Marketplace of Ideas Blog

I hope this is the last analysis of the bailouts, but I’m not betting on it.

Forbes’ Peter Robinson notes the unusual nature of this situation by beginning that “almost every lesson we think it has produced, it hasn’t”:

Take the lesson that the crisis arose from a failure to tame the rawer practices of capitalism.

“What happened,” as U.S. Rep. Barney Frank recently put it, “was they [the Bush administration] did not regulate appropriately. … totally abstaining from any kind of involvement in the market.”

Even the most casual examination of events proves this view wildly incorrect. By purchasing tens of billions of dollars worth of dubious mortgages, you will recall, Fannie Mae and Freddie Mac created the market for subprime instruments that caused this crisis.

Why did Fannie Mae and Freddie Mac behave so recklessly? Because they came under intense political pressure to do so — often from the chairman of the House Committee on Financial Services, Barney Frank. In the name of “affordable housing” — a term, we now know, that refers to putting people into homes they cannot afford — Frank leaned on Fannie Mae and Freddie Mac repeatedly. Ignoring credit risks, he declared, was their “mission.” When analysts questioned Fannie Mae and Freddie Mac’s solvency, Frank exclaimed, in effect, “How dare they?”

“The more people exaggerate a threat of safety and soundness,” he said, “then the less I think we see in terms of affordable housing.”

The invisible hand of Adam Smith didn’t create this mess. That honor belongs to ham-fisted politicians such as Barney Frank.

There remains substantial opposition to the bailout now-law. Northeast Wisconsin’s two representatives in Congress, Rep. Tom Petri (R–Fond du Lac) and Steve Kagen (D–Appleton), both voted against it. I’m inclined to believe that Petri had philosophical objections to the bailout, while Kagen, in a tight race, watched his telephone messages and emails, which blows up The Post~Crescent’s conclusion that Kagen bucked his own party.

Kagen should read this description of why this is important, from The Economist:

This is why those politicians who set the interests of Main Street against those of Wall Street are so wrong. Sooner or later the money markets affect every business. Companies face higher interest charges and the fear that they may one day lose access to bank loans altogether. So they, too, hoard cash, cancelling acquisitions and investments, in order to pay down debt. Managers delay new products, leave factories unbuilt, pull the plug on loss-making divisions, and cut costs and jobs. Carmakers and other manufacturers will no longer extend credit (see article) and loans will become elusive and expensive. Consumers will suffer. Unemployment will rise. Even if the credit markets work well, the rich economies will slow as the asset-price bubble pops. If credit is choked off, that slowdown could turn into a deep recession.

Financial markets need governments to set rules for them; and when markets fail, governments are often best placed to get them going again. That’s pragmatism, not socialism. Helping bankers is not an end in itself. If the government could save the credit markets without bailing out the bankers, it should do so. But it cannot. Main Street needs Wall Street; and both need Washington. Politicians—and President George Bush is the most culpable among them (see article)—have failed to explain this.

The Center for Individual Freedom used the phrase House Minority Leader John Boehner (R–Ohio) used in describing the bailout bill he voted for — a “crap sandwich” — and went on from there:

The overwhelming majority of we the people are not to blame for the specifics of the current disaster, that may or may not be averted, but will come at gigantic cost. We are to blame generally for electing people who, instead of representing our interests, are representing their own first and ours only tangentially, if at all.

That is very difficult to say to those who are working several jobs, trying to raise and educate their children and just live honorable, decent lives, who have little choice but just to vote and trust those they vote for to do the right thing. But when “crap sandwiches” are the only meals being offered, then voting is simply no longer enough.

Politics is currently dominated by the theory that those who lie the best and loudest and longest win. And that is the real “crap sandwich” that is being fed to the American people on all sides, by all sides. Trust? How can you trust when you can’t possibly verify, and you trust the media that are supposed to be helping you verify no more than you trust the original liars. …

We are conservative (although hopefully not nearly so arrogant as to believe we are always right). So are a large plurality of the American people, however they define their individual conservatism. Among the most fundamental principles of conservatism are individual responsibility and accountability.

We have one month to go before an important election, for the Presidency, for the entire House of Representatives, for one-third of the Senate, for a host of local and state positions. If, for just that month, rank-and-file liberal and conservative voters could reduce bashing the other side and start demanding responsibility and accountability from their own candidates, then it could be a start, just a start, for both sides having to eat a lot fewer “crap sandwiches.”

There are early signs that the bailout is actually working, which the Wall Street Journal identifies:

Meantime, in another positive sign, private capital is daring to bid for troubled banks. Don't be diverted by Friday's stock market decline; there were plenty of reasons to sell, not least 159,000 lost jobs in September. A better canary in the cyclone is Thursday night's news that Wells Fargo has agreed to buy Wachovia for $15.4 billion and without any government involvement. Only Sunday night, Wells Fargo had backed out of a similar deal for a higher price.

That's when the Federal Deposit Insurance Corp. stepped in to negotiate a Wachovia sale to Citigroup for $2.2 billion plus some government guarantees in return for $12 billion in preferred stock. Wells Fargo must have figured it was losing out on a good deal and leapt back in before Wachovia had signed a final agreement with Citi.

