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Too Big to Fail

Government should send the message that no more bailouts are coming

Anthony Randazzo
October 28, 2008

At the height of debate over the bailout, many opponents of the "stabilization" act threw in the towel and said, "All right, lets just get it over with." While this position acknowledged that a bailout was inevitable, it was naïve to think that Congress was getting anything "over with."

The congressional bailout of Wall Street highlights a growing trend of government management of the economy. Amid fears of a global recession, supporters of free markets need to stand up and help taxpayers see that economic philosophy really does matter and that America is headed in a dangerous direction: market paternalism.

The harmful, pragmatic policy solutions that come out of market paternalism can most readily be seen in the "too big to fail" philosophy. Fiscally responsible firms have added valuable assets to their balance sheets by buying up failing firms in the wake of the economic turmoil. While this is the proper market response, this must be done with the right intentions. Firms seeking to grow so large they will be considered "too big to fail" by government policymakers undermine the long-term stability of the economy.

The "too big to fail" philosophy is the belief that there are certain firms so tightly integrated into our financial system that their collapse would cause irreparable damage to the U.S. economy. The concept first emerged in a significant way in 1984 as the federal government orchestrated a $1 billion bailout of Continental Illinois Bank. At the time, Continental was one of the largest financial institutions in America, so big that Congress considered it too big to fail.

Today, JP Morgan Chase has grown so large by its purchase of Washington Mutual, the fourth largest American bank, that some might say it is now too big to fail. In the auto industry, General Motors is buying Chrysler, giving it 36 percent of the U.S. auto market, and putting GM in position to claim that it is too big to fail. Firms like Bank of America, Citigroup, Delta Airlines, and others have been positioning themselves for similar arguments.

These acquisitions are not without great risk. Wells Fargo will take on $74 billion in potential future losses by acquiring Wachovia. And the Chrysler brand is not strong in America today. Bankruptcy remains a very real possibility for these firms, especially considering the instability of the market.

Given the U.S. government's response to the bankruptcy of Fannie Mae, Freddie Mac, AIG and others, there is a very real possibility that the government's market paternalism will coddle firms in a potential bankruptcy.

Historically, the too big to fail philosophy has been applied erratically, reflective of its political nature: failing airlines were covered with $15 billion in bailouts in 2002. But Enron never saw a dime of federal bailout money.

The pattern that has emerged is clearly political, not economic. Enron's scandals made it politically impossible for the government to bail them out, despite the fact that their collapse hurt American banks, the stock market, and investors.

In contrast, after the terrorist attacks of 9/11, the airlines held immense public sympathy, and it was politically savvy to support them, despite the fact that air travel would have continued in the event of mass scale bankruptcy, albeit at a reduced level. Enron executives got blamed for financial losses following their collapse. The Bush Administration would have taken the heat if airlines began going under en masse.

Today, America is threatened with the prospect that too big to fail will actually become a policy of practice, instead of a policy of circumstance. The problem with this philosophy is that it skews the risk assessments of big corporations, which plan to use taxpayer dollars as a safety net in case their investments fail. Just the potential for government intervention changes the way firms do business.

If GM believes that by acquiring Chrysler it will receive special government treatment in the case of an even worse market downturn, then they are treating the U.S. treasury as a limitless financial backstop-economists call this moral hazard.

Of course if GM's investment in Chrysler succeeds, the U.S. taxpayer won't receive any of their profits. This economic philosophy is the privatization of economic gain, the socialization of economic loss. It's a philosophy that must be nipped in the bud before the economic situation gets any further out of control.

Given the propensity for the government to issue more bailouts and stimulus packages, we need American economic philosophy to be clear: if capital investments fail, the government won't issue more money. The free market works, but not when it is manipulated and over regulated. The government can only act as a referee in a free market, once they step onto the playing field, the whole game is changed.

The current public perception, which sees the government's support of failing firms as compassionate, doesn't realize the danger moral hazard creates for a fully functioning market. Too big to fail is the kind of market paternalism that capitalists must be prepared to counter.

Capitalists must stand up and voice their dismay at the economic philosophy being enshrined in America right now. Capitalists must stand up for the preservation of true free market philosophy. Capitalists must stand up now, before the war gets too far ahead of us. The bailout battle might have been lost, but the war has just begun.


Anthony Randazzo is Director of Economic Research


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