Bailing Out Bear Stearns

Some people will politicize anything. Take the acquisition, under pressure from the Federal Reserve and other government agencies, of investment bank Bear Stearns by JP Morgan. The argument is going about that Bear Stearns is full of people who have consistently decried government intervention in the market, but now that they’re the ones in trouble, they want a government bailout. Oh, those hypocritical capitalist pigs! At least based on what we currently know, however, this argument is pretty clearly wrong.

To begin with, no one thinks that every problem should be solved by the free market, just as no one thinks that every problem should be solved by the government. Free marketers will tell you that government should intervene in the market for all kinds of reasons—e.g., to overcome collective action problems, to prevent free-riding, to provide public goods, etc. Traffic lights are a good example of this last. The freest of free marketers agree that the government should supply the traffic lights because the market can’t do so at a reasonable cost. For, if private parties built the traffic lights, charging for their use would be prohibitively costly (think toll booths at very corner), and so the cheapest solution is for the government to tax everyone, use the tax dollars to put up traffic lights, and let us all use them without paying an additional fee. So the issue in the Bear Stearns bailout is not whether the government is intervening in the market but whether the intervention is one that can be justified on classical economic grounds.

Pretty clearly, it can. The problem at Bear was that, by late last Thursday afternoon, many market participants had concluded that there was a chance—how big a one, no one really knew—that Bear would soon be unable to pay its debts. Hence, anyone to whom Bear owed money wanted it back right away, and no one was willing to do any further business with the firm, especially by lending it money. There was, in effect, a run on the bank.

Now, this is a classic collective action problem. If all of Bear’s creditors could sit down together and decide as a group what to do, they would likely agree that none of them would seek immediate repayment, for, if they did seek repayment, the firm would collapse for sure and they would lose money. On the other hand, if they agreed among themselves to forestall, Bear could likely work out its problems and all the creditors would get paid in full. It would thus be in their collective interest to forestall. This is what George Bailey is explaining to the depositors of the Bailey Building & Loan Association in the bank-run scene of It’s a Wonderful Life . But, because there are so many creditors of Bear and because they cannot in any practical way meet and agree together what to do (they face, as economists say, high transaction costs), each creditor is left to act on his own. Each creditor, moreover, will have an individual incentive to demand immediate repayment: for, either Bear fails or doesn’t, and if it fails, better for the individual creditor to have been repaid first, and it doesn’t fail, the individual creditor is no worse off for having been repaid early. Hence, although it would be best for the Bear creditors as a group to forestall, nevertheless they will all rush to demand repayment, thus causing Bear to fail and themselves to suffer needless losses. In It’s a Wonderful Life , George Bailey manages to save the Bailey Building & Loan Association because the number of depositors is small enough to gather in one room and hear reason (having low transaction costs, they were able to overcome the collective action problem.)

When the Federal Reserve stepped in, therefore, and first advanced credit to Bear and then brokered the acquisition of Bear by JP Morgan, it was doing on behalf the creditors what they themselves would likely have done had they been able to overcome the high transaction costs that generated their collective action problem. This is exactly the kind of thing that government is supposed to do in a free market system.

Oh, and there was no bailout for the bankers at Bear. In the deal with JP Morgan, Bear shareholders will get $2 per share. That’s less than ten-percent of the value the shares had on Friday, and it’s down from $171 per share a year ago. In fact, the Bear shareholders are getting so little that some people are starting to worry that they’ll refuse to approve the deal with JP Morgan (a shareholder vote is legally required to close the merger). Furthermore, of Bear’s 14,000 employees, you can be pretty sure lots of them are going to be laid off after the deal closes. What the Federal Reserve did over the weekend was for the benefit of the creditors of Bear Stearns—the people who did business with it—not the people who owned or operated it.

This is not to say that there were not other failures, by both government and private parties, that have led to the crisis in the credit markets. To be sure, consumers borrowed money they had little ability to repay, loan originators obliged them by letting their lending standards become far too lax, and rating agencies that rated the securities into which such loans were packaged did a poor job of assessing their risk. Here’s prediction, however: when the dust settles on the credit crisis, the ultimate culprit will be—the Federal Reserve itself, which for years pursued an easy-money policy that eventually created the bubble we’re now watching pop.