Sunday, July 13, 2008

Too Big to Be Privatized

There has been buzz for the past several days that the federal government would move to bail out Fannie Mae and Freddie Mac, and now appears the rumors have proven correct. This follows not so long after the bailout of Bear Stearns. I don't know enough about the banking market to say whether the government has made the right moves with respect to these bailouts, but it strikes me as odd that any private entity should be considered "too big to fail". It seems there two potential routes around this: either ensure that no single firm in a given market obtains enough market share to make its collapse catastrophic, or simply put the critical functions under public control. The former option is problematic in that a) it would require a far more robust (and I mean FAR more) and aggressive type of antitrust regulation than we currently have, and b) it is easy to imagine that, even with a larger number of firms, intense competition might lead the firms to adopt similar approaches such that numerous firms would teeter on the edge of collapse at the same time, and a bailout would be required anyway. The latter option is problematic for the obvious reason that markets are generally more efficient than government management. But this system where private companies are free to reap really impressive profits (as the investment banks have), but the public ultimately bears the downside risk seems untenable.

This problem has always been at the foundation of my opposition to any sort of privatization of social security. In fact, it's worse for social security than for the banking system, because with social security you've got two levels risk to deal with--the institutional and individual. Because even if whatever private institutions we hand the system over to don't fail, if a significant number of individuals managed their risk poorly and get cleaned out, I find it inconceivable that the government wouldn't step in to rescue them. That is, after all, the entire point of the program. It's social security. And once that happens, of course we'd expect everyone else to try to shoot the moon with their investments, because what's the downside? This is the sort of risk we don't want to be distributed. It only works when the risk is pooled. Look for similar problems with some sort of hybridized public/private health insurance. Once we've made a social decision that some service is necessary, for whatever reason (economic stability, national security, moral obligation), handing it over to private entities will necessarily create serious problems with risk management and moral hazard.

I'm not necessarily arguing that, for example, our entire banking system or health care system should be government run. But I do think that in terms of structuring the mix of government and private management of such critical functions we need to try to identify key breaking points and either put them under direct government control or develop some clever system to ensure that private entities approach these functions with the right set of incentives.

Update (7/14): Sebastian Mallaby appears to have a similar take on the issue to mine.


Anonymous said...

I think it's important to note that Fannie Mae and Freddie Mac are institutions that were created by the gov't. I've believed for a long time that these institutions played a major role in supporting the housing bubble (the entire purpose for their existence is to stimulate the mortgage market) and that they would fail and that when they did there was no doubt that the federal gov't would step in and take care of them (an assumption that had been built into their prices for years).

The government does everything it can to make economic downturns impossible. But downturns are inevitable. The more tactics government uses to prevent a purging of the system the more desperately it ends up needing purging. But today the whole system is incredibly fragile. It's on edge. It will become more brittle and unstable until something pushes it over the edge.

As I've said before, recessions are a natural part of the economic system, that play an essential role in the health of the economy overall. Just as in forestry, fire prevention actually creates an imbalance in the system that makes fire more likely (and potential fires more devastating).

If the government has a role here they should be deliberately executing controlled burns rather than squashing the blazes that naturally arise.

I'm not saying that it's unreasonable for government to step in and bail out these big players today. It's true that if one them failed there is a good chance that it would catalyze a global meltdown. The tinder is stacked head high throughout the forest. I would argue though, that we could have avoided this if we been a bit more laissez faire all along.

Joe said...

Those points are all well taken, and I generally agree. I wonder, however, how much of a difference having a stronger social safety-net (similar to northern Europe's social democracies) could change the politics of this.

The reason why the government keeps stacking up the tinder instead of letting it burn off is obvious when you look at voter polling. The economy is typically the top priority going into any election, and as long as any bunch of politicians can stave off disaster for one more election cycle it's all good for them. For voters in marginal economic circumstances (which is probably quite a lot of voters) trying to push of economic downturn to some future point when they might be on sounder financial ground probably makes some sense as well.

Something would have to change in this political dynamic in order for the government's approach to economic downturn to change. One possible approach would be to shift the government's priority from smoothing out the economic cycle itself to smoothing out the direct impact of the economic cycle on voters though social safety nets and the like.