Why Promiscuous Bail-Outs Never Was a Good Idea
Jeffrey A. Miron explains in Reason why a government bail-out of most everyone was neither the only option nor the best option:
When people try to pin the blame for the financial crisis on the introduction of derivatives, or the increase in securitization, or the failure of ratings agencies, it’s important to remember that the magnitude of both boom and bust was increased exponentially because of the notion in the back of everyone’s mind that if things went badly, the government would bail us out. And in fact, that is what the federal government has done. But before critiquing this series of interventions, perhaps we should ask what the alternative was. Lots of people talk as if there was no option other than bailing out financial institutions. But you always have a choice. You may not like the other choices, but you always have a choice. We could have, for example, done nothing.
By doing nothing, I mean we could have done nothing new. Existing policies were available, which means bankruptcy or, in the case of banks, Federal Deposit Insurance Corporation receivership. Some sort of orderly, temporary control of a failing institution for the purpose of either selling off the assets and liquidating them, or, preferably, zeroing out the equity holders, giving the creditors a haircut and making them the new equity holders. Similarly, a bankruptcy or receivership proceeding might sell the institution to some player in the private sector willing to own it for some price.
With that method, taxpayer funds are generally unneeded, or at least needed to a much smaller extent than with the bailout approach. In weighing bankruptcy vs. bailouts, it’s useful to look at the problem from three perspectives: in terms of income distribution, long-run efficiency, and short-term efficiency.
From the distributional perspective, the choice is a no-brainer. Bailouts took money from the taxpayers and gave it to banks that willingly, knowingly, and repeatedly took huge amounts of risk, hoping they’d get bailed out by everyone else. It clearly was an unfair transfer of funds. Under bankruptcy, on the other hand, the people who take most or even all of the loss are the equity holders and creditors of these institutions. This is appropriate, because these are the stakeholders who win on the upside when there’s money to be made. Distributionally, we clearly did the wrong thing.
It’s too late to reverse history. But it would help if Washington politicians stopped plotting new bail-outs. At this stage, most every American could argue that they are entitled to a bail-out because most every other American has already received one.
Too Big to Fail
One of the most pernicious public policies aggravating the financial crisis is that of “too big to fail.” The doctrine states that some banks (now financial institutions generally) are so large that their failure would incur “systemic risk” for the financial system. That sounds terrible and it is intended to. Financial services regulators and Treasury secretaries use it to frighten small children and congressmen. How can an elected official vote to incur systemic risk? He must vote to approve the bank bailout of the day. In fact, people who use the term cannot even agree among themselves as to what it means, much less what causes it and, therefore, what the appropriate response would be. I suggest the reader substitute the phrase “too politically connected to fail” whenever he sees “too big to fail.” What follows will then be rendered intelligible.
Administration Reform Plan Misses the Mark
The Obama Administration is presenting a misguided, ill-informed remake of our financial regulatory system that will likely increase the frequency and severity of future financial crises. While our financial system, particularly our mortgage finance system, is broken, the Obama plan ignores the real flaws in our current structure, instead focusing on convenient targets.
Shockingly, the Obama plan makes no mention of those institutions at the very heart of the mortgage market meltdown – Fannie Mae and Freddie Mac. These two entities were the single largest source of liquidity for the subprime market during its height. In all likelihood, their ultimate cost to the taxpayer will exceed that of TARP, once TARP repayments have begun. Any reform plan that leaves out Fannie and Freddie does not merit being taken seriously.
Instead of addressing our destructive federal policies aimed at extending homeownership to households that cannot sustain it, the Obama plan calls for increased “consumer protections” in the mortgage industry. Sadly, the Administration misses the basic fact that the most important mortgage characteristic that is determinate of mortgage default is the borrower’s equity. However, such recognition would also require admitting that the government’s own programs, such as the Federal Housing Administration, have been at the forefront of pushing unsustainable mortgage lending.
While the Administration plan recognizes the failure of the credit rating agencies, it appears to misunderstand the source of that failure: the rating agencies’ government-created monopoly. Additional disclosure will not solve that problem. What is needed is an end to the exclusive government privileges that have been granted to the rating agencies. In addition, financial regulators should end the outsourcing of their own due diligence to the rating agencies.
The Administration’s inability to admit the failures of government regulation will only guarantee that the next failures will be even bigger than the current ones.
