 WHAT’S A FREE MARKETEER TO THINK?
Volume One
September 23, 2008
In response to the federal government’s mammoth new involvement in financial markets, on Monday I invited a number of think tank and other colleagues from around the country and Minnesota to address a purposely free-swinging question: “What’s a free marketeer to think?” We will quickly email and post their columns as they come in over the next few weeks. I trust you will find their views consistently insightful, provocative, and helpful.
These first four pieces are by Jeff Sandefer, a director of both the Texas Public Policy Foundation and National Review magazine; the Rev. Robert A. Sirico, president of the Acton Institute in Michigan; Craig Westover, a senior policy fellow for the Minnesota Free Market Institute; and Devin Foley, director of development for American Experiment.
Many thanks, and as with everything the Center does, I welcome your comments. Mitch Pearlstein
Founder & President
Center of the American Experiment |
A Bailout that Sacrifices Freedom for Dependency
By Jeff Sandefer
Throughout our nation’s history, the size and scope of government has grown by leaps and bounds during times of crisis, financial or otherwise. The political class’ natural instinct is for government to rush to the rescue, particularly when an election is near. The current financial meltdown appears to be no exception, as our government responds with a $700 billion taxpayer-funded bailout that is at best a Band-Aid and at worst a more deadly strain of the same disease.
Rather than punishing taxpayers, an array of smarter options is at the government’s disposal: abandon cheap-money policy; remove financial incentives that make home purchasing so easy for those who don’t yet have the means to own a home; let solvent firms naturally emerge from the mess while firms without sound business models go under, just to name a few.
Many people have played into the hands of big-government apologists by arguing that free markets are "better" because "they work," rather than defending freedom as a fundamental, God-given right for everyone.
I was fortunate to be with Margaret Thatcher once in England when she reminded a group of Americans fretting about a temporary dip in the stock market: "The most important word in the phrase 'free markets' is not the word 'markets.' You cannot justify your freedom based on today's Dow Jones Industrial Average." Her words ring true, as Bush appointees scramble to stoke the engine of our economy by tossing in ever-larger quantities of our tax dollars and freedom.
Charging the Federal Reserve, investment bankers, and politicians to "solve" this crisis is like deputizing arsonists to fight a wildfire. The central enabler is the government, with Wall Street hucksters as eager accomplices. It’s time to let the market sweep away decades of excessive leverage and loose monetary policy.
Worrying about a repeat of the Great Depression is a valid concern. But check out hyperinflation in Germany in the 1930’s, or Zimbabwe in 2008, before you decide that flooding the world in dollars is a better idea. Free from intrusive governmental tinkering, markets will clear soon enough, even if it means many speculators are wiped out.
Pouring in more government dollars into bailouts may rescue a few Wall Street bondholders, but it will only harm the average American. In the end, vesting large amounts of economic power in a few government officials simply is a bad idea. It won’t work any better here than it did in the former Soviet Union. The world economy is too complex to be managed in a top down fashion, even by a Wall Street dealmaker and a Princeton economist.
Benjamin Franklin once warned: “Those who would give up essential liberty to purchase a little temporary safety deserve neither liberty nor safety.” The seeds of this problem were sown long ago, and the financial bill will be paid one way or another. The only question is how much freedom Americans will lose in the process. Jeff Sandefer is a member of the board of directors of the Texas Public Policy Foundation and National Review magazine.
September 23, 2008 |
Losses are Part of the Market Process By Robert A. Sirico Consider that people complain about the market economy when there are profits and also when there are losses. But we can't have it both ways. So why aren't those who have complained about the amassing of wealth on Wall Street right now celebrating that toppling of previously invulnerable institutions? Instead, it seems like the critics of the market economy cannot be made happy. Whether people are making money or losing it, they are always ready to denounce the market for ideological reasons and advocate regulation and other forms of state intervention. We should understand a bit more about the source of the problem that emerged in the housing markets and the financial market generally before acting to remedy the current mess. The federal government's monetary system became rather promiscuous in the effort to promote homeownership, offering loose credit conditions through the two quasi-private mortgage holders Freddie Mac and Fannie Mae. It is essential that a free economy tolerate both the profit and the losses that come with this activity. But in the case of Fannie and Freddie, the profits were privatized while the losses were implicitly socialized, that is, born by taxpayers. This sets up a moral hazard. It means that people tolerate more risk than they should because the consequences will be shared. In other words, what we have here is not a free market at work but a subsidized and distorted market, one running on artificial credit and not subject to the same laws of accounting as every other institution in society. The financial events of the last weeks, and really the last months and years, are really market-based responses to earlier interventions in the market process. One has to wonder, then, what the purpose of new regulations would be. After all, were it not for the past regulations, past interventions, we wouldn't be in the fix we are in today. No one is granted any real favor when there is intervention to stop the losses associated with investments gone array. When spokesmen for the Fed and the Treasury Department talk of tens of billions, and even hundreds of billions of dollars for bailouts, we should remember those resources come from the general population in the form of taxes, debt, and inflation. It is impossible to speak of a market economy without remembering that it is also a responsibility economy. That means that people are free to profit, and there is nothing wrong with that. It is the reward for resources well invested and risk prudently taken. At the same time, losses must also be borne by those who take the risks. We need to tolerate both the rich and the situations when the rich are sent away by the winds of change. We also need clean lines of responsibility so that we know who is bearing liabilities for whom. This is the proper juridical framework for a market society. As is often in the case in a crisis, the long-run problem is not the initial crisis but the mistaken response to it. Rev. Robert A. Sirico is president of the Acton Institute in Grand Rapids, Michigan. September 23, 2008 |
The Elephant in the Room
By Craig Westover
When cornered by the media early last week, Senate majority leader Harry Reid warned that a solution to the turmoil in the financial markets wouldn't be forthcoming soon because, "No one knows what to do." A few hours later, Reid and a collection of bureaucratic and congressional cognoscenti emerged from a closed-door meeting knowing exactly what to do – put taxpayers on the hook for Wall Street's debt so bankers and brokers could take a balance sheet "Mulligan."
This economic Yalta for free market advocates – much to the glee of the collectivists among us – is portrayed as the surrender of a free market Republican administration to irrefutable evidence that unfettered capitalism produces economic disaster.
The Wall Street turmoil, as stated in a New York Times article, is "a painful lesson" for evangelists of the free market.
True, there is indeed a painful lesson for free market advocates: Never ask a blind man what an elephant is like.
"This is not a market failure as so many are now claiming," wrote Ed Crane of the Cato Institute. "It is a government failure, pure and simple."
While I agree with Crane's conclusion that government intervention is the problem, the causes of our economic turmoil are not nearly so "pure" and certainly not as "simple" as Crane's disgust (and my own) with damage caused by collectivist philosophy would suggest. Like the six blind men who went to see the elephant, economists, pundits, politicians, war heroes, former community organizers and ex-small town mayors have been feeling up the situation, and not unexpectedly, their assessments of the crisis match the part they happen to be yanking on. What we have here is a problem of knowledge, the inability to see the whole problem. And therein lies the fundamental flaw with the economic mulligan coming out of Washington. Those-who-must-be-obeyed may have a plan that fulfills the collective desire to "do something," but Reid's original assessment is still the most astute – no one knows what to do.
Any plan coming out of Washington is based on dubious assumptions that are taken for granted. It assumes that the gathered officials possess all the relevant information, that their desired objectives are achievable, and that they possess the available means to implement the plan. Given those assumptions, the economic crisis becomes simply a complex puzzle that a bunch of really bright people can solve, given enough money and the coercive power to implement their plan.
But as F.A. Hayek notes as the general case in his essay "The Use of Knowledge in Society," which I am applying to this specific case, the economic problem of society does not have a strictly logical solution. As Hayek explains, "The reason for this is that the 'data' from the which economic calculus starts are never for the whole society 'given' to a single mind which could work out the implications and can never be so given."
Paraphrasing Hayek's general argument, the financial crisis facing our elected and unelected cognoscenti is not simply a problem of how to "adjust" existing market factors to preserve the financial system – if "adjustment" assumes that all relevant information is available to those crafting the adjustment. Rather, it is a problem of how to facilitate the most effective adjustments to the financial system to the benefit of any member of society, "for ends whose relative importance only these individuals know."
The misconception we are dealing with is that government can somehow come up with a solution that will simultaneously punish the wicked, reward the righteous, leave the ignorant blissfully blameless and the rest of us financially intact. The reality is that objective is unobtainable; there is no solution, only trade-offs. And right now armies of lobbyists are clashing on Capitol Hill over just what those trade-offs are going to be.
When battle ends, bodies will be buried and poppies will be planted and victory declared for a "solution" that serves visible collective ends but has only serendipitous connection to the ends important to any individual, of which no bureaucratic planner can ever have complete and timely knowledge, empathy or concern.
We don't need better policy for management and oversight of the financial markets. We do need policy that better facilitates dispersing economic knowledge to those making economic decisions. From the creation of Fannie Mae to passage of the Community Reinvestment Act, government interventions have jammed the economic signals that the market needs to function effectively. They have created moral hazard that breaks the bonds of market discipline and unchains greed and recklessness. We may be blind to the whole cause of the current economic crisis, but government intervention is without a doubt the elephant in the room.
