"Bankruptcy, not bailout, is the right answer"

From an article by Jeffrey A. Miron, senior lecturer in economics at Harvard University and one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan:

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

I've posted both pro and con arguments on the bail-out because I really want to understand why the option was even raised in the first place. Miron's argument is a typical libertarian one (and one that I naturally sympathize with) but I also know that perfectly pure ideological solutions are not always the answer to the problems of an imperfect world.

I'm willing to hear reasoned arguments in favor of the bail-out but I feel that I have been stampeded in the past week and I think a lot of the citizens' opposition has simply been because there has not been enough discussion. Congress and the "pundits" have been stampeding us like a bunch of Indians chasing a herd of bison over a cliff.

Right now my take is that, if we do not do the bail-out, maybe the economy will crash and burn, huge unemployment will result and it may take years to recover but what's wrong with demolishing a gerry-built house and erecting one that has a sturdy (and fiscally sound) foundation?