Worldwide bailouts: A word of caution

“Something that I find to be the height of ridiculousness is the notion that certain companies are too big to fail”

By Anvesh Shetty, Arbitrage Contributor

Although many economists and experts in the field of finance have openly supported the idea of bailouts for financial institutions and industries alike, they have seemingly misinterpreted or simply omitted the long term consequences of taking such vast actions. John-Maynard Keynes himself seemed to have disregarded the long-run effects of his strategies as he has been quoted “in the long run, we will all be dead.”

Of course, this bailout phenomenon is not limited to just Obama’s United States. Governments around the world from the European Union and the United Kingdom, amongst others, have instituted many of the same ambitious “preventative” measures by guaranteeing the integrity of the respective financial systems.

These methods stem from the Keynesian ideal that when a nation is in a prolonged recession or depression, the government must step in to stimulate the economy through spending on certain programs in order to provide jobs for those who are unemployed. Theoretically, this is beneficial to the economy in the short term as it will reduce the unemployment rate as well as give people a living that they can save or spend. However, when governments administer jobs for unemployed people, the nature of these jobs is short term. Once the project(s) is complete, those that were given work will be unemployed yet again.

Now some of these spending programs initiated by government do have some validity if they provided some form of future benefit. For example, if western governments, particularly in North America, chose to spend the same amount that they have given to banks and other industries on infrastructure instead, it may provide some tangible benefits in the long run to justify the increase in spending.

[pullquote]However, something that I find to be the height of ridiculousness is the notion that certain companies are too big to fail.[/pullquote]

As it is well known, many of the major US urban centers have been crumbling for more than a few years now and this is particularly evident with stories of collapsing bridges, buildings, decrepit roads, etc. This isn’t limited to just the US, here in Toronto there are plenty of stories of broken water manes, faulty sewage systems, not to mention the crumbling Gardiner expressway. If the money allocated for bailouts and stimulus packages were instead allocated to the rebuilding of critical infrastructure, it will provide a long term benefit by speeding up the flow of goods and reducing maintenance costs.

Now even an infrastructure investment program will have its own drawbacks, namely the issue of inflation. Consider the fact that the US is already a debtor nation with an out of control deficit, which is the result of exorbitant spending. The US, Europe & the UK simply do not have the money to be able to just give it to financial institutions, unless it was borrowed from a respective central bank or another nation, and would later have to be paid back through inflation.

However, something that I find to be the height of ridiculousness is the notion that certain companies are too big to fail. If a company has made bad decisions that cause them to incur losses and subsequently to become insolvent, the market should be allowed to correct itself. This can be done by letting the company be bought out or liquidated to any public firm; this would then result in a more accurate representation of the actual value of the company in question. The result of this strategy would reward the surviving firms for having their affairs in order.

The most egregious consequence of these government policies is that businesses will continue to operate in an unsustainable fashion by taking too many risks, simply because the precedent has shown that the government will step in and shore up any sustained losses. If certain companies happen to reach a size deemed to be “too big to fail”, executives now have reason to believe they will be bailed out with taxpayer funds. And that’s the saddest part, that these policies risk setting us up for yet another fall.

As recently as April 2009, Bloomberg has reported that “the total amount spent, lent or committed by the US government and the Federal Reserve is $12.8 trillion.” To put that into perspective, that amount is almost equal to the total US GDP from 2008. By injecting that level of public (taxpayer) funds into private firms, it will only prolong the economic downturn and will have a severely negative impact on the recovery of economy in the long term. I believe the result of such actions will be the nightmare scenario: negative growth in the economy over the coming years along with hyperinflation, otherwise known as stagflation. However, in this case I believe a more appropriate term is in order: hyper-stagflation.