Craig Westover is a contributing columnist to the Opinion page of the St. Paul Pioneer Press and the online news source MinnPost. He is a senior policy fellow at the Minnesota Free Market Institute.
September 23, 2008
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Emperor Paulson? By Devin Foley Examples abound in history when real and perceived crises were used to justify tremendous power grabs. Even in the land of the free and the home of the brave we’ve seen our fair share. Recall the Alien & Sedition Acts signed by President John Adams, FDR’s threat to pack the Supreme Court in the Great Depression, the Japanese internment during WWII, LBJ’s request and Congress’s adoption of the Gulf of Tonkin Resolution, and many others.
Amazingly, we have survived them all with most of our freedoms intact, which is a testament to the Founders’ wisdom and foresight laid out in the Constitution and the character of the American people. Indeed, either Congress or the Supreme Court eventually repudiated each grab for power in the examples just listed.
Today, we are told the Republic faces another crisis. Like Caesar poised to cross the Rubicon, Treasury Secretary Henry Paulson awaits the passage of the $700 billion bailout plan to save the Republic. He points to down markets, portends financial Armageddon, and urges Congress to act quickly to cede him power.
And what are some of the powers Secretary Paulson gives himself in the Bailout Plan? · Power to purchase, on his terms and conditions, mortgage-related assets from potentially any corporation or central bank in the world. (Section 2.a)
· Power to “enter into contracts … without regard to any other provision of law regarding public contracts.” Section 2(b)(2).
· Power to nationalize the entire financial system including banks, insurers, and other financial institutions. Section 2(b)(3). · Power to regulate and set guidance at will for unknown sectors of the economy. Section 2(b)(5). · Power to increase the national debt to $11.3 trillion (Section 10).
All of this is possible with the loosely written language found in the bailout plan. After all, the plan gives the Secretary of the Treasury the power to define the loose terms of the legislation and the actions of the Secretary are not open to review by any courts or any agency. Section 8 of the plan reads, “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” What hubris occupies Secretary Paulson that he would write a law removing himself from the judicial review that our Constitution guarantees? Are you comfortable with Secretary Paulson acting on his proposed powers with no oversight by any court or administrative agency? It may seem far-fetched to imagine the following scenarios, but taking many of the proposed sections of the plan to their logical conclusions results in such possibilities and more potentially becoming true. · If you own mortgage-related assets in good standing worth $1 billion, are you comfortable with Secretary Paulson forcibly buying those assets from you for $500 million. Are you comfortable with that act when you have no access to the courts on the matter? · If you have a checking account at a local bank, are you comfortable with Secretary Paulson nationalizing that account and regulating how you can use your money in the account? Are you comfortable with that act when you have no access to the courts on the matter? · Are you comfortable as a taxpayer and an American in bailing out foreign companies and central banks when they funnel their bad debt into foreign-owned, U.S. based corporations? Are you comfortable with that act when the courts have no say on the matter?
Americans, this Bailout Plan, as currently written, is a grave threat to our freedoms, our personal property, and our Republic. Republicans and Democrats, conservatives and liberals, and any and all who believe in the importance of upholding the Constitution and our way of life ought to stop and consider just how much power our elected representatives are considering giving the unelected Secretary of the Treasury and former Goldman Sachs CEO, Henry Paulson. As it stands, the markets are only down 16 percent for the year. That drop has justified an 80 percent ownership of AIG by the United States government and the nationalization of $5 trillion in mortgages, roughly half of the mortgages in America. Additionally, $300 billion was spent on the housing bailout bill, $160 billion on stimulus checks, and $100 billion in loans to institutions such as Bear Stearns and temporary clearing loans to institutions such as Lehman Brothers. Set aside the idea of another bailout that further socializes losses and privatizes profits, remove the partisan blinders, and recognize that we are marching down the road to serfdom at a frightening pace. Come what may, we must not destroy our children’s future by burying the nation in debt and destroying the Constitution in exchange for false promises of financial security provided by one man. We must protect and continue our American Experiment in self-government. If you have not yet read the $700 billion bailout plan, click here. Devin Foley is Director of Development for Center of the American Experiment.
September 23, 2008 |
WHAT’S A FREE MARKETEER TO THINK?
Volume Two
September 24, 2008
In response to the federal government’s massive new involvement in financial markets, on Monday I invited a number of think tank and other colleagues from around the country and Minnesota to address a purposely free-swinging question: “What’s a free marketeer to think?”
We published four pronto columns yesterday and here, in what might be described as Volume Two, are four more by former Minnesota congressman and current Brookings Institution scholar Bill Frenzel; Shannon Goessling, president of the Southeastern Legal Foundation in Atlanta; Larry Reed, president of the Foundation for Economic Education in New York; and Devin Foley, American Experiment’s director of development. We will continue disseminating incisive pieces likes these as we receive them over the next two weeks. Many thanks, and needless to say, I welcome your comments. Mitch Pearlstein
Founder & President
Center of the American Experiment |
No Democracy will Allow its Economy to Implode
By Bill Frenzel Our credit markets are in shambles. Few Americans comprehend the reasons for the system’s failure, but nearly everybody understands that it is “broke.” Ironically, a country renowned for devotion to free markets now seems to require the government to “save” those markets.
The Bush Administration, led by the Secretary of the Treasury and the Chairman of the Federal Reserve Board, is asking Congress to enact a $700 billion rescue plan. There is heavy resistance. But, after much complaint and criticism, and the addition of its own “improvements,” Congress will probably agree to some version of the proposal.
Purists and populists alike bewail the plan. A government solution is usually a wrong solution. The greedy risk-takers should not be protected. Every other loser in the country will insist on salvation, too. Even those who have lost nothing will demand much.
Whenever the government meddles in the marketplace, whether in crisis or to respond to criminal behavior, it tends to go too far. There is always an urge to overdo the relief, or to reward an unworthy class, or to lay on too much burdensome regulation.
The critics, many of them conservatives, are dead right. A free market system should require that mistakes be corrected, and paid for, in the marketplace. The problem is, however, that no democracy will allow its government to stand idly by while its economy implodes. Most people would devoutly hope that the government would not have to intervene. But when the panic strikes, the people can usually be counted upon to demand government interference.
A basic question policy-makers need to ask and answer is this: How bad is it? If the crisis can be weathered without major damage to the economy, the urge to meddle should be restrained.
Cases for restraint would include the Chrysler and New York City loans of the 1970s, specific industry requests like the current auto industry loans, and the never-ending demands for protectionism. The economy can withstand the loss of a couple of big companies which made mistakes.
But when the whole financial system begins to crumble, the government is driven to respond. Failure to act means punishing everybody, probably for a very long time, until the system is rebuilt.
Another basic question: Whose rescue plan is to be used? When the government is poised to meddle, the time-tested rule is don’t let Congress lead. If the Executive Branch does not lead, Congress will. With Congress in charge, the rescue becomes a bidding match to shower benefits on favored constituencies. Everybody gets paid off with someone else’s money.
The good news here is that there are some successful modern precedents. Two of them are Long-Term Capital Management and Continental Illinois Bank. Those rescues were swift and successful. The system was protected and the economy hardly burped.
More to the point is the case of the Resolution Trust Corporation, a five-year rescue operation of the early 1990s. Savings and loan firms were beginning to fail in significant numbers. The financial system appeared to be at risk.
RTC was successful. Its operations shored up the system. Many S & Ls failed, but most survived. Best of all, RTC left the taxpayers about as well off as they were before its creation. Its success, and reductions from Cold War Defense spending levels, helped put the U.S. budget in the black in the mid-‘90s.
No two crises are the same. The S & L meltdown, we are told, was only half as difficult as today’s problem. Different situations require different solutions. No one can be sure that the Paulson-Bernanke rescue plan will work like the RTC did, but experts assure us the problem is serious.
So how does this free marketeer react to the Paulson-Bernanke rescue operation? He wishes that they had not been obliged to propose it. He is grateful that they waited long enough to be sure the crisis was real. Believing that it is, he is equally grateful that they have finally moved toward a solution they believe is adequate.
He prefers an executive branch plan over a legislative branch plan, and hopes Congress does not “water up” the administration’s proposal by adding pay-offs for favored constituencies. Or, more realistically, he hopes congressional add-on costs and regulations can be limited in scope.
Finally, he hopes that our fabulously successful market system will infrequently require future interventions and that the marketplace will be able to exact its own punishment for incompetence and greed.
He has regrets but no illusions about government intervention into the private marketplace. It will happen again, and often. We simply have to do our best to manage it carefully.
Bill Frenzel is a guest scholar at the Brookings Institution and a former Member of Congress from Minnesota who voted against federal loans to Chrysler and New York City in the 1970s.
