October 16, 2008
Government Bailout Action--Unintended Consequences Abound
The government is using the wrong analogy. They are using the "finger in the dike" analogy -- it needs to stop the leak. A more appropriate analogy is "routing a river"; the government is fixing a breach in the river bank in one location only to find that it was led the river's flow to breach its banks in other locations.
When government protects asset-backed commercial paper, unsecured commercial paper money leaves and runs to asset-backed commercial paper. When the government stops short selling in financial institutions, hedge funds concentrate on uncovered companies and also stop purchasing financial company stock in hedged positions. When the government hikes FDIC insurance on interest bearing accounts, money market funds hoard cash worrying about heavy redemptions requests from fund investors who want to put funds in the FDIC insured accounts. When the government backs banks, investors sell bonds in operating companies and run to bank bonds. When the government gives United States banks better terms that UK bank received in their bailout, foreign money rushes into United States banks. In each case, the government scrambles to fix the fix.
October 16, 2008 | Permalink
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