"A Perception of 'Good faith' is Key to Economic Growth"

Robert Shiller explains the moral issues behind bailouts:

A perception of ‘good faith’ is key to economic growth, by Robert Shiller, Project Syndicate: The United States government’s takeover of mortgage giants Fannie Mae and Freddie Mac constitutes a huge bailout of these institutions’ creditors... With the government now fully guaranteeing Fannie’s and Freddie’s debts, ... 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. ...

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 ... told about the markets in which they invested? Was it all really truthful? Unfortunately, there is no way to find out. ...

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 ... 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?