If the new Wells Fargo deal goes through, the FDIC would be relieved of $270 billion in exposure to Wachovia's ugly mortgage portfolio. The FDIC said Friday that it "stands behind" its deal with Citigroup, but we doubt FDIC Chairman Sheila Bair would be sorry to relieve the taxpayer of that burden. ...

Wells Fargo's offer is a sign that some people are willing to take risks on discounted financial assets even amid the current credit panic. While Wells Fargo hasn't said so, our guess is that Treasury's rescue facility helped give the bank the confidence to take that risk. The financial fear is deep-seated enough by now that even the daring want to see a life-preserver.

Lurking in the background here is none other than Warren Buffett, who owns 9% of Wells Fargo. The celebrated stock picker has also made major investments of late in Goldman Sachs and General Electric, a pair of blue-chip financial outfits suffering from bad credit bets. Mr. Buffett clearly thinks there's money to be made here sooner or later, and he's implicitly making a big bet that the Paulson plan is likely to work. ...

Also Thursday, the Federal Reserve released the latest data on its balance sheet, which has ballooned by some $500 billion to $1.5 trillion in the past month. That may sound alarming, but it beats cutting interest rates across the board to prop up the banks. Those extra Fed assets and liabilities can be worked off as the crisis passes without the long-term inflationary impact of pushing interest rates still further into negative territory. By lending freely in a bank run until they stop running, the Fed can make banks pay for their desire for safety while contributing to financial stability.

For those who think Wisconsin's finances are bad (and they are), it could be worse — imagine being in New York, which, the Wall Street Journal's E.J. McMahon notes, "for decades has built its budgets on the expectation of raising ever-greater revenues from a Wall Street that now no longer exists":

New York was once a great industrial state. But for the past quarter of a century, with occasional bear-market interruptions, the state's dependence on Wall Street has grown as manufacturing has shriveled. Last year, nearly 18% of private wages in New York State came from the securities industry. That was up from 3% in 1980. Nationally, only 2% of private wages are earned in the securities industry. The average Wall Street salary and bonus last year was $379,000 -- more than six times the average for all private-sector jobs in the state. As securities jobs dry up, the economy in the rest of New York is not nearly robust enough to make up for the income and other tax revenue that will be lost.

Premeltdown, the securities industry accounted for one-fifth of the state's tax revenues -- and a large share of Albany's net revenue growth over the past five years. That's not even counting capital gains and dividends, or the profits that investment banks, private equity firms, and hedge funds generated for other businesses, from white-shoe law firms to black-car companies throughout the New York City metro area.

What effect will the bailout have on federal government finances? (Remember, a large deficit existed well before this.) Former Treasury Department economist Bruce Bartlett, a bailout opponent, explains how this could work:

It's important that the cost of the bailout be fully accounted for in the federal budget. We cannot continue to use the Federal Reserve as a piggy bank. The Fed's primary responsibility must be the maintenance of a stable currency, which means control of the money supply. ... Consequently, it is critical for the bailout to be handled by the Treasury Department, which must issue bonds to raise the funds necessary to pay the cost. But in the short run, this means that the federal budget deficit is going to balloon to more than $1 trillion--$400 billion for the deficit the government was already expected run plus $700 billion for the bailout on top.

The deficit normally represents an increase in national indebtedness, which many economists view as the root of our current crisis. But the financial bailout represents something different. Rather than measuring the pre-emption of real resources, this element of the deficit is more akin to an exchange of assets. In effect, Treasury securities will replace private sector debt that is now too risky to trade. So the $700 billion cost of the bailout won't necessarily raise the aggregate level of debt in the economy. It will simply change its composition.

Furthermore, the $700 billion doesn't necessarily measure the true cost of the bailout because the assets being acquired by the Treasury will ultimately be sold, thus recouping much or all of the up-front cost. It's not inconceivable that the Treasury could even make a profit in the long run if, as many analysts believe, the financial assets that would be purchased are grossly undervalued by markets presently due to excessive risk aversion and mark-to-market accounting rules that force financial institutions to recognize large paper losses on fundamentally sound assets.

Thus the $700 billion is not so much a cost, but more like working capital.

Bartlett also notes that "the next president is going to be under enormous pressure to reduce the deficit even if a good chunk of it is just an exchange of assets":

No president wants to go down in history as the first one to preside over a deficit exceeding $1 trillion. This means that some kind of budget deal involving big budget cuts and tax increases is almost a certainty.

Politically, the best case scenario is Bill Clinton in 1993. He got the pain of deficit reduction out of the way quickly and by 1996 it was largely forgotten, giving him an easy re-election. The worst case scenario is that of George H.W. Bush, who waited two years into his presidency to do a budget deal that was still clearly in voters' minds when they went to the polls two years later, contributing to his defeat.

The wild card is Congress. Democrats believe that while Clinton's 1993 plan eventually helped him, it was the main reason they lost control of Congress in 1994. This may mean that effective deficit reduction will require a Republican in the White House to give cover to the Democrats who will almost certainly control Congress next year.