All Commentary
Wednesday, November 18, 2009

Too Big to Fail?

Government's New Excuse for Bad Economics

The New York Times declares that the Obama administration wants to “rein in” those businesses “too big to fail.” The story says:

Congress and the Obama administration are about to take up one of the most fundamental issues stemming from the near collapse of the financial system last year — how to deal with institutions that are so big that the government has no choice but to rescue them when they get in trouble.

That sentence represents the sort of ignorance of economics that helped lead to the current crisis. Unfortunately, it seems that the government is bent on pushing through legislation and regulations that might seem on the surface to be an “answer to the problem,” but actually will make things worse.

However, I think I should note that for all of the “novel” and “innovating” things we have seen from the government and the Federal Reserve System over the past two years since the crisis began, what we really are observing is Washington doing today what Washington was doing during the 1930s. We know how that turned out.

So far the government has trotted out ideas like increasing reserve requirements for large financial institutions to actually breaking them up via government force so that if one fails, it will not likely “threaten the financial system.” The Times notes:

Some economists believe the mammoth size of some institutions is a threat to the financial system at large. Because these companies know the government could not allow them to fail, the argument goes, they are more inclined to take big risks.

This is a non sequitur, and it certainly does not follow logically that the very size of a firm is what will lead its managers to take large risks. Instead, as we have seen throughout the meltdown, firms took huge risks because (1) the Federal Reserve System made a number of both explicit and implicit guarantees that it would “provide liquidity” if problems arose, and (2) the government and the Bush administration’s ill-fated “Ownership Society” initiative pushed home sales. At the government’s insistence, financial firms lowered their underwriting standards, creating a hollow “subprime” market that ultimately imploded, taking down a lot of firms in the process.

As for other firms like General Motors and Chrysler, the notion that their failures would force a never-ending downward spiral is not based in sound economics but rather politics. Both firms were in such sorry financial shape earlier this year that to permit them to go out of business and sell all their assets would have had a positive effect on the U.S. economy. That is because forcing taxpayers to throw money into the bottomless pit of GM and Chrysler ultimately made people poorer not wealthier.

The notion that governments can determine the “optimal size of the firm” is beyond laughable, yet the socialist U.S. Senator Bernie Sanders has introduced a law that does just that, and it is being taken seriously. As Murray Rothbard noted in his classic Man, Economy, and State, the “optimal” size of a firm is determined by the ability of its principals to engage in the necessary economic calculation that will permit the firm to prosper. It is a market, not a government, issue.

The demise of GM and Chrysler had nothing to do with their size; it had everything to do with wrongheaded decisions made by managers who gave into the United Autoworkers, which raised company costs while contributing to productivity declines. These firms operated in imaginary worlds that should have come to an end in bankruptcy court.

Unfortunately, the last thing the U.S. economy needs are bloated firms that are making “profits” only because taxpayers are forced to make themselves poorer by transferring their money from their own accounts to these unprofitable behemoths in order to prop up ridiculous labor agreements that never could survive in a free market. And, of course, the final irony is that the greatest behemoth of them all, the U.S. government, supposedly has the wisdom to impose the rules for “optimal” size of firms. Good luck.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.