Government bailouts occur when a government wants to save a firm that is struggling and on the verge of collapse. In order to do so, it gives funds to a firm, either directly or indirectly, in order to allow it to continue its operations. However, doing so poses many risks as bailouts can distort markets and provide dangerous incentives to the large, ‘too big to fail’ firms. In the future, bailouts must only be utilised in particular circumstances and with particular conditions in order to balance their benefits, costs, and risks.
One reason governments might decide to bailout a company is that they want to prevent job losses and protect workers. A clear example of this rationale can be seen in the American response to the COVID 19 pandemic, where the federal government gave around $660 billion to small businesses through the Paycheck Protection Act, whose purpose was to ensure workers remained on firms’ payrolls. While keeping workers employed in this manner can be helpful, there are significant flaws with the idea. Firstly, indirectly supporting workers by giving their companies’ funds can be more costly than giving money directly to newly unemployed workers. For example, the American airline industry was given around 50 billion dollars in bailout money to major airlines during the pandemic, saving 75,000 jobs. However, it is estimated that it cost $300,000 to save each of these jobs. This money could have supported the average airline worker (who makes $60,550 per year in the USA) for over four years without a fall in living standards. That’s probably long enough for the average worker to find another job.
Another flaw with this idea is that it risks distorting the efficient functioning of a free market. Recessions, such as that caused by the COVID pandemic, have a vital role to play in generating greater efficiency. Poorly run firms are less likely to survive recessions than well-run firms in the same industry. This is because such firms may have higher costs, which means they need more revenue to break even and hence are more vulnerable to a sudden drop in demand. The same is true of heavily indebted firms, which might need more revenue simply to meet their interest payments. Finally, there is some evidence that not preparing for a potential crisis by making contingency plans increased the chances of a firm stagnating after the Great Recession. As a result, inefficient firms with high costs and no contingency plans will be the first to go. Meanwhile, firms that are well-run and don’t limit themselves to just cost-cutting but use the recession as a chance to innovate are more likely to not only survive the crisis, but thrive after it. If bailouts are given fairly indiscriminately within a hard-hit industry, firms which are inefficient are more likely to survive. In the long-run, this could mean that the economy is operating less efficiently than it would have been, leading to less growth and hence probably less job creation. There would also probably be less innovation, as firms tend to invest more in new technology and adopt new management strategies during recessions since the opportunity cost is lower.
This does not mean that bailouts are never an appropriate policy response. In some cases, firms may be very strategically important, or they may be too large and interconnected to fail without dragging many other firms down with them, potentially triggering an economic crisis. A good example of the latter is the role of “too big to fail” firms in the financial sector. This sector is highly interconnected and interdependent, meaning that the fall of one or two major lenders can be enough to threaten sector-wide collapse. There is even evidence that in some cases liquidity problems in minor lenders could pose a threat to the stability of the whole system. This is particularly dangerous because collapses in the financial system can lead to economy-wide problems. When the financial sector is threatened, banks stop lending money, which slows investment and consumer-driven spending. This situation, known as a credit crunch, can cause a drop in aggregate demand great enough to trigger a recession. It could be argued that if major lenders are at risk of bankruptcy, the government should bail them out or risk sending the entire economy into a deep recession. This argument is strengthened by the fact that recessions caused by financial sector collapse can be unusually deep and severe; both the Great Depression and the Great Recession originated in the banking sector.
Even using bailouts to save “too big to fail” firms can be controversial. This is because firms might realise that they are too big to fail and resort to increasingly risky behaviour, hence creating a moral hazard. After all, the government will always rescue them if they get into trouble, so they do not even have to face the full costs of their own risky behaviour. As companies take more and more risks, the chances that some of these risks will lead to crises increases. Hence, bailouts might avert a crisis only to make future crises more frequent. It’s clear that while the economy-wide effects of bailouts in the short run are clearly positive, the long-term effects on firm incentives might balance out or even eventually outweigh them. Furthermore, the situation can be considered unfair as well as damaging in the long run. Ultimately, it is taxpayers who have to foot the bill when a government decides to bailout a firm, leaving them to pay for the recklessness of others.
Balancing the costs and benefits of government bailouts is challenging. However, governments should try to limit the circumstances under which they are willing to give funds to struggling companies so that they minimise the market distortions generated. They should not bailout firms with no strategic importance simply because workers will become unemployed as a result of the firm closing. Instead, they must focus on supporting laid-off workers while they find other jobs. If a company is deemed highly strategically important or “too big to fail”, the government may be justified in providing funds to support it. However, ideally, it should limit this to firms that are not directly responsible for their downfall due to their own reckless business practices, as bailing companies out in those circumstances is going to generate a moral hazard and encourage future risk-taking behaviour. Governments should also be wary of giving funds to inefficient firms threatened by exogenous shocks, as propping these up is likely to reduce the efficiency of the market in the future.