When Scandalous Governments Are Unnoticed

A lot of people over the past few days have been bemoaning the fact that George Osborne is going to sell our stake in RBS for a £7 billion loss. Such people need to remind themselves of the sunk cost fallacy (that is: acting imprudently in the present to protect past costs), but they also need to understand something else more general. Sometimes governments do scandalous things and the world recoils in horror, like when politicians in Kenya, Zambia or Zimbabwe rig votes and maltreat their people. There are other times, however, when governments do scandalous things and hardly anyone recoils in horror because they don’t understand why those things are bad. A prime example of this is when governments bail out businesses that have failed in the free market.

Some politicians bail out businesses to the tune of millions, sometimes even billions of pounds or dollars (Alistair Darling's bank bailouts and George Bush’s airline bailout spring to mind). Be clear firstly that bailouts, like small business subsidies, are ultimately not socially useful. But on top of that, they also cause lots of societal harm. An analogy will illustrate why.

Imagine a company called Canyon Flights that does helicopter tours around the Grand Canyon. Due to competition in the shape of competitors Canyon Views, Canyon Flights loses money. Barak Obama’s second cousin owns the struggling Canyon Flights, so he decides to help them out with a government bail out. As well as all the other obvious reasons why this is bad, the bail out won’t actually put any Canyon Flights helicopters over the Grand Canyon. Helicopter rides over the Grand Canyon only take place when it’s profitable to do so – that is, when the cost of transporting passengers is less than the money made in ticket sales. This is true irrespective of whether Obama bails them out or not.

The reason Canyon Flights is doing poorly is because Canyon Views is doing better. If Canyon Flights goes bankrupt then Canyon Views will pick up their customers, maybe even expanding in the process. Or perhaps a new competitor will enter the market. Either way, just like the issue of small business subsidies, money poured in from politicians won’t have any significant impact on the business’s efficacy, it will only enrich the company owners at the expense of everyone else (taxpayers). Taxpayers don’t get a share of the profits when private businesses do well, and they shouldn’t pick up the costs when they do poorly, which is what happens with government bailouts.

A fully reformed, highly deregulated, banking sector would work towards seeing banks lending with fully costed capital, making insolvency much less likely, and taxpayer bailouts nigh on impossible. For a full explanation of this, see my blog post here.