Spurning creative destruction

You know what makes free markets work? It's the fact that people don't just enjoy the profits made possible by their good decisions, but also that they must shoulder the losses caused by their mistakes. Decisions must be, of necessity, tempered by the awareness of risk and potential failure. If the potential for failure is removed by, say, transferring responsibility for shouldering losses to a third party, then the moderating effects of risk are lost since only profits are possible from even the most fanciful ventures. The third party willingly or unwillingly taking the responsibility for losses then faces much higher costs than investors would if they took responsibility for their own decisions.

Which is why the Fed's bailout of Bear Sterns is such a monumentally bad idea. From the New York Times:

Hoping to avoid a systemic meltdown in financial markets, the Federal Reserve on Sunday approved a $30 billion credit line to engineer the takeover of Bear Stearns and announced an open-ended lending program for the biggest investment firms on Wall Street.

In a third move aimed at helping banks and thrifts, the Fed also lowered the rate for borrowing from its so-called discount window by a quarter of a percentage point, to 3.25 percent.

The moves amounted to a sweeping and apparently unprecedented attempt by the Federal Reserve to rescue the nation’s financial markets from what officials feared could be a chain reaction of defaults.

After a weekend of intense negotiations, the Federal Reserve approved a $30 billion credit line to help JPMorgan Chase acquire Bear Stearns, one of the biggest firms on Wall Street, which had been teetering near collapse because of its deepening losses in the mortgage market.

In a highly unusual maneuver, Fed officials said they would secure the loan by effectively taking over the huge Bear Stearns portfolio and exercising control over all major decisions in order to minimize the central bank’s own risk.

Creative destruction, folks, to use Joseph Schumpeter's excellent term. It's a "process of industrial mutation...that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." When you remove the potential for destruction from the equation, you eliminate the discipline of the marketplace, and you don't get the benefits of creativity that arise from failure and the potential for failure. In this case, you remove the lessons to be learned about the wisdom of taking on such a large burden in the form of mortgage-backed securities, which largely proved to be Bear Stearns's undoing.

Why should investment companies temper their decisions with the awareness of risk when the example of Bear Stearns says that their failures will go unpunished? What creativity can possibly come of a world in which business decisions effectively have no downside? As the Times goes on to point out:

It was unclear just how much risk the Federal Reserve was taking on, especially in the bailout of Bear Stearns. But analysts said it was clear that JPMorgan Chase was getting an extraordinary bargain, buying Bear Stearns at a tiny fraction of its market value just one week ago, and with the Fed shielding it from much of the risk.

JPMorgan Chase may be getting a bargain, but it's a deal that's likely to prove pretty expensive to taxpayers and the economy in the long run. Letting Bear Stearns fail and requiring that its buyers take on its losses would have hurt some people in the short run, but it would have involved the kind of discipline that makes the economy healthier and wealthier for everybody over the long term.