Monday, December 15, 2008

Bailouts Raise Moral Hazard Issue to New Levels as Deficits Grow

Just as the mantra of the dot.com era was profits don’t matter, at least until the bubble burst, the mantra of the federal bailout era is deficits don’t matter. This mantra has even been taken up by supposedly fiscal conservatives in Congress who have abandoned the pay-as-you-go principle that they so recently embraced. Can there now be any doubt that the tax cuts in the 2009 economic stimulus legislation will not be offset by revenue raisers and enhancers in direct contradiction of pay-go.

For the first time in history, waging a very expensive war was accompanied by a huge tax cut instead of austerity. With the budget thus thrown off balance, it will be very difficult to try and spend our way out of the current crisis. The G-20 countries have called for fiscal stimulation measures, while at the same time maintaining fiscal sustainability. But we cannot have it both ways. The unpleasant truth is that the room for another monetary stimulus is extremely limited. There is no way of knowing what the ultimate budgetary consequences of the unpaid for bailouts will be.

Should we abandon central bank and government support of the financial sector? Obviously not, since interventions by public authorities around the world is necessary to avert a systemic meltdown. But we must admit that free market advocates grossly underestimated the moral hazard, said Hans Hoogervorst, Chair of the Netherlands Authority for the Financial Markets and Vice Chairof the IOSCOI Technical Committee. When a financial or even industrial sector knows it will be bailed out when things go wrong, he reasoned, it has a huge incentive to privatize gains and socialize losses.

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