What We Have Here Is a Failure to Communicate
There are two parts to securing a country: making the country secure and making the country feel secure.
The head of U.S. Strategic Command, General Kevin Chilton, failed at the latter when he talked about security in a way that produced the following headline: U.S. General Reserves Right to Use Force, Even Nuclear, in Response to Cyber Attack.
As a theoretical matter, every element of military power should be on the table to respond to attacks. But the chance of responding to any “cyber attack” with military force is vanishingly small. To talk about responding with nuclear weapons simply helps spin our country into a security tizzy.
Politicians and military leaders should stop inflating the risk of cyber attack.
An Overdue Reckoning in the Auto Sector
Bloomberg reports:
General Motors Corp., facing a probable bankruptcy filing by June 1, is telling 1,100 “underperforming” U.S. dealers they will be terminated as the automaker starts shrinking its retail network.
Most of the closings will occur by October 2010, and none are happening now, Detroit-based GM said today. The targeted outlets will have until the end of the month to appeal the decisions, GM said, without specifying the stores on the list.
The shutdowns are the biggest U.S. automaker’s first step toward paring domestic dealers to a range of 3,600 to 4,000 from 5,969 by the end of 2010.
To be sure, it is a very sad day for thousands of workers and businesses around the country. But we’re in the midst of a deep recession, which may be nowhere deeper than in the auto sector. Demand for cars and light trucks has absolutely tanked, which means the economy has an excess supply of inventory, productive capacity, and retail capacity.
Patching up the Education Monopoly
The Eli and Edythe Broad and Bill and Melinda Gates foundations have sponsored a report, “Smart Options: Investing the Recovery Funds for Student Success,” on how to spend $100 billion of “stimulus money” on improving America’s schools, according to Jay Mathews in The Washington Post. Ideas include national standards, better teacher evaluations, special help for struggling students, and more.
But let’s try a thought experiment. Bill Gates made his money in software. Eli Broad made his money building houses. Imagine a slightly different universe, say one in which Henry Wallace and Al Gore had become president, and we had monopoly providers of both software and housing. How good do you think the software and the housing would be? And if the U.S. Department of Technology and the U.S. Department of Housing announced that they would be spending another $100 billion, what would happen?
It seems clear that the way to improve housing and software in that world would be to open the fields up to competition, or even to privatize them. A government monopoly provider of software would be lucky to have given us Minitel by now. And monopoly provision of housing was tried in much of the world during the 20th century, with poor results. So if we were afflicted with these albatrosses, surely we’d recognize that deregulation, competition, and privatization would produce better results by far.
So then why don’t we realize it when we’re afflicted with a virtual government monopoly on the provision of education? Why are zillions of smart people studying and debating how to improve the performance of a sluggish, stagnant, tax-funded government monopoly? Maybe we shouldn’t be so sure that we’d see the failure of the software or housing monopoly either. Whatever enterprise the government chooses to monopolize — and there’s really nothing inherent or inevitable about which enterprises that will be — will most likely become a massive bureaucratic undertaking, and we will find it difficult to imagine how the enterprise could be privately run.
But Bill and Melinda, Eli and Edythe, Jay, Barack — the evidence on monopoly vs. competitive provision of services is out there. To a great extent it’s the history of the 20th century. Check it out.
Bank ‘Stress Tests’ Need Transparency
As the bank stress tests are released, it is vital that the public receive specific and detailed information on each financial institution. The Administration’s and the Federal Reserve’s continued policy of attempting to disguise the differing health of each bank has been a failure. What is best for the taxpayer and the investing public is sufficient information to separate the good banks from the bad.
For those institutions which lack sufficient capital to remain solvent, they should seek private capital or else be closed and resolved. Too many taxpayer dollars have already been wasted keeping alive failed institutions. The Administration’s policy of keeping failed institutions on taxpayer-financed life-support only serves to retard the market’s ability to move assets away from those who do not, or cannot, make productive use of them toward those who can. It is time to remember that the unparalleled wealth-creating engine of the market depends as much on allowing failure as it does in encouraging success.
Banks passing the stress tests should be allowed and encouraged to re-pay their TARP funds as soon as possible, and with no additional strings attached. More importantly, the Administration should use any returned TARP funds to pay-down the increasing government debt, rather than be diverted to bailing-out other failed companies.
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