Are financial bailouts ethical?
Contributed by TS.
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Ethical Decisions 
Generalization test
Main reasons for bailout: to improve performance of struggling firms and prevent widespread economic collapse.
Issues:
1. If everyone gets a bailout, performance will become meaningless, and the bailout loses its purpose, as it is meant to be a last resort, not a frequent event. [Moral hazard]
2. Not all firms are equal. It is hard to determine who deserves a bailout and who doesn’t. When AIG is bailed out, whom do we compare it to when considering generalization test? Investment banks? Commercial banks? Other insurers? Not all financial firms are created equal. Why were Bear Stearns and Lehman allowed to fail? Why was Goldman Sachs favored?
Utilitarian test
This is a heated debate, at least from an economic perspective. Society will definitely be better off in the short run, but many argue that we are worse off in the long run. Depending on how much we discount utility in the future, you may get different answers. So this is unclear.
Virtue ethics
One of the main reasons the Federal Reserve exists is to act as the lender of last resort, so it’s doing what it was designed to do. (But one may question should it exist in the first place?)
Rawlsian ethics
Will the worst firm be better off? Yes, but this is not random – the worst firm retained its positions because of poor choices, so in a sense it may deserve to be punished.
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Similar thoughts popped up my mind a while ago when I was working on loans for individual borrowers. Based on the borrower’s delinquent payment history, updated financials, and some other factors, I needed to determine when we, as the bank, would write off a debt or foreclose on the property. If the bank agreed to just charge off a portion of the debt, the borrower’s monthly payments (or sometimes even the interest rate) would drop significantly, compared to borrowers who work hard to ensure that they can pay their bills on time.
Is this fair? Does it pass the generalization test? Personally, I felt the loan workout deal is unfair to borrowers who strive to make the payment on time, or even to people who have a greater sense of their financial responsibility and understand that they shouldn’t over-leverage their equity.
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There is another way to view bailouts: ultimately, as a way to protect the economy and, therefore, our capitalist system.
Capitalism depends on the best among us rising to the top and pushing us forward. Banks exist in our capitalist system to efficiently allocate capital to the most productive actors.
A bailout in this circumstance would decidedly fail the generalization test. Banks needing bailouts would have invested in unproductive actors that were unable to repay the original investment, let alone expand the economy. Consistent bailouts for all banks would undermine capitalism by removing the importance of efficiently allocating capital. Capital would then be allocated to good and bad investments indiscriminately, without regard to risk and return. Based on the number of new ventures that are started and then fizzle out, it is likely that such a practice would eventually crowd out the most productive actors and result in a failed system.
The utilitarian test is even more damning for bank bailouts. Capitalism relies on creative destruction to reallocate resources to where they are needed most. Bailouts prevent that creative destruction and prop up firms that were adding so little utility that they were on the brink of failure. Additionally, individuals with the most wealth, and thus the smallest marginal utility per dollar, stay in their positions of power. Meanwhile, the young and ambitious are crowded out for the sake of stability in the best case and cronyism in the worst. Elder generations prolong their time in power and put off the younger generations’ rise. As the circle of life is skewed evermore towards modern day Gilgameshes past their prime, the next generations frustratingly bide their time, drastically reducing lifetime utility.
The virtue test is more nebulous. Do bailouts protect the economy and create stability? Experts almost unanimously point out the risk of moral hazard. If those experts are correct, we are simply sacrificing stability today for instability in the future.
Bailouts certainly fail the Rawlsian test. The largest firms that would cause the most damage to the system receive the most assistance. The worst off firms–poised to expand in the vacuum that should be left when larger firms fail–are left watching as noncompetitive forces pick the winners and the losers. Taking the test to the extreme, the worst among us are unemployed, unbanked and certainly without stock market wealth. A bailout to them is inconsequential. Except, maybe, to reaffirm the belief that the deck is stacked against them.
Ayn Rand would leave a “who is John Galt.” Young Libyans would have an emphatically more aggressive response.
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This is a very broad issue that must be broken down into more specific questions.
ST raises the question of when a bank should write off (or reduce) a mortgage loan rather than foreclose on the property. In this video (transcript here) I deal with the foreclosure issue for subprime loans, but the arguments are similar for general mortgage loans.
The other comments address government bailouts, notably the massive and controversial U.S. government bailout of big banks in 2008. An analysis in a nutshell might go like this. Let’s grant for now that a bailout of banks that are “too big to fail,” for the purpose of avoiding an economic crash, is generalizable, simply due to the rarity of the circumstances that led to it. This brings us to the utilitarian question. Let’s also grant that bailing out the banks on this occasion creates more utility than not doing so, because it avoids a crash. Still, it seems that utility is even greater if the bailout money is used as leverage to demand restructuring and more responsible behavior on the part of big banks.
Many observers say that the opportunity to use the bailout as leverage was largely missed, because the banks received the money with few strings attached. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act tightens regulation somewhat, without going so far as to restore time-tested provisions in the 1933 Glass-Steagall Act (effectively repealed in 1999). However, implementation of the Dodd-Frank Act is reportedly weak and far behind schedule, due in part to bank lobbying efforts. There is a clear utilitarian obligation for those with influence on this process to get busy and write regulations that will help avoid financial debacles in the future.
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