The Government Bailout of AIG: Why I oppose it and those like it.

           I have been asked why I still opposed the bailout of American Insurance Group (AIG) in 2008 even though it now seems as if the government has made all of the money they ‘invested’ back. I shall endeavour to respond in this post.

           Essentially, the key question that has to be asked when determining whether a seemingly good government ‘investment’ was in fact good is: did the government use its ability to coercively intervene in the economy in order to significantly favour the company it was ‘invested’ in? If it did, it is not fair to compare the return on the government’s ‘investment’ to the investments of private actors, because the government essentially used its power to redistribute wealth from others in favour of the enterprises it has invested in, something that private actors are, thank goodness, not allowed to do. In the case of AIG, the answer to this question is a clear ‘yes’, but the government’s way of doing so was a bit subtle.

           The immediate cause of AIG’s 2008 crisis situation was when credit rating agencies downgraded AIG’s creditworthiness rating because of continuing losses it was making on subprime mortgage-backed securities, which AIG had valued 1.7 to 2 times higher than the recently-bankrupt Lehman Brothers had. This, understandably, weakened investor confidence in AIG, leading to a dramatic drop in their stock price. Ownership of these overvalued mortgage-backed securities, and other ‘toxic’ assets, was what put AIG and many other big financial firms in such a precarious financial position, which came to a head when, due to the bursting of the housing bubble, market participants started valuing these assets more realistically, at far lower levels than their book values. Supposedly in order to avert a serious financial crisis, it was at this point that the Federal Reserve, the central bank of the US, started engaging in unorthodox monetary policy manoeuvres: they started giving banks and financial companies freshly-created cash in exchange for the ‘toxic’ assets these private companies held. To be more precise, between March 2009 and August 2010, the Fed purchased approximately $1.1 trillion (book value) of mortgage-backed securities from the banking/financial system.

           Needless to say, these policies were highly inflationary moves. Monetary inflation is a means of redistributing resources: resources are redistributed from those who will receive the newly-created money late in its flow through the economy, or not at all for those on fixed incomes, to those who receive the newly-created money relatively early on in its flow through the economy. In this case, the most obvious and greatest beneficiaries of these inflationary policies are the companies holding the toxic assets that the central bank is now willing to buy at an artificially high, by market standards, cash value. In this sense, AIG benefitted greatly from the Fed’s policies. Since the mortgage-backed securities are still toxic assets, that is, holders of the mortgages are not more likely to pay them now than they were before the 2008 crisis due to falling home prices and generally bad economic times in the US, we see that only through the Fed’s extraordinary inflationary measures to save the financial system was AIG itself saved.

           Besides this, one major purpose of inflationary monetary policy is to push the market interest rate artificially below what would have prevailed in a non-inflationary free-market. These artificially low interest rates without a doubt were beneficial to AIG, it made ample use of this cheap credit to bridge the gap between its crisis situation and its recent return to financial stability. The downside of these artificially low interest rates is that they set the stage for another boom and bust cycle in the future. Thus, the government (the Fed is for most intents and purposes an agency of the government), did in fact coercively intervene in the economic order to secure its ‘investment’ in AIG, at the expense of late receivers of the newly-created money and all those who will suffer in the future boom-bust cycle that its monetary policies have set the stage for.

           So much for the particular case of AIG. When considering government bailouts of ailing firms in a financial crisis in general, several more pernicious effects can be identified:

           1. Moral Hazard: The big financial firms took on a large amount of risk in the boom period before the 2008 crash, and they profited in accordance with those risks. When the bust came though and the risky investments turned sour, the government stepped in and bailed these firms out of their mess, thus socializing a substantial portion of their losses. If economic actors believe that the government will take similar actions in the future (and it would probably make sense to do so given the almost unanimous, bi-partisan support for the allegedly ‘necessary’ 2008 bailouts), a situation is created where actors expect profits to be private, but losses to be socialized. This will create perverse incentives favouring the taking on of excessive amounts of risk and debt amongst many economic actors. This will tend to result in an above-normal rate of capital misallocation, which makes poorer all members of the market society. In a situation which promotes these perverse incentives, calls for tighter government regulations on these actors’ economic activities make some sense. However, at best, these regulations will be cumbersome, reactive, insufficiently flexible, costly, and generally inferior substitutes for the market’s natural regulation of economic activities through the mechanisms of profit and loss. At worst, regulators will be ‘captured’ by the lobbying efforts and the political influence of the firms they are trying to regulate, and the regulations will become means of favouring one group of firms (usually bigger, more well-established ones) at the expense of other firms in the industry and the consumers in general.