September 24, 2008 |
Gold. Solid as a Rock
By Shannon L. Goessling The underlying strengths of our economy, and the creative power of our people, are testament to the adage, “The business of America is business.” American commerce and industry – along with the world-sustaining entrepreneurial class – is now held hostage to a Government-Finance cartel dictating the future of our Republic This week, the world responded with a resounding NO when the $700 billion-plus bailout plan was announced – the dollar sank, commodities flew off the charts, and foreign banks threatened to stop funding the U.S. deficit. Doing “something” is not necessarily better than doing nothing, at least when the public fisc is at stake. The evidence is in: the leveraged fiat money system has run its course, and it cannot be sustained.
A startling and seriously underreported statement came from the world’s largest purchaser of U.S. dollars. "The U.S. dollar is no longer a stable anchor in the global financial system, nor is it likely to become one," said Fan Gang, a member of the Monetary Policy Committee of the Chinese central bank and director of the National Economic Research Institute. "Thus it is time to look for alternatives." Who do we think services our national debt? It’s not American free enterprise.
If the assets of Main Street are on the table, then let’s make “the people’s dollar” – the world’s reserve currency (at least for now!) and the “oil” that runs the global economy – an asset that matters. The “full faith and credit” of the American people means that this nation’s real assets, not just our ability to be taxed indefinitely and exponentially, should back our currency – precious metals, a commodities basket, or other alternative that demonstrates that the true wealth of this nation is not in its ability to print and loan and borrow leveraged money, but rather in our shared value as an industrious, innovative, and productive nation. Think it’s just not done anymore? It’s too old-fashioned? Ask the more than 40 nations who have moved back to the gold standard, including and especially Switzerland, which never left the gold standard. Solid as a rock.
The results would be nearly immediate – a refloated, revalued U.S. dollar backed by tangible assets will stave off inflationary pressures and avoid the boom and bust cycles we’ve experienced, and will once again make our markets attractive to essential foreign investment. The United States simply cannot be the world’s marketplace if the currency representing our productivity is degraded and debased, as we are currently witnessing.
American freedom, independence, and strength are at risk – this is truly a “once in a lifetime” crisis that begs for the right actions, not reactive maneuvers that fail to address the real danger. And certainly not actions that result in outright government ownership of a significant percentage of our economy.
Shannon L. Goessling is executive director and chief legal counsel of the Southeastern Legal Foundation headquartered in Atlanta.
September 24, 2008 |
Not So Fast!
By Lawrence W. Reed
“Thank God we had the federal government last week to bail out the private sector!”
That’s what a rather statist friend of mine declared, almost gleeful that the financial crisis seemed to be proving how much we all need a massive federal establishment to both regulate and rescue us.
Never mind the federal government’s own indispensable role as an enabler in the crisis, from its reckless monetary policy to its jawboning banks to make dubious mortgage loans. Never mind the long-term danger of its assumption of colossal new obligations and the moral hazard in the message its intervention sends. My response to my friend was of a more narrow focus. “Thank God we have the private sector to bail out the federal government not just last week, but EVERY week!”
Think about it. Taxes on the private sector pay a majority of the federal government’s bills. For most of the rest, the government borrows by selling its debt obligations mostly to private sector entities—including banks, insurance companies, and individuals.
The federal government is the world’s biggest taxer and the world’s biggest debtor. If those of us in the private sector didn’t pay our taxes or didn’t buy Washington’s paper, the feds would have gone belly-up decades ago. We’ve rescued Washington to the tune of about $10 trillion and rising. A big difference between Washington bailing out the private sector and the private sector bailing out Washington is that the private sector has to work, invest, employ people and produce goods to come up with the cash. It can’t print it like Ben Bernanke can.
Our friends in Washington have blessed us with future burdens almost too astronomical to comprehend. In the name of taking care of us in our old age, we are saddled with no less than $6 trillion in Social Security payouts over the next 75 years for which there are no presently earmarked funding streams. The unfunded obligations for the new federal prescription drug program, enacted under President Bush, according to Brian Riedl of the Heritage Foundation, total another $8 trillion. On and on it goes. The private sector has an awful lot of bailing out to do in coming decades.
If you have any doubts about the role played in the present crisis by the very federal government now posturing as our rescuer, take a look at this article from the September 30, 1999 edition of The New York Times: http://tinyurl.com/3jdn9e. And then contemplate how deeply we taxpayers will have to dig in the not-too-distant future to pay the bills of our benevolent, compassionate and forward-thinking government.
Lawrence W. Reed is president of the Foundation for Economic Education in Irvington-on-Hudson, New York (www.fee.org) and president emeritus of the Mackinac Center for Public Policy in Midland, Michigan.
September 24, 2008 |
Distorting the Very Idea of Free Markets By Devin Foley
We may or we may not be at the brink of Great Depression 2.0. Whether we are or not, the crisis will likely worsen in coming weeks and through it all, the death knell for markets, particularly of the free variety, will be sounded.
We’re already hearing how markets have failed, how greed overtook the country, and how deregulation and free market ideology are to blame. The solution? Almost always more government control.
Unfortunately, over the past few decades many policy wonks, public leaders, and politicians have claimed the ideas of free markets as their own, all the while increasing the size, scope, and budget of government. They paid lip service to the ideas, but in few ways did they actually work toward implementing the ideas. In doing so, the very definition of free markets has been distorted making public debate about whether or not markets are failing, especially free markets, terribly difficult in this present crisis.
Let’s clear things up a bit.
Are “free markets” to blame for this mess? Simply put, no. A market is basically an individual or corporation trading something of value for something else of value with another individual or corporation. A free market would be one in which the exchange is free of government regulation or manipulation. Try and think of something that isn’t somehow regulated by the government. It’s hard to do because free markets do not exist in America and have not for a very long time, if ever.
So what about markets in general? Did they fail? Are they to blame for all of this mess? Again, the answers are no. What you are seeing is the failure of government and the power of the market. Try as the government might, it simply cannot suppress the invisible hand of the market. One way or another, the invisible hand will sort things out to determine the real value of stocks, goods, houses, labor, and anything else of value.
If you walk into a grocery store to buy some apples and find that apples are $10 a pound, are you going to buy? Probably not. Is that a failure of the market? No. It simply means that the grocery store overpriced apples. So if the grocery store crashes the price of apples to something more reasonable like $3 a pound, are you going to buy? Probably. Did the market fail because the price came down? Absolutely not.
It’s the same thing for stocks and houses.
Last week Treasury Secretary Henry Paulson said, “Let me step back a bit and provide a little perspective. As I've long said, the housing correction is at the root of the challenges facing our markets and our financial institutions.”
I disagree. The root of the challenges facing our markets and our financial institutions is the government-sponsored credit binge.
Under Alan Greenspan’s leadership, the Federal Reserve opened the spigot to easy money and the country drank deeply. Money was printed and credit was made available to the banks. The banks naturally took their cut and then passed the credit on to their customers in the form of easy-to-get loans of all sorts. The customers then went out and bought houses, cars, TVs, vacations, and all manner of consumption goods. We were drunk on credit.
All of this easy credit inflated asset prices, kept the economy growing, and thoroughly indebted the country. Home prices climbed to unsustainable levels in every housing market around the country. And how do we know house prices climbed too high? We know, because the markets worked and the housing bubble popped. Just like the overpriced bag of apples at $10 a pound, the overpriced houses are coming down in price.
Sadly, now that our country and many of its people are up to their eyeballs in debt there isn’t a lot of cushion for an economic slowdown and so there isn’t a lot of tolerance for pain. Instead of taking the pain and working through the debt hangover, in a panic the government is now proposing we drink a new, credit-induced bailout to forget about our problems.
The cure for too much debt is not more debt. The cure for this problem is to free the markets, set a responsible monetary policy, and let the chips fall where they may. If we do not confront the problem now and deal with it like adults, the government’s actions will push us into a great depression, just like in 1929.
Devin Foley is director of development for Center of the American Experiment.
September 24, 2008 |
WHAT’S A FREE MARKETEER TO THINK?
Volume Three
September 26, 2008
In light of the ongoing financial crisis, on Monday of this week (September 22), I invited think tank and other colleagues from around Minnesota and the nation to address a purposely free-wheeling question: “What’s a free marketeer to think?”
We published four quick-turnaround columns in Volume One on Tuesday, another four in Volume Two on Wednesday, and we’re pleased to broadly disseminate six more in Volume Three today by David Himebrook of Arbor Capital Management in Minneapolis; Randall Holcombe of the James Madison Institute in Tallahassee, Florida; John Hay, formerly of the Prudential Life Insurance Company of America; Jake Haulk of the Allegheny Institute in Pittsburgh; Tom Schock of Capital Growth Real Estate in St. Paul; and Gordon Anderson of the Professors World Peace Academy, also in St. Paul.
Please note most of these columns were written just before the White House and congressional leaders reached their tentative – and then dashed – agreement on Wednesday night (September 24). We will continue publishing creative and important pieces like these as we receive them over the next ten days or so.
Many thanks, and as always, I welcome your comments.
