Don't Experiment the Rubbish Economics of "Laissez-Faire"

I was amazed at the U.S. Congress's rejection of the Paulson Plan. As I looked for the reason, I was even more amazed that overwhelming majority opinion in blogs and SNS was classical laissez-faire, i.e., the government should do nothing. Today the most popular entry of digg is written by a Harvard economist named Jeffrey A. Miron that insists:

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. [...] 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.

Indeed, someday it will happen, but when? In Japan, the "voluntary" resolution of bad loans didn't happen for ten years. At last, when the government forced banks to write off their bad assets, net loss amounted to more than 120 trillion yen (1.1 trillion dollars), 24 per cent of GDP. Meanwhile Japan's nominal growth rate has been almost zero, so Japanese economy has lost almost 500 trillion yen.

Economists (including me) defend market economy, but nobody except Miron subscribe to laissez-faire. In particular, when the price mechanism breaks down due to the fear of holdup, the economy-wide disorganization would continue for years, according to Blanchard-Kremer. It brought about 60 percent drop of GDP in Russia and Ukraine for ten years.

The key is the trust that borrowed money will be repaid. When the trust breaks down, the economy never recovers automatically. If nobody repay, why should you repay alone? This is the notorious paradox called Prisoner's Dilemma. If default should become the Nash equilibrium, nobody would repay. In such situation, the trust becomes public goods that can't be supplied by private sector.

If American disaster were contained to the U.S., they would be free to experiment laissez-faire economics themselves. Unfortunately, they have collected money from over the world, so the current deficit of the U.S. is as huge as 2 percent of world GDP. If their financial system collapsed, the Great Depression would come again, in which American nominal GDP halved and unemployment grew to 25 percent. Don't make the world economy a test bed of rubbish economics.