Reason Foundation

Reason Foundation

Financial Losses Seen and Unseen

The bailout and the broken window

Anthony Randazzo
October 17, 2008

In his famous essay, "What is Seen and What is Not Seen," Frederic Bastiat uses the illustration of a broken window to explain the idea of unseen costs. He dispels the misconception that a broken window adds value to society by creating work for glassmakers, noting that the money spent to replace the glass could have been spent on shoes or books, providing work to shoemakers or printers. Creating a demand for glassmakers by breaking a window disrupts market forces and slows innovation. Bastiat explains that this is the unseen cost of a broken window, which strips value from society, instead of adding value to the economy.

The wisdom of Bastiat is extremely relevant in an assessment of what unseen economic losses will result from the Emergency Economic Stabilization Act (EESA), the bailout of 2008.

Many of the arguments supporting the bailout assumed absolute knowledge of the costs: $700 billion if we act, Great Depression II if we fail. The bailout's proponents never considered hidden costs such as loan interest, the value of the unknown societal benefits we will never see (because money has been reallocated according to a central planner's preference), and discouraged innovation.

The most apparent cost of the bailout is the interest on the loan (or loans) the government will need to finance the stabilization project. Unlike taxpayers, the government lacks an incentive to avoid high interest charges because they can afford the rate no matter what the cost. There is no telling what interest rates the Treasury Department will get, nor what the final interest payments will be, nor how long it will take to pay back. Treasury Secretary Henry Paulson has said that the government would hold on to the assets it buys for as long as it takes to recoup their value. Even if the government manages to break even by selling the assets it plans on purchasing, this is unlikely to cover the mountain of interest the massive loan will pick up.

Yet, the dollars are just the losses that are seen. Bastiat's unseen losses are much greater and more important to understand.

The Treasury Department will get its $700 billion, but that money has to come from somewhere. Printing the money might lead to hyperinflation, so the government will raise the billions it needs in U.S. and foreign debt markets. What might the U.S. and foreign firms have been able to fund around the world if they didn't need to loan the government money?

There is an invisible third player in the system that could have started a business, raised capital for an invention, or financed a college loan. Every dollar the government takes out of the system-whether by tax or loan-is a dollar not invested in the market. Taking money away from private-sector firms or individuals hurts the economy because it prevents companies from helping the economy grow.

Furthermore, the law of supply and demand means investors will charge higher borrowing rates on their decreased supply of capital, limiting the number of firms who have access to seed funding for whatever their project might be. The unseen losses are in how the bailout stifles innovation that could help America end its financial woes.

The bailout lets companies that should go bankrupt because of fiscal irresponsibility stay solvent, while the successful firms that would have taken their place lose out on the value they could have created. Financial firms like Wells Fargo, JP Morgan Chase, and Bank of America didn't overextend themselves into the subprime market, and have been able to thrive amidst the Wall Street fallout. They have been able to step into the hole left in the market by firms like Lehman Brothers, Bear Stearns, and Wachovia. In those places they have created value by adding productive assets to a fiscally responsible management structure.

However, these fiscally responsible firms have been precluded from taking over failures like Fannie Mae, Freddie Mac, and AIG. Banks like BB&T have voiced their concern with federal bailouts saying they and others like them could have created value from the rescued financials giants by buying up their assets piecemeal instead of taxpayer money keeping them solvent and whole.

In the case of AIG, their loan from the Federal Reserve allowed them to maintain their failed leadership and corporate philosophy. Just days after getting $85 billion to stave off bankruptcy, AIG sent company executives to St. Regis Resort in California for a week of relaxation. Instead of letting a solvent bank like BB&T take over AIG's assets and use them to rebuild the economy, the troubled insurance giant wasted away over $400,000. The unseen loss is the missed opportunity for fiscally responsible firms to create value.

The unseen losses are also in the value destroyed by increased regulation. For example, the ban on short selling only forced brokers to trade in "longs" more, increasing the volume activity for long-term investments and contributing to the stock market's loss of prosperity. In addition, compensation limits decrease corporate incentives to create value, thereby decreasing the value of the firm they manage.


Claims that the bailout is an investment in our economy fail to pass the "broken window" test and fail to consider the unseen lost value in the economy. Understanding this, America should begin looking for ways to counter the negative market force President George W. Bush and Congress have released on the market and capture some of the economic value that would have been created.

Anthony Randazzo is Director of Economic Research

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