Mitch Pearlstein
Founder & President
Center of the American Experiment
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“Much Like the War Bonds of the 1940s”
By David Himebrook I begin with the assumptions that a bailout of some sort is necessary and that $700 billion is the correct amount needed to stabilize the system. The current alternatives being discussed are considered government bailouts. They would be more accurately described as taxpayer bailouts under which the taxpayers have nothing to show for their participation other than a functioning financial system. My proposal calls for a government "facilitated" indirect program to be funded primarily by the American tax-paying public.
In general it would work as follows. The Federal Reserve would purchase the securities in a manner consistent with existing plans. All securities would be placed in a pooled structure. All taxpayers would then be able to purchase units of the pool at the price consistent with that paid by the Federal Reserve. These units would be marketed much like the "war" bonds of the 1940's to finance the war of survival for our financial system. A patriotic duty to participate.
In order to enhance the attractiveness of this investment the government would allow a one-time contribution of up to $100,000 per taxpayer to a tax-free, IRA-like account to fund the purchases. These contributions would be fully deductible for federal tax purposes over five years without restriction.
These securities would be hold-to-maturity in nature with the only cash flows coming from collections of the underlying pooled securities.
If only the top 5 percent of taxpayers participated to the full extent the program would be nearly 100 percent privately funded. It would be hoped that taxpayers at all levels would participate giving them a feeling of direct participation in the solution and an improved national savings rate.
Under this proposal the opponents who claim the government is bailing out "Wall Street" would lose standing as most funding would be private and voluntary. For those who think the government actually stands to profit from the ultimate collection of these securities, this plan would allow those profits to flow through directly to those individuals who contributed to the solution in direct proportion to their contribution. For those who think individuals wouldn't buy these worthless securities, let them know that we the taxpayers are buying them under any solution, the only difference being whether or not we have something to show for our purchase. If the securities prove worthless then that loss will be born by those who made a voluntary decision to participate.
From the government perspective, the forgone tax revenue on the IRA-like contributions seems to be a small concession for a direct funding by U.S. citizens.
Let’s recognize some bailout is necessary and try to structure it in an optimal fashion that is not just lose/lose for the taxpayer. The appropriate pricing for the “junk” securities from the financial industry remains an issue but no more so under this proposal than under others.
David Himebrook is a partner with Arbor Capital Management in Minneapolis.
September 26, 2008 |
Government Actions Encouraged
Wall Street's Risky Business
By Randall G. Holcombe Many observers blame the current financial crisis on a breakdown of private markets. A more careful look shows that government policy, step by step, led to the current crisis.
First, Fannie Mae and Freddie Mac were created to help provide mortgages for people who didn’t qualify for conventional mortgages. As government-sponsored enterprises (GSE), they rapidly grew to where their debt was nearly half the size of the federal government’s debt.
As long as housing prices rose, they could handle their debt. When prices fell, they rapidly became insolvent. This wasn’t a surprise. Experts had warned that they might collapse, but low-interest loans to poorly qualified buyers were too popular for Congress to rein in those lenders.
In part their popularity was due to the mortgages, but it was also because the GSEs used profits generated from their favored status in the “market” to make campaign contributions and offer high-paying jobs to congressional staffers. They purchased political support.
A related problem began with the Community Reinvestment Act (CRA) of 1977. If lenders wanted to expand their lending, they had to balance their loans to financially secure buyers with loans to buyers who did not meet the conventional mortgage criteria.
The push to extend mortgages to less qualified buyers was amplified by the Home Mortgage Disclosure Act (HMDA), passed in 1975 and expanded in 1991 to require lenders to report rejection rates by race. Lenders were put on notice that their lending practices would be examined for evidence of bias, with violators facing the possibility of fines as high as $500,000.
The CRA was broadened in 1995, allowing the securitization of sub-prime mortgage loans. Securitization combines a large number of loans into a security that can then be sold. The idea was that while some loans might default, most would not, so the securities would spread the risk and make it safe to hold portfolios of sub-prime loans.
An obvious drawback is that the originating lenders had little incentive to consider mortgages’ long-term prospects because the loans are held only a short time before they’re sold off and securitized.
A third factor in this crisis was easy-money policy adopted by the Federal Reserve Bank early in the decade to mitigate the effects of an incipient recession exacerbated by the after-effects of the September 11, 2001 terrorist attacks.
Low rates meant lower-cost mortgages, further enabling people to buy houses. But the increased demand pushed prices up, and many buyers wouldn’t have qualified for mortgages except for the relaxed standards.
Worse, many borrowers used variable-rate mortgages. The idea was that in a rising housing market, owners who couldn’t afford to refinance if the rates rose could always sell and turn a profit.
As long as interest rates remained low and housing prices rose, the problems were hidden. From 2004 to 2006, however, the Fed boosted the Federal Funds rate to 5.25 percent, pushing up mortgage rates and bringing the artificial housing boom to an end.
Those mortgage-backed securities, so attractive when interest rates were low and housing prices were rising, lost their luster quite abruptly when conditions changed. Firms that held lots of them found themselves in trouble. AIG, which insured such mortgages, foundered and was effectively nationalized.
The current crisis has two root causes. First, the federal government tried to extend home ownership to people who formerly wouldn’t have qualified for mortgages. This vastly increased the risk, which was hidden because mortgages were quickly resold, bundled, and “securitized.” Second, the Fed’s artificially low interest rates enabled the mortgage-backed security market to grow rapidly.
So government policy, not the free market, created much of the current financial crisis. Market participants aren’t blameless, however. Nobody forced Wall Street’s large investment banks to take big risks. They willingly accepted such risks in pursuit of bigger profits.
Why should the government now support the firms that made risky bets and lost? To do so would forever change our financial markets, which can work only if firms that accept risk in the pursuit of profit also suffer the loss if the market turns against them.
To bail out firms that made risky bets and lost would mean, at best, supporting managed capitalism and, at worst, the nationalization of financial markets. The long-term harm would far exceed any short-term financial stability a bailout might bring.
Randall G. Holcombe is DeVoe Moore Professor of Economics at Florida State University and Senior Fellow of the James Madison Institute in Tallahassee.
September 26, 2008 |
No Returning to Capitalism as We Have Known It
By John Hay I’m truly a "Free Marketeer." A graduate of the Wharton School at Penn and a retired vice president of the what used to be known as the world's 'largest and greatest" insurance company, a "mighty pump" (as Fortune magazine then characterized it), whose money pump helped to drive the economy back in the 1950s and ‘60s – the Prudential Insurance Company of America, as it was known then. That grand prominence, of course, has been diminished, though Prudential Financial is still very much a great company and has been holding up pretty well under the current onslaught.
What's happened within our capitalistic economy over the past couple of weeks was inevitable, almost prophetic, had we but been able to read the tea leaves. How could it have progressed in any other way?
We now have almost three generations of citizens who have experienced few, if any, remarkable economic hardships in their lives. Nothing has been so serious as to keep them from the shopping malls. No one in government has asked them for any sacrifices through the Vietnam and Iraq wars. And everyone in government has told them they can have it all, regardless of the consequences. Indeed, there would be no consequences. Just keep consuming, and we will be OK.
Interest rates were so low (and relatively speaking, still are) that money was almost free. It was loaned, and then traded creatively on secondary markets, with abandon. Almost any Joe or Jane could qualify for any kind of a loan. Extraordinarily obscene amounts of money were being made on Wall Street, by people of just ordinary talents. But we now all know that sordid story. Now the markers are being called in, and we're about to pay the piper.
Enter the politicians! Inevitable. Like vultures circling far above a wounded animal, waiting for it to die before they pounce and pick at the carcass. The two presidential candidates know absolutely nothing about economics and can't even begin to understand the current problems, but, of course, that doesn't keep them from mouthing off. Fire Cox! Yeah, right. No doubt, that will take care of everything. And Nancy Pelosi, Harry Reid, Chris Dodd, and Barney Frank will inevitably agree before this week is out to Hank Paulson's and Ben Bernanke's $700 billion bailout "solution." But not before making Paulson and Bernanke sweat before the TV cameras. And not before taking the stage themselves and pontificating their righteous and populous views before the American people. Quite a show, if the consequences were not so terribly serious.
It's now far too late to let the financial markets sort this out. The American people are now used to, and indeed demand, instant fixes. Entitlements have now become, well . . . entitlements. Rescue me from my ill-considered decisions. Put these CEOs in jail (where, of course, some of them probably deserve to be!). But, above all, make me whole. Make this all go away, and do it quickly. And, as a small business owner, what are you now going to do for me? You're taking care of the big guys, and I want my share. And then there's Ford and Chrysler and GM, ad infinitum.
After Congress acts this week, there will be no returning to capitalism as we have known it. I'm afraid the march to ever-increasing government meddling has taken one giant step forward, never to look back. Hey, you can't spend $700 billion of taxpayers' money without the Democrats (and some Republicans) extracting a quid pro quo. FDR is looking more conservative every day!
John Hay is a retired executive with the Prudential Insurance Company of America.
