My Two Cents

Smart thoughts on the bailout

Chris Farrell Dec 3, 2008

Economist Oliver Hart of Harvard University and Luigi Zingales, professor of finance at the University of Chicago graduate school of business have a thoughtful piece in today’s Wall Street Journal. (a subscription is required.) They are distressed by the current Administration and they’re proposing two principles for government intervention in the market.

We believe that the way forward is for the government to adopt two key principles. The first is that it should intervene only when there is a clearly identified market failure. The second is that government intervention should be carried out at minimum cost to taxpayers.

How do these principles apply to the present crisis? First, the market economy provides mechanisms for dealing with difficult times. Take bankruptcy. It is often viewed as a kind of death, but this is misleading. Bankruptcy is an opportunity for a company (or individual) to make a fresh start….

Thye wonder why not let Bear Stearns, AIG, Citigroup Geeneral Motors and other troubled companies go into bankruptcy. If there are systemic financial problems that emerge from the fling of Chapter 11 help the third parties rather than the distressed company itself.

In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG’s obligations to J.P. Morgan and those who bought insurance from AIG….

They then look at the housing market. Forget propping up home prices. Yes, lots of people made a financial mistake betting on home prices. But that’s the nature of the beast. However, there is a role for government:

Where there is arguably a market failure is in mortgage renegotiations. Many mortgages are securitized, and the lenders are dispersed and cannot easily alter the terms of the mortgage. It is unlikely that the present situation was anticipated when the loan contracts were written. Government initiatives at facilitating renegotiation therefore make a lot of sense.

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