gambling on the stock exchange to work less well.
However, Hart explains that, when the government steps in to bail out ruined borrowers, the entire system of borrowing begins to fall apart. Although it may seem that government bailing out a failed borrower would help stabilize the economy, in reality it does not, explains Hart. He is right in that government action makes loans beneficial to both the borrower and the lender. There no longer remains a risk of failure and losing money for either side. While this may be good for the investors and banks, it is terrible for the average taxpayer as precious tax dollars are spent bailing out loans that would never have taken place if the parties involved knew the government would let them fail.
Hart's final claim involving distorted incentives is that the perception that some companies are too big to fail encourages blatant risk-taking. In the penultimate paragraph of his article, Hart says that: "The most dangerous legacy of the financial crisis is the perception that some institutions are too big to fail. This perception distorts competition and the allocation of capital, favoring risk-taking and incubating the conditions for the next crisis." Institutions that seemingly cannot fail hurt the entire financial sector because of the assumption that the government must step in to save them causes unnecessary risk-taking from both lenders and borrowers. However, a government also cannot refuse to step in, because this could result in the entire banking system falling apart. The profit-only focused, self-centered motives of the financial sector result in tricky situations for governments. The distorted motives need to be checked by internal systems.
Although some large firms have been bailed out by the government, many have not. Although this could often be viewed as negative by people who think that the government should always step in to save companies, it also has a positive side. The failure of some large institutions causes awareness that the government cannot and will not always bail out large companies. However, the core issue is the distorted incentives that persist in the financial sector. Risk-taking cannot succeed overall without checks and balances, otherwise, the investors simply walk away, leaving the lenders or the government in trouble. The government's role in the financial sector should be to put checks and balances in place, and then let companies keep themselves afloat. When the Silicon Valley Bank failed in 2023, the Biden administration stepped in, carefully avoiding the word "bailout" to save the people with deposits in the bank. However, due to cost the government could not afford to bail out all of the investors, showing some partiality on the side of the government. However, the entire cost still reached $22 billion dollars, although it is unclear who exactly paid all of that. As Oliver Hart says, the distortion of incentives in the financial district was a leading cause of the 2008 crisis and, unless checked, could lead to another unless corporations and governments realize that no corporation is "too big to fail" and that bailouts are not the way to save corporations. 
(c) 2024 Owen Kamphuis. This is Owen Kamphuis's first contribution to Enter Stage Right.
