Thoughts on “the Big Bailout”

The biggest bailout plan (so far) will continue to be revised in an attempt to win approval of a congressional majority. The goal of the Emergency Economic Stabilization Act of 2008 is to put the brakes on the unwinding of the largest debt and leverage bubble in history in the hope of preventing a crash.

Nobody feels good about this extraordinary proposal. It is terribly expensive, it expands government power tremendously, it strikes many as being terribly unfair for rescuing fat-cats, it is supported even by some who acknowledge that it may not work, and it is (at best) the lesser of two evils.

The partisan politics of the bailout negotiations have been fascinating. A majority of congressional Democrats favor the bailout, even though polls show most Americans dislike it. A majority of Republicans have resisted the bailout. This is a very high-risk strategy, because if the financial system collapses before Election Day, the public probably would take it out on the party currently in the White House, thereby guaranteeing a Democratic triumph in the November elections.

One particularly cynical aspect of the bailout negotiations was the Democrats’ request for 20 percent of any profits that the Treasury might make on the eventual sale of assets that they would purchase under the plan; those profits would go to groups that serve as slush funds and lobbyists for Democratic special interests. The profits would go there instead of back to the Treasury. Republicans naturally balked at agreeing to fund the Democratic political machine as a condition of trying to rescue the country.

The heart of the plan is to allow the Treasury to purchase bad mortgages from various financial institutions—financial instruments that nobody knows how to value, for which there are no market prices, and indeed, for which there is no market at all. Few financial experts, however, believe that the Treasury can save all the banks and other financial companies that are choking on these depreciated, possibly worthless, assets. Officially, there are 117 banks on the FDIC’s “in trouble” list, but private estimates say it’s more like 1400 banks. How will Treasury decide which firms to save? Will there be a merit system, or will it all boil down to who has the best personal connections and most influential lobbyists?

Economics teaches us that policies have costs as well as benefits. While preventing the financial system from collapsing is something that most of us would prefer, the bailout plan will interfere with markets from correctly pricing assets that are currently mispriced. That is, in an effort to prop up floundering financial institutions, the Treasury interventions are designed to keep housing prices from falling. But housing prices got way out of balance in recent years, stretching beyond the affordability of many Americans. The negative side of falling housing prices is a lot of pain to homeowners, particularly those who would end up with negative equity, as well as the financial institutions holding mortgages and mortgage-backed securities (MBSs). That is a huge negative, because the MBSs are spread throughout the global financial system, which is tottering as falling housing prices erode the foundation of the huge financial house of cards resting on them. But if the market prevails, with all its merciless short-term pain, the outcome will be more affordable housing prices—a boon to younger Americans just entering the workforce.

The original wording of Treasury Secretary Paulson’s proposal included a provision that would make his office’s decisions unreviewable and irreversible. At this moment, I don’t know if that language remains intact. It probably doesn’t, but just the fact that someone would dare to propose that an unelected official and his team would have sole discretion over the use of $700 billion of taxpayer monies is incredible. It would utterly banish the “checks and balances” principle of our representative system of government. I rarely agree with Speaker of the House Nancy Pelosi, but when she told “60 Minutes” that the proposal asked for “czar-like powers,” she was spot on.

What, exactly, should Uncle Sam do? I am asked that question frequently these days. The short answer is “I don’t know.” Neither does anyone else. I’m not sure that King Solomon, with all his legendary wisdom, could solve this problem. The policy-makers certainly will try to preserve the existing system, even though that system is full of financial rot, such as excessive debt and leverage. On the other hand, the market—that is, all of us as buyers and sellers—will ultimately assert itself, correct the excesses, and price assets rationally, as surely as water finds its way to the sea. All this economist can do is sit back and watch this extraordinary drama unfold.

, Thoughts on “the Big Bailout”

About Mark W. Hendrickson

Dr. Mark W. Hendrickson is a retired adjunct faculty member, economist, and fellow for economic and social policy with the Institute for Faith and Freedom at Grove City College.

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