Wednesday, February 18, 2009

Who will bail out the taxpayers?

Everybody from large banks and insurance companies, auto makers to Larry Flint is asking for a bailout. Huge numbers of over committed borrowers are all seeking (and often getting) a bailout in the form of debt relief. The bail out may be provided through capital injections or the acquisition of assets of questionable value, but all of that money has to come from somewhere. Likewise, debt relief for borrowers comes at the expense of either the lenders or the taxpayer.

There is no such thing as a free lunch and not even governments can freely print money without consequences. So where is the money coming from?

Ultimately, it can only come from four sources:

1. higher tax revenues: in a recessionary economy raising taxes is obviously a good way to make a bad situation worse because higher taxes (i) divert money from private sector consumption and/or (ii) inefficiently divert money from private sector capital formation. Higher taxes typically hit mid-higher income earners the most - and this is the same group of taxpayers who include small business owners. In most developed economies small businesses generate a very high percentage of new jobs. Cutting taxes (or similar) is a better move;

2. borrowing: the government can borrow the money. As a short term fix this is a better alternative than options 1 and 3, but someone (future taxpayers) will have to repay the loan with interest. Low interest rates make this a more attractive option but is comes with a price beyond the obligation to repay - because government debt is perceived as being lower risk, it has the effect of crowding out or increasing the borrowing costs of private sector borrowers. There is also the question of who the money is being borrowed from? If the lenders are domestic, then it can be argued that it is simply a case of redirecting money from one group of participants in the economy to another group of participants;

3. printing the money: many governments/central banks have been running the printing presses pretty hard in recent years. Conspiracy theorists would argue that the decision to stop publishing M3 data is evidence of just how much money is being printed. The trouble with simply printing money is that every new dollar printed has the effect of devaluing all the existing dollars. In effect, when new money is printed, the holders of old money become poorer. This is inflation in its most simple form. While there is plenty of evidence and conventional wisdom that says that mild inflation is better than deflation, even mild inflation has adverse consequences (see what happens to a person on a fixed income over 30 years experiencing "only" 2% or 3% annual inflation);

4. spending surpluses: Keynesian economic theory holds that governments can smooth the economic cycles by accumulating surpluses in good times and spending those surpluses in bad times. This is what some countries are going now (e.g. China and Hong Kong). Unfortunately, many countries seem to have forgotten the part about accumulating surpluses and were already heavily in debt when the current crisis began.

Whatever the source(s) of the bailout money, someone has to pay for it. In the end it will either be future taxpayers or the holders of money and other assets which get devalued with inflation. Put differently, all a bailout does is transfer the pain from one group of societal stakeholders by imposing a burden on another group.

This is not say a bailout is a bad thing, but ignoring the costs and future pain associated with the bailout would be a very bad thing. The point can be illustrated with the contrasting examples of Japan and Zimbabwe. Japan spent massive sums of borrowed money attempting to stave off the consequences of its financial markets collapsing in the early 1990s. Over a decade later, the economy has continued to contract and remains burdened by high public sector debt levels. Zimbabwe simply ran the printing presses too much and rendered the local currency close to worthless.

So, who will end up paying the price for the current round of bailouts?

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