A year ago, I posted this question about the Bear Stearns bailout:
Who are the Bear Stearns creditors and why is it so important [that it requires Central Bank intervention] that they be paid?" They invested and it turns out that they lost. They might have a case in court, but why do they have a special claim on the federal government?
Hundreds of billions of dollars later, I still don't believe we have a satisfactory answer to that question as it pertains to the many federal bailouts of financial institutions. The unsatisfactory answer to that question that we often hear is some version of preventing damage to the broader economy.
It is worth unpacking that answer. When Institution X fails, the damage falls first on Institution X's equity holders and secondly on Institution X's creditors in reverse order of their seniority. I don't think any reasonable definition of the "broader economy" can include parties that have transacted with Institution X, whether in labor, capital, or product markets. They are in what I would call the "narrow economy of Institution X."
A distant third in the damage lineup to the failure of Institution X is the "broader economy," in which we might reasonably include taxpayers who no longer get to tax the profits of Institution X and potential customers of Institution X who no longer get the consumer surplus associated with transacting with Institution X. But of course it would be crazy for taxpayers to give Institution X money so that some fraction of that money could be paid back as taxes. And the notion that the potential customers of Institution X cannot be served nearly as well by Institution Y -- or the Federal government temporarily standing in for Institution Y -- is just as crazy.
There are some entities in the "narrow economy of Institution X" that have federal insurance protections: bank depositors via the FDIC and workers via the unemployment insurance system. Speaking on behalf of "the broader economy," I have no problems with paying on those insurance claims as needed when Institution X fails. But that's where I draw the line. Small damage to the broader economy is being used as an excuse to transfer large sums to various narrow economies. This practice should stop.