September 26, 2008 |
Hayek was Right
By Jake Haulk
In yet another verification of the Hayekian warning that government involvement in the marketplace begets more government involvement, we now face the mother of all financial market bailouts, putatively to prevent a credit market collapse of economy-endangering proportion. The bailout is needed to counter the consequences of the granddaddy of government interventions in the economy. Beginning with the Community Reinvestment Act, it moved on to the congressionally forced conversion of Fannie Mae and Freddie Mac into buyers and sellers of junk mortgage paper. And now the toxicity of the colossal volume of subprime loans and the securities they back has spread like flesh eating bacteria through the financial world.
So far this year the Federal government and the Federal Reserve arranged for and assisted in a buyer takeover and bail-out of Bear Stearns; arranged a $300 billion program to help banks and homeowners in foreclosure or danger of foreclosure; created an open-ended credit line for Freddie Mac and Fannie Mae; made a loan of $85 billion to AIG; and now has recently placed Fannie Mae and Freddie Mac in conservatorship.
Despite these heroic efforts to shore up the nation’s confidence in financial markets, it has now become necessary to launch a staggering $700 billion program to buy up the ever-growing stack of bad mortgage paper and the securities they back. As of this writing, the final details are not in place and we do not know if $700 billion will be enough. And little wonder. Together Freddie and Fannie have $5.4 trillion in guaranteed mortgage backed securities and debt – about the same figure as the publicly held national debt. What’s worse they are still in business, still acquiring more loans and mortgage-backed securities.
Free marketeers have long since warned against the intrusion of government into the economy, especially the intrusions that create market distortions and moral hazards. These intrusions cause people and businesses to make misguided decisions and engage in hyper-risky behavior they would not contemplate absent the government’s promise to prevent their suffering any serious consequences for bad decisions.
Unfortunately, these warnings have not only gone unheeded, they have been totally ignored. So, all things considered, there is not much free marketeers can learn from another episode that merely confirms what they have confidently predicted would happen.
There is one new and frightening twist in this latest calamity. It has become obvious that most of the major media are completely in the tank for Obama and will report nothing that might harm his chances to be elected, including his ties to Jim Johnson and Franklin Raines, both of whom played major roles at Fannie Mae. Nor is there any mention of his being the biggest recipient of Fannie Mae contributions over the last three years. Neither will the liberal media begin to point out, as Fox News has done, the perfidy and complicity of Democratic senators and congressmen in creating the mess that Freddie Mac and Fannie Mae have become, refusing even to allow corrective legislation on a number of occasions when it was clear that the two behemoths were about to go careening off the tracks. The media have to protect those miscreants as part of the protect Obama effort. And besides, they’re in bed politically with the liberal Democrat agenda anyway.
So what we have learned to our great horror and dismay is that liberal media and some legislators have no real concern about the underlying institutional infrastructure of the United States and are willing to undermine it, even at enormous risk to the nation, if it is necessary in order to promote their selfish political goals. They will get away with it because the Bush administration failed to draw a line in the sand five years ago and say this will not be allowed to happen on our watch. And they will get away with it because as long as the American people cannot get the truth from the major media, a large number of them will continue blindly believing that it was all Wall Street greed that created the mess and Wall Street, as they all know, is a bunch of Bush-loving Republicans. Yet another media created untruth.
That’s what one free marketeer thinks.
Jake Haulk is president of the Allegheny Institute in Pittsburgh.
September 26, 2008
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Same Fix as with Failed Savings & Loans
By Tom C. Schock Our best course of action likely would be to handle this debacle as was done with the failed Savings & Loans: Sell the loans for market value and then, due to the implicit guaranty attendant to “Fannie” and “Freddie” securitized loans, have the federal government (in reality, taxpayers) make the mortgage holders whole by covering the shortfall between the amounts owed and the amounts the loans sell for. In this manner, taxpayers end up “stuck” only for the spread between fair market value of the loans and the balance owed on them. This, as opposed to picking up the tab for the entire amounts owed.
Applying this methodology would result in the mortgagees getting “bailed out,” not the Wall Street gurus with latent liability after monumentally profiting from securitizing and selling substandard loan packages.
I understand the Fed and Treasury’s concern regarding getting liquidity into the system as quickly as possible. However, it’s well known that vast sums are sitting on the sidelines; money that will come back into the financial markets once a plan is in place and which would be available to purchase packages of mortgage-backed securities at their current fair market value.
The other inevitable result of the current plan on the table, as noted by another author in this American Experiment series, will be inflation due to “monetizing the debt.” This is an economist’s term for printing money. In addition to the methodology I just described for liquidating troubled assets, I would suggest the Fed now look to increase interest rates and decrease the money supply in order to keep inflation in check and to ward off further declines in the value of the dollar.
Tom C. Schock is a developer with Capital Growth Real Estate in St. Paul.
September 26, 2008 |
Don’t Give into a Protection Racket
By Gordon L. Anderson The first American Revolution was fought, in part, because the British wanted to control our money. Ben Franklin is reported to have once said that the economy of the colonies was so prosperous because the colonies issued their own money, “colonial scrip,” issued in proportion to the level of goods and services in the economy. No interest was paid to anyone for it. The result was that the British declared the use of colonial scrip illegal.
Consolidation of money accompanied the consolidation of Federal power over the states with the Civil War, with the National Banking Act of 1863 and the two revisions which followed in 1864 and 1865. This legislation promoted currency notes issued by nationally chartered banks rather than state banks. The Act imposed a 10 percent tax on state banknotes, effectively eliminating non-federal currency from circulation.
The control of federal money was largely taken away from the government, with the Federal Reserve Act and secrecy following later.
It isn’t that we weren’t warned by the founders about the consolidation of power and credit. The request by Fed Chairman Bernanke and Secretary of the Treasury Paulson was delivered in the form of a Mafia protection racket: “Give us your money now or something bad will happen.” No serious explanation, no attempt at accountability, no willingness for transparency.
It may be that some type of bailout by the government is called for under the premise that the role of government is to protect innocent people from harm by others. And that mandate refers to financial harm as well as physical harm. But the bailout as requested does not sufficiently meet this basic test. Who is innocent and who is culpable must be established, and any bailout should be accompanied by protection of the innocent from financial harm and punishment for the guilty. If Congress does not proceed in a way that protects the innocent and simply pays extortion, they will only be compounding the problem.
Gordon L. Anderson is general secretary of the Professors World Peace Academy in St. Paul.
September 26, 2008 |
WHAT’S A FREE MARKETEER TO THINK?
Volume Four
September 30, 2008
In light of the continuing financial crisis, a week ago I invited think tank and other colleagues from around Minnesota and the nation to take on the question: “What’s a free marketeer to think?” Here are four new columns, bringing the running total to 18.
My thanks to former United States Senator Rudy Boschwitz; King Banaiain of St. Cloud State University and the Minnesota Free Market Institute; Jim Van Houten, formerly CEO of MSI Insurance Companies; and Gary Palmer, president of the Alabama Policy Institute.
Please note these columns were written before the House of Representatives on Monday defeated a proposal aimed at remedying the problem. American Experiment will continue publishing important pieces like these as we receive them over the next week or so.
Many thanks, and as always, I welcome your comments.
Mitch Pearlstein
Founder & President
Center of the American Experiment
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Failure to Act will Cost Much More in Dollars and Pain
By Rudy Boschwitz I regard this bailout as a positive, as it’s something only the federal government can do. The result of not doing it would be far more costly to the people of our country in many ways, and the Federal government would lose far more tax revenue from a serious economic downturn than the cost of the bailout. I believe the bailout will cause the economy to bottom out and start upwards again – far sooner than would occur without this government action.
It is not going to cost $700 billion as the press irresponsibly trumpets. The government may indeed buy $700 billion of mortgages or mortgage packages that are in trouble. If the underlying real estate covered by the mortgages is worth zero, it will indeed cost the government $700 billion. But the underlying property is far from worthless. You may remember the Savings & Loan crisis of the late ‘80s. The government took over many S&Ls which had gone broke for somewhat different reasons than the root cause of the present mess – though the S&Ls were also a mess.
Those S&Ls held several hundred billion dollars of real estate through defaulted mortgages. The government created the Resolution Trust Corporation (RTC) to sell the real estate and recovered 65-70 percent of the value of those mortgages through an orderly sale of the property. In hindsight I think they rushed the sale of the real estate a bit and could have recovered more if they held on to it longer and given the market more time to recover.
It's the same with the "bailout" of AIG. The press gives the impression that present action by the U.S. government has already cost the taxpayer $85 billion. Not so unless you count the value of AIG at zero and it is far from that. It is (purportedly) the largest insurance company in the world. That’s big! The government got rights to about 80 percent of AIG stock. Remember the "bailouts" of Chrysler and Lockheed? As I recall the government saved both companies and made some money in the process by obtaining rights to some of its stock in exchange for guarantees and capital infusion – very much like what Warren Buffet has now done in providing additional capital for Goldman Sachs.
