THE COST OF GOVERNMENT GUARANTEES

December 4, 2009

Government guarantees to banks are detrimental because they involve hidden, but large costs, says John Kay, an analyst with the Financial Times.

According to Kay:

  • Such guarantees distort competition because sheltered banks outperform rivals not because of greater efficiency, but because capital becomes cheaper to obtain.
  • Sheltered banks gain too-big-to-fail status, which creates barriers to entry for smaller, more efficient banks.
  • Relief from business risk leads to more risk taking, AKA moral hazard.
  • Cheaper private risk management incentives are reduced within and outside the bank.

Other kinds of government guarantees, such as social insurance, also involve large hidden costs.  Social Security and Medicare's guarantee of a paid holiday with medical care for the rest of retirees' lives generates the same types of costs, says Jagadeesh Gokhale, a Senior Fellow with the Cato Institute:

  • Labor competition is reduced because the programs induce early worker retirements, which leads to higher wage costs, on average, and lower national output.
  • Workers who believe they will receive Social Security and Medicare will engage in lower personal saving, which means less capital formation and lower economic efficiency.
  • Retirement income guarantees induce riskier personal savings portfolios, AKA moral hazard.
  • Guaranteed retirement income means poorer financial knowledge and poorer risk management.

Source: Jagadeesh Gokhale, "The Cost of Government Guarantees," Cato Institute, December 2, 2009; and John Kay, "The real cost to business of government guarantees," Financial Times, December 1, 2009.

For Cato text:

http://www.cato-at-liberty.org/2009/12/02/the-cost-of-government-guarantees/ 

For Financial Times text:

http://www.ft.com/cms/s/0/168ba380-dead-11de-adff-00144feab49a.html 

 

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