A Perception of ‘Good Faith’ Is Key To Economic Growth

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Project Syndicate

The United States government’s takeover of mortgage giants Fannie Mae and Freddie Mac constitutes a huge bailout of these institutions’ creditors, whose losses have ballooned as house prices continue to plummet. With the government now fully guaranteeing Fannie’s and Freddie’s debts, American taxpayers will have to pay for everything not covered by their creditors’ inadequate capital.

Why is this bailout happening in the world’s most avowedly capitalist country? Don’t venerable capitalist principles imply that anyone who believed in the real estate bubble and who invested in Fannie and Freddie must accept their losses? Is it fair that innocent taxpayers must now pay for their mistakes?

The answers to such questions would be obvious if the moral issues in the current financial crisis were clear-cut. But they are not.

Most importantly, it is not clear that the bailout will actually impose any net costs on US taxpayers, since it may prevent further systemic effects that bring down the financial sector and, with it, the world economy. Just because systemic effects are difficult to quantify does not mean that they are not real.

The bonds issued by Fannie and Freddie were widely thought to carry an implicit US government guarantee. Even though there was no official guarantee, the US government’s failure to come to the rescue could destroy confidence in government debt, and, by association, other financial paper as well.

The issues go far beyond the US economy. The global economy has been driven in recent years by remarkable speculative asset booms and busts, which bring into the equation questions of confidence and trust, as well as fairness. Similar housing booms in many other countries are now ending, and they may face the pain – and the moral dilemmas – that the US economy is now experiencing.

Moreover, housing markets are not the only issue. So are stock markets. The Shanghai Composite in China rose by a factor of five in real terms from 2005 to 2007, and then lost two-thirds of its real value. The Sensex in India rose by a factor of five in real terms over 2003 to 2007, and has since lost a third of its value. Similar stock market booms and busts have occurred in many other countries.

While they lasted, the booms that preceded these busts caused these economies to overheat. Now that the booms have been reversed, a decline in confidence could engulf the world economy, throwing it into recession. To prevent that, some selective bailouts will likely be needed, not to support the market but to deal with injustices.

There is no accurate science of confidence, no way of knowing how people will react to a failure to help when markets collapse. People’s reactions to these events depend on their emotions and their sense of justice.

The booms and busts have caused great redistributions of wealth. People who bought into the stock market or housing market did either well or poorly, depending on their timing. People will judge the fairness of these outcomes in terms of what they were told, and what kinds of implicit promises they inferred.

What were people in all these countries told about the markets in which they invested? Was it all really truthful? Unfortunately, there is no way to find out. Policymakers can provide only general responses, not deal with all cases individually.

We do know that recent economic growth in many countries has been spectacular. But were investments in their markets oversold? Did cynical salespeople in these and other countries lead people to believe that the boom times would produce wealth for everyone?

To be sure, while there may have been much ‘cheap talk’ – general advice with disclaimers – most of the losers in this game are not starving. But we cannot blithely conclude that all the losses should be allowed to stand in full force.

The gnawing problem is one of ‘good faith’. Economies prosper only on the perception that ‘good faith’ exists. The current situation, in which speculative booms have driven the world economy – and, having collapsed, are now driving it into recession – suggests that there may have been a lot of bad faith by people promoting certain investments.

Consider investors in Fannie and Freddie bonds. While the US government never officially promised to bail them out, it did create a special agency, the Office of Federal Housing Enterprise Oversight, which was to assess their strength in an annual report. But this agency never even acknowledged that there was a housing bubble. Government leaders gave no warnings.

So can we really say that investors must suffer the full consequences of any losses? How can this be fair?

The world is discovering capitalism and its power to transform economies. But capitalism relies on good faith. A perception of unfair treatment can be deadly to economic growth, because it means that people will lose trust in businesses, and hence be less willing to offer to them their precious capital and labor. Is that outcome morally superior to a bailout?

Robert Shiller is Professor of Economics at Yale, chief economist at MacroMarkets LLC and is the author of "Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do About It".

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