Econ 101: The Problem with Bailouts

     The difficulties in the subprime lending market are beginning to generate a chorus for a bailout of the mortgage industry. The media emphasize stories of people losing their homes to foreclosure and potential panic as adjustable-rate mortgages are adjusted up. Yet a bailout, however structured, would be a bad idea.

     As Sherlock Holmes told Dr. Watson in “Scandal in Bohemia,” one problem is that we see but do not observe. For every homeowner who loses his home and moves into a smaller home or a rental, there is another homeowner who moves into that home and out of a smaller home or rental.

     When someone defaults on a mortgage and that home is foreclosed, bulldozers do not show up the next day and plow the house into the ground. For every seller there is a buyer.

     It would be interesting if the media began doing stories on how much more affordable it is for people to move from rented apartments into owner-occupied homes. The house that used to cost $280,000 and was out of the reach of the young family is now $220,000 and becomes affordable.

     It seems that when housing prices are high, the view is that we have a problem with affordability, and when housing prices fall we have a problem with declining homeowner equity. Actually, we just have a situation where prices move up and down in response to demand and supply conditions. Some people bought high and will now sell low, and some people will be able to buy low and will sell high at some point in the future.

     Professor Gordon Tullock used to suggest in his class that if we wanted to reduce driving accidents we should put a sharpened spike on the end of the steering column. The point he was making is that insuring against risk causes people to behave in a riskier fashion.

     This is known as moral hazard. A bailout of the mortgage industry would be a good example of moral hazard. The currently perceived problems are the result of overly aggressive lending practices by lenders; risk taking by buyers who, when taking out a mortgage, guessed that housing prices would rise and interest rates fall; and hedge fund managers who were highly leveraged and gambled in the mortgage-based securities market.

     If the federal government, including the Federal Reserve, bails out the mortgage industry in some fashion, the market will quickly learn that taxpayers will bear some of the risk of the investments of homeowners, lenders, hedge funds and other market participants. This will result in their taking more risk than is economically justified, encouraging the very activity that led to the situation of declining housing prices and foreclosures in the first place.

     Noble Laureate Friedrich Hayek wrote in “The Constitution of Liberty” that a free society demands more than any other that people be held responsible for their actions. In this case, that included several groups. Lenders who made loans to people who were likely candidates to default. Borrowers who took out a mortgage with payments too high for them to make realistically unless they could refinance in the future. Hedge fund managers who made great returns for awhile in the mortgage-based securities market because of their highly leveraged positions – but lost a lot of money when prices fell. All need to be held responsible for their actions.

     We as individuals may feel sorry for all those who made a decision that turned out badly for them. Some may be helped through charitable contributions. But a market economy and a free society cannot operate when people are not held responsible for their actions.

     Government bailouts really mean that all those who made responsible decisions and/or undertook less risky behavior will be forced to give money to those who undertook great risk or made irresponsible decisions.

     This will set a precedent not only for the housing market, but for financial markets in general. Why not bail out dealers in commodities markets, or individual businesses who invested heavily in a product that didn’t pan out? Rather than continue the precedent of bailouts, we should set the precedent that individuals will be held responsible for their actions. The markets will absorb this information quickly, and it will greatly reduce the chances that we will have future problems in the mortgage sector – or any other sector of the economy.

Dr. Gary L. Wolfram, a Business & Media Institute adviser, is the George Munson Professor of political economy at Hillsdale College in Hillsdale, Mich.