As I write late on Thursday evening, some conservative Republican senators and representatives are opposing the Paulson bailout plan because they think that the government should not intervene in the market¯that it is better to let financial institutions that took risks that turned out badly for them bear the consequences of their actions. As one of the freest of free marketeers, I want to explain why that thinking is wrong-headed.

To begin with, even the most conservative economists recognize that markets are imperfect and that there are certain things that the government can do more efficiently than the market. National defense is a good example. If we tried to privatize defense, we would find that everyone in the country benefits from the national security that a strong military provides, whether he paid part of the bill or not. Knowing this, everyone would have an incentive to refuse to pay for national defense in the hope that his fellow citizens would pay enough to maintain the military¯i.e., to free ride on the payments of others. The result would be that almost no one would pay, and we would have no military. Hence the solution: The government taxes everyone and uses the money to pay for the military.

All intelligent conservatives, therefore, recognize that there are known classes of cases where markets do not work. Free-rider problems such as that with national defense present one example, and collective action problems are another. A third¯the one relevant in this case¯is a market panic. From time to time, market participants become so irrational that markets cease to function because no one is willing to buy or sell. That is exactly what has happened in the mortgage-backed securities market right now. Financial institutions all over the world are holding various kinds of mortgage-backed securities, and everyone knows that these securities are worth less than people paid for them. How much less, however, no one knows for sure. That will ultimately depend on what percent of homeowners default on their mortgages and how much the lenders recover when they foreclose on the loans.

Now, no one believes that the default rate will be all that high (the rate is around 6% now, and even in the Great Depression it never got much above 40%), and everyone knows that when a lender forecloses on a home, it will receive at least most of its money back. Under normal circumstances, market participants would gather the available data, make some informed estimates about these matters, and calculate a price for the relevant securities. Pricing securities is always a very uncertain business, and under normal circumstances this doesn’t bother anyone. Right now, however, people are so panicked about mortgage-backed securities that they will either not buy such securities at all or will pay only absurdly low prices for them. Merrill Lynch, for example, sold some securities like these last July for as little as 22 cents on the dollar. We thus have the most extreme form of market failure imaginable: the total collapse of a market, not because the items traded in the market are valueless (in fact, everyone agrees that they are very valuable), but because people are too panicked to value them.

Such behavior is highly irrational, and savvy people everywhere know it’s highly irrational. Hence we saw that coolest of rational minds, Warren Buffett, buying into Goldman Sachs earlier this week. Once a market-collapsing panic starts, however, it is very difficult to stop. It’s like trying to convince the crowd in the theater that there really is no fire after all. Sometimes, a particularly respected market participant can stop the panic. J.P. Morgan did that in the financial crisis of 1907. Nowadays, however, no private party has the clout to do it.

Fortunately, the government does. What the Paulson plan amounts to is this: The government will buy up all the securities that the market is currently too irrational to value, and it will hold them for a while¯long enough for the market to calm down and return to sanity. Then the government will resell the securities into the market. Since the government will have bought the securities at panic prices and sold them at more rational prices, the government may well turn a tidy profit on the deal. Exactly this has happened before. Back in 1998, the Federal Reserve organized the major investment banks to bail-out distressed hedge fund Long Term Capital Management, and when all its positions were finally unwound, the banks had made a profit. There is thus good reason to believe that the treasury will make money, not lose money, on the Paulson plan.

So, are you an economic conservative who thinks that the government should intervene in the market only when markets fail and it is efficient for the government to act? Then you should support the bailout plan because what we are seeing in the credit markets is probably the most serious market failure that will occur in our lifetimes. Are you an economic conservative who thinks the government spends too much and the national debt is too high? Then you should support the bailout plan because the government will likely make money in the long run and so reduce the deficit. The intelligent conservative position here is to support the bailout.

Right now both parties are allowing their ideological commitments to come before doing something that will benefit all Americans. I will leave it to responsible Democrats to explain why it is not helpful at the moment to insist on measures related to executive compensation or shareholder access to the corporate ballot. Those on the political right need to make sure that the Republicans in Congress do not through ignorance or stupidity misunderstand conservative economic principles and so lead us into economic disaster.

Robert T. Miller is an assistant professor at the Villanova University School of Law.

Articles by Robert T. Miller

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