I was involved in another similar situation which occurred in agriculture in the late-1980s. The farm economy was very stressed due to falling land prices plus low commodity prices. Because farmers were stressed, their principal lender (for farm land), the Farm Credit System, was headed for bankruptcy. The FCS was an independent government agency. If it had failed, it would have cost the government many billions. In the Senate the FCS came under the jurisdiction of the Agriculture Committee, of which I was a member. More directly, it came under the credit sub-committee of the ag committee. Sen. David Boren, a Democrat from Oklahoma, was its chairman and he recruited me to be a member specifically to deal with the farm credit crisis. So I became the ranking Republican on the sub-committee.
The FCS was organized in nine (as I recall) districts around the nation, with one of the headquarters in St. Paul. The president of our district, a very smart banker named Larry Buegler, had come to me stating that if we gave the FCS some flexibility, some time, and the ability for healthy districts to absorb failing districts, they could work their way out of it.
Farm land mortgages generally had a single payment a year (after the crop came in), not monthly payments like your home mortgage. As I further recall the FCS could not accept less than the full payment so farmers were either paying it all or nothing - and enough of them paid nothing to create the problem. So Dave Boren and I held hearings. Then we drafted a bill, got it passed in both Senate and House, which gave the FCS both time (for land prices to stabilize) and flexibility in dealing with the farmer borrowers. Several weak FCS Districts combined with healthier ones. The result: Time did its work and helped stabilize land prices and the Farm Credit System worked its way out of its problems and didn’t cost the government a dime. The oversight agency we created was disbanded (not many government agencies ever are!) when the FCS was once again healthy. It was a proud achievement for Dave and me.
I tell these stories to say: credit problems are not new. Nor is government intervention new. The same mistakes keep being made but always with new wrinkles and twists.
The government is right to act. Failure to act will cost the economy and the American people far more in dollars and pain. The government would be right to restrict huge payments or parachutes to officers of these companies. The cost to the taxpayer will not be nearly as high as the press is saying. Our country and our economy have survived far worse. Indeed, the economic jolt of 9/11 was probably worse than this credit crisis – and a crisis it is that requires the government to act.
Rudy Boschwitz served as a United States Senator from Minnesota from 1978 to 1991.
September 30, 2008 |
“As in a Bomb Going Off”
By King Banaian
The free market has taken an enormous amount of abuse as regards the current financial crisis. It shouldn’t; it had nothing to do with it, as many of the other authors in this series have pointed out (and will). To the extent that the market has failed, it has done so largely because of government coercion over the years.
The “free market” did not get us into this mess, but we need the free market to get us out. For that to happen, the free market needs government as a partner, whether conservatives like that idea or not.
Free markets have always had booms and busts. This is the nature of Schumpeter’s “creative destruction,” of which some think this crisis is just another example. Some think this would be good for our economy.
They are wrong. Those who see in the current crisis only creative destruction underestimate the dose of simple destruction – as in a bomb going off – we are facing, and the magnitude of that destruction.
In creative destruction the boom that follows the bust needs to have credit to stoke its engines. The genius of capitalism is the movement of capital from the investor who seeks returns to the entrepreneur whose new innovation will help drive the next boom.
The current crisis threatens the engine of capitalism – finance – and hence we cannot sit idly by as the crisis deepens.
Financial markets are susceptible to a variety of maladies. Gearing is the ratio of an owner’s equity to borrowed funds. The use of derivatives – themselves the result of innovation – created an ability to leverage assets like our world has never seen. One of these innovations are insurance policies investors could buy to protect them against the default of another firm. This innovation – that a private firm could insure against the defaults of many other firms – ended up assisting firms in gearing, and was in retrospect a mistake.
Free markets are not free of mistakes; they just make fewer mistakes than governments. When a big enough mistake is made by either government or the market, panic ensues.
Panics are not new, and neither are the solutions. Panics have occurred when we have had central banks and when we have not (e.g., 1907 and 1929.) The history of those panics before the founding of the Federal Reserve was largely of liquidity crises: Many banks had assets greater than liabilities, but no ability to convert them to cash. In those times with smaller, more national than international markets, private banks could and did work together to solve their problems without government help.
But we suffer from more than a liquidity crisis at this time, and the most disconcerting for the free marketer is that many assets and derivatives on the banks’ balance sheets have an undetermined price. Mortgages on real properties are relatively easy to liquidate, but some other bank assets are relatively new securities innovations that turned out to be bad ideas. How these will be liquidated is unknown.
Ideally the government can act as a “market maker of last resort” in these securities, just as the Federal Reserve was envisioned as a lender of last resort for the liquidity crises of old. If the government can create a market where none exists, our system might recover without too much violence done to it.
Free markets do not mean always private markets. Free markets mean markets with an absence of coercion. It is possible for government to step forward for a missing market and not be coercive. A bailout that did not consume taxpayer dollars would be one example. Forcing banks to alter their lending standards would be coercive and unfree.
The problem we face is the absence of a market. Government can help create a free market where none exists today, and that would be a good thing. It may be that we cannot avoid costs associated with previous government meddling in the market that helped create this crisis, but we can all hope that the costs will not extend beyond those already sunk.
King Banaian is a professor of economics at St. Cloud State University and an economics fellow with the Minnesota Free Market Institute.
September 30, 2008 |
Goodbye to All That
By Jim Van Houten
In 1929 Robert Graves was 33 when he wrote his bestselling book, Goodbye to All That. In biographical form it describes his boyhood in English public school and the heady experience of being a member of the British Foreign Service in Cairo. When the narrative moves into his experience during the First World War (then the “Great War”), the tone becomes ominous. Graves’ concerns were mainly post-war. And we now know he was right: the British Empire never regained its stature and world influence after its “victory” in 1918.
Similar to Great Britain during the First World War, the United States now faces a great uncertainty which may result in both a tactical “victory” over its current financial markets problem, while suffering a strategic loss in world confidence in its historic free market philosophy. To achieve the former without the latter is the task at hand. So far the outlook is discomforting.
The London Times, among others, has written extensively of the damage being done to the world economy (which the World Bank estimates at $54.3 trillion in nominal GDP) by the U.S. financial crisis. (The World Bank estimates U.S. GDP at $13.8 trillion; or 25 percent of world GDP). The Financial Times reports that the new French president, Nicolas Sarkozy, is calling for an emergency G8 meeting for the world to address the U.S. problem. The Financial Times also quotes G8 member Peter Steinbruck, Germany’s finance minister, saying that, “the U.S. will now lose its status as the super power in the world financial system and be replaced by the emergence of better capitalized centers in Asia and Europe.” And Reuters reports that Venezuelan President Hugo Chavez ($0.2 trillion, or 1.5 percent of U.S. GDP) is telling anyone who will listen that this is a crisis of capitalism, and that socialism is the only solution to the world’s economic problems.
It’s not surprising that the media are reporting every scary opinion given the readership benefits which result from a big story. However, it’s surprising that much of recent reporting (the New York Times, for example) has been prescriptive rather than informational – advocating for government to manage broad aspects of complex financial markets without noting that previous meddling by those same players is a major cause of the current crisis. Few are urging caution and thoughtfulness in what the Economist called “the argument by some that the Federal Reserve and the U.S. Treasury are nationalizing the economy faster than you can say Hugo Chavez.” And few have reminded their audiences that there is a dearth of evidence that beneficial long-term effects follow when a nation increases government’s role in free markets.
U.S. history in this regard is telling. Franklin Delano Roosevelt regulated almost everything, including the price to be charged to press a pair of pants, but could not end U.S. economic stagnation during the Great Depression. In April 1938 unemployment remained at 20 percent, about the same as when he took office in March 1933, five years before. At the time he was also being warned by the liberal but policy-exhausted economist John Maynard Keynes that, “it is a mistake to think businessmen are more immoral than politicians.”
So far the only group consistently “standing athwart history yelling ‘stop’ ” (paraphrasing William F Buckley, Jr.) is the minority party in the U.S. House of Representatives. Whether or not they can win this argument with a majority party less concerned about free markets remains to be seen. If they fail we will be ready for another bestseller with Graves’ title.
Jim Van Houten is a former CEO of the MSI Insurance Companies and served as a member of American Experiment’s board of directors during the Center’s early years.
September 30, 2008 |
Using Assets Subject to the Inheritance Tax
By Gary Palmer It is evident that American taxpayers are angry about what it appears Congress is going to do: a $700 billion taxpayer bailout of the ailing financial and mortgage institutions. According to a USA Today/Gallup poll (September 24), 56 percent of the American people want a different plan. Unfortunately, this is very likely an article about what Congress could have done instead of what they will do to recapitalize our nation’s financial markets.
Apparently, the dire warnings from the Bush administration and others that the economy is on the brink of failure are not enough to persuade American taxpayers that a bailout is the answer to the financial crisis. The perception is that the federal government is forcing the taxpayers to pick up the tab for the problems created by the mismanagement and corruption of greedy corporate executives and their enablers in Congress.
The fact is the bailout is more of a buyout. The package that Congress is considering would commit the federal government, i.e. the taxpayers, to spend hundreds of billions of dollars buying mortgages. This means the federal government will be in the real estate business, at least until it can sell its new real estate holdings, hopefully at a profit.
