Back to principles

In these torrid times, it is sometimes good to remind ourselves of some basic principles. Oliver Hart and Luigi Zingales do this today in the Wall Street Journal.

We believe that the way forward is for the government to adopt two key principles. The first is that it should intervene only when there is a clearly identified market failure. The second is that government intervention should be carried out at minimum cost to taxpayers.

It has clear implications for how we should handle failing companies.

the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG’s obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG’s viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard. AIG may be responsible for its financial problems, but the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior.

One thought on “Back to principles”

  1. The problem is basic principles aren’t enough, especially since most economists highly over-estimate ‘market failure’ and highly underestimate ‘government failure’ (if they even recognise that such a thing exists).

    One also needs to know history. For example, one would have to study banking history in some detail before being able to conclude whether a deposit guarantee is a good thing or bad thing. Before the government guaranteed everyone’s losses, there were private insurance companies that would take care of struggling banks and firms during rough patches. Then you would have to compare whether these companies worked as well as the government alternative, in terms of bringing stability to the system.

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