In a 1994 paper, George Akerlof and Paul Romer detailed exactly what’s going on in the current bailout of criminals who should instead be imprisoned. The entire thing is available at the site as a PDF file. The day that this sort of thing will stop is the day that such actions are punished at all, much less in as draconian a fashion as are drug users who fill our ever-expanding prison system today.


During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent - and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and the suffered a dramatic collapse. Also in the United States, the junk bond market, which fueled the takeover wave, had a similar boom and bust.


In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds.


Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.


Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the the politices of insurance companies, the pension obligations of private firms, virtually all the obligations of large banks, student loans, mortgage finance of subsidized housing, and the general obligations of large or influential firms. These arrangement can create [i.e. have created] a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of worth [I guess you could read that in 1994 without collapsing in paroxysms of laughter]. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values.


If so the normal economics of maximizing economic value is replaced by the topsy-turvy economics of maximizing current extractable value, which tends to drive the firm’s economic net worth deeply negative. Once owners have decided that they can extract more from a firm by maximizing their present take, any action that allows them to extract more currently will be attractive - even if it causes a large reduction in the true economic net worth of the firm. A dollar in increased dividends today is worth a dollar to owners, but a dollar in increased future earnings of the firm is worth nothing because future payments accrue to the creditors who will be left holding the bag. As a result, bankruptcy for profit can cause social losses that dwarf the transfers from creditors that the shareholders can induce. Because of this disparity between what the owners can capture and the losses that they create, we refer to bankruptcy for profit as looting.


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