This action is supposed to result in the recapitalization of the financial industry. Could there be another way to unclog the financial arteries of the nation’s economy without adding $700 billion to $1 trillion to our federal debt?
The answer is yes.
Congress could create an opportunity for private sector funds to be used to recapitalize banks and the housing industry by using assets subject to the inheritance tax. It is estimated that between $1-1.5 trillion in assets will be transferred to heirs over the next ten years. In 2009, under current law, estates with assets worth more than $3.5 million will be subject to a tax of 45 percent on everything above the exemption. And, unless Congress renews the Bush tax cuts, in 2011 the exemption will decline to $1 million and the tax will increase to 55 percent on the amount above the exemption.
In order to get more private equity into the financial and mortgage markets, Congress should create a 12-month window in which anyone with assets subject to the inheritance tax could use those assets to purchase residential real estate or mortgages. The assets used within that time frame would never again be subject to an inheritance tax.
If the real estate purchase produces income, such as rental income or increases in value, the estate owner would pay the usual income and capital gains taxes. However, if the investment resulted in a loss, investors would not be able to deduct the loss on their income tax return.
A 45 or 55 percent tax is a hefty penalty for dying and there is a lot of incentive to try to avoid paying it. Because every dollar of private money infused into the real estate and mortgage markets would replace a dollar that the federal government would have to spend in a bailout, this option could significantly reduce the size of a bailout and save billions of taxpayer dollars.
Given the dire circumstances we face, members of Congress should be willing to consider this option. It will benefit all American taxpayers as well as those faced with paying inheritance taxes. Moreover, even though some portion of the inheritance tax would be eliminated, directing those assets into the financial and real estate markets gives it the effect of a tax in that the resources are being directed to a specific purpose.
There is another idea that also makes sense. Congress should create a six-month window in which investors could purchase residential real estate and receive a tax credit of 20 percent of the purchase price as an incentive to buy. The tax credit could be taken in the first year or it could be carried over in successive years until it is used up.
Currently there are more than four million houses on the market nationwide. Given that the median price of a house is around $196,000, it would take about $400 billion to cut that inventory in half. Using the above figure as a baseline, by offering a tax credit of 20 percent of the purchase price, the cost to the federal government of the tax credit would only be $80 billion.
Perhaps the most important thing about a private sector solution is that it would help restore market discipline. A taxpayer bailout increases moral hazard; i.e., the likelihood that this will happen again. Keeping these transactions entirely within the private sector would not only stabilize the market, but would also enforce a degree of accountability and responsibility on those who created the crisis. As a result, those who made the really bad deals will still suffer some consequences for their actions.
These ideas will not totally eliminate the possibility of direct federal action. But if the federal government eventually has to act, it would be at a significantly lower cost to the taxpayers and with significantly less danger of nationalizing the mortgage industry.
Clearly, Congress is going to address this problem. Will Congress pay attention to the American people and consider alternatives such as allowing the private sector to be a part of the solution? Unfortunately, it appears at this point that some congressional leaders believe the only plan is a taxpayer bailout.
Gary Palmer is president of the Alabama Policy Institute, in Birmingham.
September 30, 2008 |
WHAT’S A FREE MARKETEER TO THINK?
Volume Five
October 2, 2008
In light of the continuing financial crisis, ten days ago I invited think tank and other colleagues from around Minnesota and the nation to tackle the question: “What’s a free marketeer to think?” Here are two new columns, bringing the running total to 20.
I offer my thanks this time around to Tom Kelly, a partner in the Minneapolis-headquartered law firm of Dorsey & Whitney, and Devin Foley, American Experiment’s director of development. It’s actually Devin’s third contribution to the series, though the first one with the title, “Sordid Tales of a Mobile Loan Closer.”
The Center will continue publishing varied and vital pieces like these as we receive them through next week.
Many thanks, and as always, I welcome your comments.
Mitch Pearlstein
Found & President
Center of the American Experiment
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Myths and Realities of the Credit Crisis
By Tom Kelly
Following the news about the credit crisis has been frustrating for a “free marketeer,” particularly one who worked in the mortgage industry for seven years. The realities of the situation are very different than the myths our political leaders and the media have been repeating:
Myth Number One: We are facing the “worst economic crisis since the Great Depression.”
Reality: We are facing a credit crisis, which could become an economic crisis if the government continues to mismanage it. If things go badly, it could end up as the worst economic crisis since the Great Depression. But we aren’t there yet. In August of 1979, the unemployment rate was about the same as today’s (6.0 vs. 6.1 percent), but the inflation rate was 11.8 percent compared to today’s 5.4 percent. The loss of confidence was reflected in President Jimmy Carter’s infamous “malaise” speech and a prime rate that approached 20 percent.
But in one very important sense, we were better off in the fall of 1979 than we are today. In August of 1979, Paul Volcker became Chairman of the Federal Reserve Board. He understood the cause of the problems facing the economy: an easy money policy that had debased the value of the dollar over the previous decade. He also understood the Fed’s role in solving the problem: to stop creating so many dollars. The treatment was painful – in 1982 unemployment reached 10.8 percent – but the patient was cured. Unfortunately, there is no sign of similar leadership on the horizon today.
Myth Number Two: We are facing a “liquidity” crisis.
Reality: We hear a lot of talk about the fact that there is no “liquid” market for mortgage-related assets, but that is not the problem. Most of these assets were designed to meet the needs of specific investors, not to be widely traded. The current crisis is a credit crisis, and the primary cause was monetary policy that provided too much liquidity to the economy over the last seven years.
In 2001, many economists were worried that our economy was becoming deflationary. The stock market declined after the dot.com bubble burst, consumer prices were stable overall (actually falling for many items), and long-term interest rates fell below short-term rates. The shock of 9/11 reinforced the concern about deflation. Since deflation is as bad – or worse – for an economy than inflation, the Fed responded by reducing interest rates to the lowest level in four decades, and kept them there for the following three years. The result was a credit bubble – the one that is currently unwinding. Compounding the error, the Fed chose to respond to the early stages of the current crisis by slashing interest rates below the inflation rate again. Today, there is no shortage of liquidity in the system – rates on short-term U.S. government obligations were close to zero last week. But because we are still unwinding the inflated asset prices of recent years, lenders are afraid to rely on the balance sheets of potential borrowers who are carrying these assets. That is the problem that needs to be addressed to re-establish confidence in the credit markets.
Myth Number Three: The mortgage-related assets being held by many banks and investors are “toxic” because of their complexity and opacity.
Reality: Mortgage-backed securities and related assets, though complex, are “toxic” to the banks and investors that hold them primarily because they are overvalued and/or financed with short-term debt. The extent to which real estate prices inflated during the credit bubble is not hard to measure. From before 1980 until 2001, home prices had a consistent relationship with income. Beginning in 2002, when the Fed cut rates below the rate of inflation, that relationship vanished. Home prices rose approximately 35 percent above where they would have been had the historical relationship with income been maintained.
The best prediction of where home prices will stabilize is at the level where the historical relationship with income will be restored. So, to calculate a fair value of mortgage-related securities, you need to model the securities based on home prices returning to their historical relationship to income, making related assumptions about defaults, foreclosure losses, refinances, and write-downs to avoid foreclosure. In most cases, that price will be lower than the current book value of those assets, rendering some holders insolvent and others undercapitalized. In addition, some holders (particularly the traditional investment banks, which have now all been bought by or converted into commercial banks) funded these assets with short-term debt. My formula will not give you a current “market” price – nobody is going to take on the risks of these assets right now unless they can buy at a substantial discount. So when the debt comes due, lenders (who frequently loaned the money at rates reflecting low risk) are reluctant to extend the maturity because they know those assets cannot be sold in a pinch to pay them off. This mismatch between the maturities of assets and liabilities will render additional holders insolvent.
Myth Number Four: The current crisis is a market failure.
Reality: Although the workings of the markets (and political system) have created the current atmosphere of crisis, the root causes of the housing bubble were government policies. The first, discussed above, is the “easy money” policy followed by the Federal Reserve since 9/11. That policy translated directly into inflated real estate prices by a simple mechanism: When interest rates are low, the same monthly payment will service a larger debt, thus enabling buyers to pay more for homes.
The second is the policy of promoting home ownership, particularly as it manifested itself in the operations of Fannie Mae and Freddie Mac. Fannie and Freddie were (until a few weeks ago) hybrid entities; private for-profits companies that paid dividends to shareholders (and generous compensation to executives) but served the “public purpose” of promoting homeownership. Because Fannie and Freddie were chartered by the federal government for a public purpose, the companies were widely considered (correctly, as things turned out) to have the backing of the federal government, and thus very low borrowing costs. Fannie and Freddie were able to make large profits through arbitrage, borrowing at low rates and using the money to buy mortgage-backed securities bearing higher rates, including securities backed by subprime mortgages that were not eligible for purchase or securitization by Fannie and Freddie. Fannie and Freddie became the largest buyers of mortgage-backed securities, thus reinforcing the artificial inflation of home prices generated by loose monetary policy. These two policy errors set the table; the mortgage industry and Wall Street were only too happy to gorge themselves at the feast.
