Friday, December 12, 2008

Institutional Aspects of a Bailing Out Santa

One of yesterday's posts on this blog referred to a humorous piece about bailing out Santa. But the piece got me thinking about some interesting segues to discuss some the role of institutions (rules) in economic decision-making. And, to be fair, I was further spurred by this morning's news about the failure of the auto bailout. The Santa Bailout is an opening to discuss at least three things that relate to institutions and bailouts.

Moral Hazard: The idea here is that we make different choices if our losses are covered - specifically we take more risk if we know our downside is limited or eliminated. The moral hazard argument against bailout is that firms that have their losses covered do not learn the harsh lessons of the market. However, restructuring is a big risk with no guarantee of success. When backs are against the wall, maybe it's time to take a risk.

Precedent: This concept refers to the fact that something that was done before provides a reason to do it again. While the idea is not generally considered part of the economic lexicon as I know it; it is an idea that is firmly entrenched in American society. Our legal system (rules?) has strong foundations in precedent. And it is not just in the formal rules, but it is a strong informal belief. Our students and we often fall back on precedent when making a case for a decision. "Last time it was done...," or "That's not the way we've handled this before..."The argument that raises precedent against bailouts is that if you bail out this industry, you may need to consider bailing out other industries because the precedent is set. The precedent argument for bailouts is...well, the precedent was already set - see banks (earlier this year), Chrysler & Boeing (for those of us with longer memories).

Expectations: Expectations does have a place in the economic lexicon. It usually refers to how our decisions about future action are shaped, based on past experience. We talk about inflationary expectations, as well as deflationary expectation leading to price spirals. It is the damping of expectations (one way or another) that is often cited as the role of monetary policy in maintaining price stability. But expectations can have other institutional effects. When referring to bailouts, one group sees another group receiving aid and then may make choices based on an expectation that they may be next in line. The anti-bailout argument based on expectations is similar to the precedent argument. Group A received a benefit; my group should get one, too. There have been reports (anecdotes are not data, I know) about people wondering whether to go into default on their mortgages based on stories about programs for delinquent homeowners. The pro-bailout argument is that positive expectations may restore some level of confidence to borrowers/consumers, and to the financial system.

I do not think any of these arguments are definitive. The situation is complex. But as a method to help students understand the complexity of developing institutions, the Santa bailout piece could be valuable.

I look forward to your comments.

1 comment:

bhagan said...

Are there ways that we can solve the moral hazard problem? What can make the car execs act in the interest of the company rather than their own best interest?