Friday, January 16, 2009

Why Bail-outs May Not Work

The New Year is yet to start.

I was hoping, like everyone else, that there will be something magical on 31st December night. 2008 was a year like never before: Shall we say it was the best of the times and the worst of the times? Or, more appropriately, it was the season of darkness and the spring of hope, perhaps. A recession, worst in many years, was setting in. But, at the same time, a historical American election took place, wiping out the disappointments and disconnects of last eight years, giving people, across the world, something to cheer about. And, this, apart from the usual flipping of the calendar, will bring a fresh start, I was hoping, along with the usual New Year confectionary.

Recessions are painful, but one can not avoid them. Recessions, as the economists see it, are instrumental in moving forward our economic system and sustaining the cycle of innovation and progress. Joseph Schumpeter talked about creative destruction as the principal driver 0f efficiency and improvement in capitalism: We have one at hand right now.

However, while recessions may be an unavoidable aspect of our economic system, even necessary, but it is corrosive and destructive socially. So, it is understood that the politicians can not let a recession happen. They have to intervene, and they have to stop this from happening.

And, the great hope for Joe Blogs, Joe the Plumber, and myself is that they are successful in the effort.

However, I think, so far, we got a very wrong approach to managing the recession. Great hopes were pinned on government activism, fiscal tools funded by taxpayers' money, and one hoped that such activism will allow us to escape the chaos of the Great Depression of 1929, or even a protracted deep recession of the 1980s. I thought this would turn out to be an unfinished crisis - something tamed up fiscal intervention, leading to a greater chaos coming out of an American loan default years later.

Sometimes, things go bad faster than one would imagine, and this year is turning out to be one. We have already had a significant amount of fiscal stimulus and it has solved nothing. The US government was inconsistent and half-hearted, wasting huge amounts of public funds on failed projects and sending out wrong signals. And, more disturbingly, the incoming administration of Barack Obama seems to be committed on a similar fiscal stimulus plan.

This is bad news. Because this reflects the lack of will to fight the recession and sort it out soon. Schumpeter said it and America preached it to everyone else in the world: Structural adjustment was the word they dished out to every other country in the world, including Japan. The advise was - it was painful, but necessary. But when it came to America, no one seems to have the appetite for the fight.

What am I trying to say? When recession sets in, the appropriate policy response is to try to contain the social impact of it and providing support to people who are losing jobs and income. It is important to provide loan guarantees to small firms, so that credit can flow. However, it is also important to recognize that the structural adjustment is necessary, and the economic pain must be bourne. There is no point giving in to inefficient bosses, bloated unions, and greedy investors. Mistakes must be paid for, by them. Throwing money to keep things as it is, is a colossal mistake and will only worsen the situation.

Think about it: what a colossal mistake bailing out Bank of America is. Those guys went out and bought Merill Lynch. Now, they must pay for their mistake. This is crazy that they eat the lunch and taxpayers pick up the bill - and, in turn, everyone in the world, whose retirement money is saved in US Treasury Bonds [because their governments chose to do so]. There are better uses of that money, and these can be spent in building a social safety net, which will allow us to take on future recessions as they come. Instead, we are bankrupting ourselves - spending our money on some greedy banker and his fat-cat speculators.

There is indeed a lesson to be learnt from Japan's experience. Businessweek published a timely article on Japan's Lost decade, which makes this point. And, as things unfold, and the article points out how fast things are happening now, we must brace ourselves for economic pain [yes, let Barclay's fail!] but social resolve. That's the lesson of recession, one which we refuse to learn.

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