The Vicious Cycle

While I am not surprised that Washington's solution to this current financial crisis is to bail the firms out at taxpayers' expense, I am surprised at the overwhelming support for these actions coming from even some of the mainstream media's most fervent supporters of free markets.

The problem with this entire financial crisis and the subsequent government bailouts is that the government refuses to understand the nature of malinvestment. To demonstrate the significance of malinvestment in an economy, a professor once gave this analogy in a course of mine last year:

There is a such thing as a naturally-occurring forest fire. It's often said that these forest fires are somewhat of a self-cleaning mechanism for the forest -- to rid itself of all the dead forestation on the surface and open up the soil to more sunlight and precipitation. The economy, in a sense, acts in a similar way. When poor investment decisions are made, they are eventually rooted out and learned from, allowing for better investment in the future.

While there are certain complications to such an analogy -- as the process of natural wildfires has a multitude of effects other than the one discussed -- it works on the most basic level.

What politicians and pundits alike don't seem to understand about malinvestment is that these sorts of bankruptcies and failures are part of the natural process of rooting out poor investment and financial decisions. Despite this, the government consistently intervenes on behalf of the interests on Wall Street in order to bail out firms whose poor investment decisions have led to the current problem.

Not only that, but both presidential candidates are calling for more regulation of the financial industry as a result of this crisis. This is the fatal error that we seem to commit over and over again, without regard for the vicious cycle that has been created over time. To put it simply, regulation of the banking and finance industries often encourage risk-averse behavior in these industries; that is, when firms know they can count on the government for a billion-dollar bailout, they have less incentive to make more cautious investment decisions. It's economics 101, not rocket science. Instead of letting the natural market process root out this malinvestment, the government calls for more regulation and more safety-netting, further encouraging the exact behavior that got us here in the first place -- thus, a vicious cycle.

Though his rhetoric may be fiery at times, libertarian commentator Lew Rockwell wrote a wonderfully coherent critique of the bailouts in his popular blog, found here. I strongly encourage everyone to read it.