The economy that swallowed a fly

The Obama administration has proposed a new tax on large banks and are promoting it as a way for taxpayers to recover the money lost due to the TARP bailout.

At FoxPolitics.net Jo Egelhoff has all the right reasons as to why this is a bad idea. Among them, the TARP losses primarily stem from AIG and the auto companies, which are NOT subject to the tax and the fact that these banks will simply pass the tax on to consumers.

With another view is Harvard Economist Greg Mankiw. Mankiw is not known as a promoter of higher taxation, so his advocay of the proposal cannot simply be dismissed as promotion of an agenda aimed at government expansion.

We could promise never to bail out financial institutions again. Yet nobody would ever believe us. And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time.

Alternatively, we can offset the effects of the subsidy with a tax. If well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts.

So the tax could be an antidote to the poisonous bailouts that have now become the norm. While Mankiw may be absolutely right on the economic merits, I can't help but find his argument thoroughly unconvincing.

So many in the financial industry conducted themselves recklessly, but were saved from the consequences of their actions by a government bailout. And because of the bailout, we now need to impose a tax on those institutions? When I heard this proposal, I couldn't help but think of the old lady who swallowed the fly, then the spider, then the...well, you know.

Mankiw may simply be arguing for the best solution given the reality of our situation, but there may be an alternative.

We should make it clear that there won't be any more bailouts, but how?

Since many reasonable people believe that letting large financial firms collapse in a chaotic manner would have been even worse than the present conditions, solving that problem becomes key to ending the era of bailouts. Finding a way to let failed firms go into bankruptcy in an orderly manner should be the number one priority of our financial reform efforts. Such a system would not, and could not, ever be perfect. It would just have to be good enough to avoid the catastrophic.

Bailouts are only tolerated when the alternative seems even worse. With a system in place to provide a framework for the dissolution of failed firms, people, and the politicians that represent them, will be far less tolerant of bailouts, and better off in the long run.