George Mason economist and EconTalk podcast host Russ Roberts has said:
Capitalism is a profit and loss system. Profits encourage risk-taking. Losses encourage prudence.
It follows, then, that if you remove losses, you wind up with risk-taking and less prudence.
This removal of losses, and therefore prudence, is a key driver in things like the real estate and mortgage bubble that we are still trying to recover from.
The Wall Street Journal provided a perfect example in this article about a real estate development around a new downtown events arena in Kansas City, Missouri. The city government signed up as partner with a private developer. The city pledged taxes that would be generated from the area to pay off $295 million in bonds issued to help finance the $850 million construction.
Now, with the entertainment center generating about one-third of the original forecast in tax dollars, the city has to cover the bond repayment from its other funds.
Do you believe the private developer would have invested the full $850 million if the City hadn’t agreed to fund $295 million of the construction? Do you think the investors would have been a little more prudent in their investment? Maybe they would have still invested, but perhaps on a smaller scale.
(Thanks to a friend for sending the article to me)