Too Big To Fail: A Problem For Capitalism

All those firms that the government deemed "too big to fail" are reaping the benefits of their largeness. According to the Wall Street Journal, these firms will have their borrowing costs reduced by billions. After all, when the government guarantees your debt, you will have cheaper funding costs. That's great news for them, but bad news for a capitalist economy.

Here's what the WSJ says:

The government's guarantee since November on new debt issued by financial firms such as Citigroup Inc. and General Electric Co. will save those companies about $24 billion in borrowing costs during the next three years, according to an analysis by The Wall Street Journal.

In the second quarter alone, the eight largest issuers of corporate debt under the Federal Deposit Insurance Corp.'s Term Liquidity Guarantee Program cut their interest costs by about $2.2 billion, increasing their profits and delivering an extra jolt to the stock market's two-week rally.

Another way to put it is that these firms have a distinct competitive advantage over other firms. That edge is government imposed. This is one of the greatest problems with saving firms that are deemed too big to fail: you have to give them an advantage that their competition will not enjoy.

This does two things. First, it exacerbates the too big to fail problem. With cheaper borrowing costs, these firms will be able to eliminate even more competition, grow even larger, and become even more important to save if they make poor decisions again down the road.

Second, it rewards bad behavior. Those firms who played by the rules and made good decisions are suddenly facing higher borrowing costs than the firms that screwed up. A backward incentive structure makes for a poorly functioning economy, because the bad are propped up at the expense of the good.

Capitalism only works when good firms can thrive and bad ones can fail. When the government prevents that, it also prevents capitalism from working properly. Unfortunately, that's exactly what this guarantees is doing.