Bail Out For The Foolish

My Daddy always said never get between a fool and his mistake – it would sacrifice the only good that might come from the situation. Yet, as the Asian economies have soured, politicians have rushed to “stabilize” the situation and prevent “contagion” – in other words, to protect the foolish.

Perhaps the most critical task of any economy is the allocation of capital. Markets perform this task better than any other system because they rely on human self-interest. Brilliant investors profit greatly; poor investors lose their shirts. Capitalism works because it is a profit and loss system.

Tragically, few politicians are able to resist the temptation to intervene in the market. The result is a mind-boggling array of political instruments that anesthetize the market’s capital allocation institutions. Politicians interfere with prices to reward “politically preferred” investments and penalize pariah sectors; those distortions are exacerbated by the political investment priorities of the World Bank and foreign aid programs. When these distortions create instabilities, as they inevitably do, the International Monetary Fund (IMF) rushes to stabilize the situation, to ensure against cascading losses in today’s increasingly globalized world.

Politics destabilizes the world’s economy, why do we believe more politics will stabilize it? Consider the IMF’s history as “Credit Doctor” for the ailing economies of the world. The IMF typically prescribes painful medicine: increased taxes, decreased spending, austerity and so on. To alleviate this pain, to encourage the nation to make the needed reforms, the IMF typically provides temporary bridging loans to “candy coat” the medicine. But the IMF is a political agency and responds to political incentives – thus when the candy begins to dissolve away and the bitterness of the medicine becomes evident, the IMF rushes in to add more candy. Empirically, this factor accounts for an extremely poor track record. As a credit doctor, the IMF must be classified as a quack.

Sometimes such interventions seem to have no downside. The Mexican bailout – so we’ve been told – was quickly repaid and allowed Mexico to regain economic, if not political, stability. But that lack of pain is misleading. There are always consequences – at minimum, each such intervention encourages some foolish investors to believe that they need not bear the consequences of their acts – and the world becomes more foolish.

Thus, in southeast Asia, the risks of investment – of still another apartment or office complex in Jakarta or Bangkok – were lessened. Implied and explicit guarantees of intervention encouraged the most sophisticated investors in the world to rush money into already over-invested areas. The result was – and will be – a dangerous glut of investment for many years.

Daddy was right – encouraging foolishness is not a good idea. Capitalism works when both profit and loss are private. A system of profit-side capitalism and loss-side socialism is even less stable than full fledged socialism. To remedy this, the role of market-oriented disciplining institutions should expand. IMF bailouts — and indeed the IMF itself — are destabilizing forces. Politicians aren’t skilled at investments; they are no better skilled at selecting which investors to protect.