Despite the announcement on Sunday that a bailout deal had been reached, I was pleased to see yesterday that the deal fell through. Good. The markets were down because people realized that the government wasn't about to pay $1 for assets that are probably only worth 50 cents. That's bad for the people who own those assets, but good for the taxpayers who were about to buy them at inflated prices.

Harvard professor Jeffrey A. Miron has written the best prescription that I've seen so far: the solution is bankruptcy, not bailout. I've been saying the exact same thing for weeks. Maybe I should be an economics professor?

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.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

Just go read the whole thing. It's concise and exactly right on every point.

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