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Why Government Bailouts Actually Lower GDP Growth PotentialBy Sasha Cekerevac for Investment Contrarians | Jan 17, 2013

What does it take to create and sustain long-term gross domestic product (GDP) growth in an economy?

One of the most important factors is a high level of investor confidence.

Investor confidence throughout the economy can help support the formation and expansion of businesses and the development of new technologies and ideas.

GDP growth, as we all know, does not originate from government-led initiatives, but from businesses creating new innovations and technologies.

One of the problems with government intervention is that GDP growth is actually stifled and reduced due to a misallocation of resources. This misallocation of resources occurs when weak firms are supported or bailed out due to poor management decisions.

The funds allocated to support weak or underperforming companies are then unable to flow into stronger corporations that can expand, innovate, and make the economy fundamentally stronger, lowering GDP growth potential and ultimately weakening investor confidence.

Over the last few years following the financial crisis, many have thought about ways to prevent such an outcome. One of the more original writers of our time is Nassim Nicholas Taleb.

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Author of the famous books Black Swan and Antifragile (both of which I highly recommend), Taleb recently suggested several ideas, with which I completely agree, to reduce the possibility of another financial crisis, while helping restore investor confidence.

One of the most interesting ideas I’ve heard to restore investor confidence is to remove the incentive for firms to become too big to fail. Instead of forcing companies to be broken up, Taleb suggests that any firm deemed “too big to fail” should pay its staff no more than a corresponding civil servant. (Source: “From Fat Tails to Fat Tony,” The Economist via The World in 2013, last accessed January 15, 2013.)

According to Taleb, since the government is effectively backing the company, the firm is essentially an extension of the government and should not pay employees any higher wages than other government workers.

Another good idea from Taleb that would help restore investor confidence and long-term GDP growth is that any person who becomes a politician should never earn more than a set amount from the private sector, meaning no massive payday.

As it stands right now, politicians have the huge incentive to create favorable conditions for a company that they might join upon leaving politics. This can lead to a massive misallocation of capital that favors companies that will grant guaranteed bonuses and jobs to politicians; not what’s best for the economy.

Any time an economic decision is not optimal for the economy, potential GDP growth levels will decline and investor confidence will weaken.

One idea that Taleb suggests, which I have supported for some time, is that the “value-at-risk” calculation should be banned. The problem with trying to calculate risks in such a manner is that they underestimate the possibility of massive moves.

By creating a lower-than-expected probability of an extreme event, the risk manager assumes false confidence. This leads to higher levels of risk-taking, making the entire system more fragile.

The core to all these ideas is not changing how humans act, since that’s not possible, but working with our human traits. This is something that I’ve suggested for a long time: creating an incentive and disincentive structure for all major human activities.

For an economy to generate strong, long-term GDP growth, we need to incentivize people in the proper areas. This will create a high level of investor confidence in the knowledge that the funds allocated to various businesses are being used in the best possible way.

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Investor confidence has waned over the last few years due to the inexcusable level of uncertainty throughout the economy. Business owners are constantly unsure of how politicians will act. Plus, there’s the structural fragility of some parts of the economy due to government intervention and bailouts.

Sustainable GDP growth has to be built on a solid foundation. This means that businesses that are truly innovative will have capital flowing into them that’s not based on bureaucratic intervention.

Risks to the entire economy need to be systematically reduced by creating natural disincentives to government bailouts. We can’t have it both ways; the company managers can’t take risks if they are not willing to bear the losses.

This type of structural reform, I’m afraid, is not likely to occur anytime soon. With so much of the infrastructure embedded, this naturally will lower GDP growth potential for the economy.

For now, all we can hope for is a lower level of government intrusion to help restore investor confidence and to at least try to improve GDP growth levels to a sustained level.

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