2. The government forces a certain level of risk on the taxpayers: Even in a bailout situation where the government has not intervened elsewhere in order to favour the firms it has ‘invested’ in, it is still taking on a certain level of risk with its investment. The government doesn’t typically save up piles of money in order to invest though, so in most cases, it is the taxpayers (or inflation victims) who are actually on the hook if the investment turns sour. When investing their funds through voluntary, free-market means, people will either invest the money themselves or will hire an expert to do it for them. In either case, directly or indirectly, the owner of the invested sum will consider how much risk he is willing to take on, with riskier investments usually promising higher returns if they work out. When the government takes the taxpayers’ money and ‘invests’ it for them, the taxpayers have, for all intents and purposes, no influence over the amount of risk the government takes on using their funds (To the best of my knowledge, no election campaign has ever concerned itself with such technical, financial issues, and in a ‘crisis’ situation like in 2008, there is no intervening election anyway). Some people are more risk averse, some less so, but the government’s ‘investing’ does not take these subjective preferences of the people whose funds it is handling into sufficient account.

3. Negative Political Effects: the ‘Occupy Wall Street’ syndrome: The government bailing out big private firms with ‘public’ money lends itself to the socialist theory that the market, or ‘capitalist’ system, is a system where ‘the rich’ constantly exploit ‘the poor’, enriching themselves at the expense of the downtrodden. This is a fairly accurate description of a government bailout, but has nothing to do with a free-market unhampered by government interference. Unfortunately, most leftist political activists are too ignorant and intellectually shallow to recognize this distinction, so they just attribute all of the negative effects of a system of government interventionism, or ‘crony capitalism’, to ‘capitalism’ in general, including the free-market variety. They don’t distinguish between the rich who have made their money primarily through government favours, a form of exploitation, and those who made it by serving the consumers well. Radical policies, sure to do more harm than good, are proposed and are given credence because of this confusion, occasioned by bailout politics.

4. Theoretical reasons why the government will, on average, be a worse investor than private ones: Whenever the government is determining how to allocate money, there is always the distinct possibility of political considerations affecting their decisions. Various governments’ investments in ‘green energy’, an industry of questionable market value but of great political value, illustrate this point, to say nothing of more sinister political considerations such as whether potential investment candidates are friendly with the government or political party in power. Also, the officials responsible for government investments will tend to have less personally riding on the monetary outcome of these investments than private investors, where their own monetary interests if independent or the size of their client base if a professional is directly related to the performance of their investments.   

5. Under a regime where bailouts are expected, a higher premium is placed on political connections: The more discretionary benefits the government is capable of dispensing, the more of a premium is placed on establishing political connections if you are a private firm. Money that could have been spent developing better and cheaper products for the consumers is increasingly spent on lobbying and campaign contributions. This is important in an interventionist regime where the possibility of receiving a bailout in times of trouble is high for those with political favour: political influence can make the difference between being the ones bailed out versus being the ones asking “where’s my bailout?” in a crisis.

           Finally, we should ask the question: what is so bad about big firms who have made bad investments in the past going bankrupt when these bad investments are revealed as such anyway? The bust is the corrective phase of the boom-bust cycle, it is when malinvestments made during the boom are revealed as such and thus must be revalued by the market to coincide more closely with economic realities. When a firm goes bankrupt in a crisis, its assets do not disappear from the face of the earth, they are just revalued and taken over by the creditors of the firm, who tend to be intent on deploying these assets to their most value-productive uses in order to reap a return in the new economic climate. In AIG’s case, there are sophisticated liquidation procedures in place for when insurance companies go bankrupt, in which policy holders are given high priority claims to the bankrupt company’s assets in order to keep their policies going and to collect outstanding claims. Also, claim guarantee associations are organized in each state in the US that covers a certain amount of a life insurance or health insurance claim in the eventuality of liquidation of the insurance company. Besides the moral hazard effects outlined above associated with rewarding improvident firms with bailouts, trying to artificially prop up the prices of ‘toxic’ assets through government bailout policies and central bank unorthodox monetary policies can only delay the necessary corrective adjustments and prolong the stagnation of the bust period.   

           Thus, though the bailout of AIG was seemingly costless, in fact it was anything but, and the relative ‘success’ of the government’s ‘investment’ in AIG cannot be assessed in isolation, without taking the costs of the government’s economic interventions in favour of firms like AIG and of bailouts in general into account. This is why I don’t support government bailouts of private firms.