Myth Number Five: The mortgage market is an example of “unregulated capitalism.”
Reality: The mortgage market is highly regulated. Although mortgage brokers are not regulated in some states, mortgage companies (who actually make the loans) are required to be licensed everywhere. There are extensive regulations about appraisals, disclosure of terms, closing of loans, and the sale and securitization of loans. There are programs that encourage mortgage companies to make and investors to buy loans made to less-than-creditworthy borrowers and there are regulations that require some investors to purchase only “investment grade” securities.
As discussed above, Fannie Mae and Freddie Mac also play a substantial role in the market. In particular, Fannie and Freddie, because of their low cost of funds, make it impossible for private firms to compete with them for the loans they will buy, thus forcing firms to look to the “non-conforming” (i.e., higher risk) market for opportunities. This had the effect of concentrating the risk of default instead of spreading it across the entire market. For politicians looking for an example of “unregulated capitalism” to attack, the mortgage industry is a bad choice.
Myth Number Six: The mortgage boom and bust have been a disaster for homeowners and the economy.
Reality: It’s too soon to tell. From 2001 through 2006, the percentage of American households owning their own homes went from 63 percent to 69 percent. It has fallen since, but not below 63 percent. The homes that were built during the boom still exist; as a result, prices for homebuyers will be lower for at least several years. That is good for families looking to buy a home though bad for families looking to cash out. As with any boom and bust, there will be winners and losers: only time will tell whether the benefit to the economy as a whole will outweigh the cost. But anybody who uses a 3G mobile device knows that the infrastructure built during the dot.com boom did not go to waste.
Myth Number Seven: Government should take action to mitigate the crisis.
Reality: The way to end a financial crisis is to let it run its course, not to try to slow it down. Government actions designed to mitigate financial crises can turn them into economic crises. The best example of this is the Great Depression. Anybody interested in a good, but not technical, book on this topic should read Rethinking the Great Depression by Gene Smiley.
So where do free marketeers go from here? The answer, I believe, is not to lose faith in markets. At the same time, I think we need to recognize that markets are not as “efficient” as many of us had believed – if they were, credit markets would be making distinctions between borrowers exposed to mortgage-related assets and borrowers without mortgage exposure. Those distinctions are not being made today. Based on these premises, I propose the following “free market” solution to the credit crisis. · No federal purchase of "toxic" assets. No “insurance” program to make well-managed banks pay for the errors of poorly managed ones. No bailout. As discussed above, when Wall Street says "toxic" it means "overvalued." Write the assets down to their true value and they are no longer toxic. But some institutions will be insolvent.
· We have insolvency regimes for ordinary businesses and broker/dealers (bankruptcy), banks (FDIC receivership and liquidation), and insurance companies (state receivership). Use them to establish the losses and move the overvalued assets out of the system.
· In cases where the failure of an institution does pose a systemic risk, create a means for the government to intervene, but only to address the systemic risk, and only on the following terms: Government money is last in and first out.
· Immediate receivership for any institution that has to participate, as was done with Fannie and Freddie. Management should be out, and the receiver should be charged with preventing systemic risk and maximizing the recovery for creditors.
· The receiver should have the power to recapitalize, sell, or liquidate the institution. The proceeds should be distributed to claimants based on their legal priorities (e.g., shareholders get nothing unless creditors are paid in full). As a result of this process, the people and assets currently tied up trying to preserve failing firms will be redeployed to where they can help restore growth.
The events of the last dozen days have demonstrated that our economic and legal system is up to the task of resolving the credit crisis without transferring massive losses to taxpayers. Institutions that were not heavily involved in subprime lending, like Bank of America and JP Morgan, or that wrote down subprime assets aggressively, like Citigroup, are buyers in this market. Citi, JPMorgan, Goldman Sachs, and Morgan Stanley have each raised $9 billion or more in new capital. The FDIC is moving aggressively to clean up the banking system. If we give the system time to work, it will.
This course, unlike the proposed bailout, will end the "crisis" as quickly as possible. Once the credit markets realize that insolvent borrowers have been weeded out, they will return to normal functioning. There will be a recession, but recessions are an inevitable part of the business cycle, and efforts to postpone them always end up making them worse. Once the crisis passes, we can turn to reform.
Tom Kelly is a partner in the Finance and Restructuring Department at Dorsey & Whitney LLP. He is also on the Board of Directors of the Minnesota Free Market Institute.
October 2, 2008 |
Sordid Tales of a Mobile Loan Closer
By Devin Foley
I find it hard to believe that no one saw this financial mess coming. I find it even harder to believe that adding another $800 billion of debt is going to fix it.
Outside of what I learned in college about markets, economies, and history, my understanding of the economy over the last seven years has been informed by my research aimed at making sense of what I saw take place around me.
I graduated from college in May of 2001 and got a job a few weeks later working in sales for a telecom company. Life was good until reality struck six months later in November when a few thousand of my coworkers and I were laid off. If it wasn’t for 9/11, the lay-offs would have happened in September, as it would have been a PR disaster to let so many people go right then. A few months after boxing up my desk, cutting up my company credit card, and turning in my computer, reality struck again when the stock market really took a beating and times were terribly tough at my new non-profit job.
One would think that at the time with so much creative destruction in the economy folks would be a bit more leery about buying a house. Not so as my wife and I learned in the spring of 2002.
The race to buy a house struck us as ridiculous at the time, but we figured that was what we had to do to get a house before the prices rocketed any higher. Many times we would try and schedule a showing only to find out the house was already sold for the asking price or more. Finally, in May 2002 we found a “reasonably priced,” modest bungalow. At the time we thought we were getting a good deal. I later found out we paid twice what that starter house went for in 1996.
Even at the time, I knew starter incomes had not doubled in six years and surely the population of the Twin Cities had not doubled in six years. The economy was simply not right.
In 2003 I began mobile loan closing in the evenings to make a little extra money for my family – which quickly obliterated any confidence I had in the soundness of the American economy. The job was simple: Be available in the evening, get a call from a closing company needing a refinance loan closed, pick up the loan documents from the closing company, drive to the borrower’s location of choice (usually their house), walk them through the documents, notarize the needed signatures, and drop the loan documents off to the closing company the next day.
Back in those days, house values were soaring and ads were extolling the virtues of turning those houses into ATMs. It didn’t matter if they were sub-prime, Alt-A, or prime borrowers: Everybody was loading up on cheap debt and I saw it happen.
I went all over Minnesota, from Baudette in the northwest to Albert Lea in the southeast, and everywhere it was the same story. If I saw a shiny, new $30,000 truck in the driveway, sure enough the debt for it was getting rolled into the home loan. If there was a flat-screen TV as big as a wall, sure enough the debt for it was getting rolled into the home loan. If someone had a framed picture of their time in the Virgin Islands, sure enough the debt for it was getting rolled into the home loan.
My job was just to go over what the loan said and notarize the borrower’s signature. During that half-hour to hour, people talked. On paper, everything seemed fine and dandy. The borrower makes $x amount and is going to carry $x amount of debt at x percent interest rate, and the loan to value is x:x.
More precisely, all was deemed proper and sound as discerned and spit out by computer programs. But I often found matters to be radically different when I visited clients, saw where they lived, and learned what they had done or planned on doing with the money.
I went into one house not far from where I lived. Before I could knock on the door I could smell the stale cigarette smoke from inside. To the left there was a cement pad where a garage once stood. Once I got inside, I could see it was a rundown house with plywood cabinets and ripped and stained carpeting – albeit sporting a giant flat screen TV.
While I went over the paperwork with him, I found that the mortgage company set the value of his house at about $200,000. I about fell over. Again, my house wasn’t far from the borrower’s location, and mine had just been valued at about 10 percent less than his. I had a garage, a remodeled kitchen, nice layout, etc. I thought to myself, who would pay $200,000 for this house? But I’m not an appraiser, so what did I know.
As if that wasn’t shocking enough, I found out he was getting almost $40,000 in cash-out. He said he was going to fix things up a bit and maybe buy a newer car. He also said he might go to the casino at Turtle Lake to celebrate – all because the mortgage broker told him he could do it. I’m not a mortgage broker, so what did I know.
If you think it was just sub-prime folks, you’re wrong. After going into house after house, rich or poor, and seeing what the money went for, it was impossible not to think the whole economy over the last six to seven years was a credit-induced sham.
More disturbing than what was purchased, were some of the attitudes of borrowers. Always, the perfectly appropriate question: “How much is my monthly payment?” Well, I would say, you have an adjustable rate mortgage so the rate can change, though it’s capped at 8, 10, or even 13 percent – which meant if your rate changed, your payments would be affected. And always the response: “Well, my house will keep going up and rates are going to stay low, so I can refinance later.” Well, no one can ever know that for certain and people should plan for a worse-case scenario.
What did we get for all of this debt? Overall, will it generate wealth or will it turn us into serfs as we pay for already consumed goods and services of depreciating value? Is borrowing $800 billion a step in the right direction or is it a continuation of what got us here? If the latter, are we suffering hubris by believing we can painlessly unwind a debt-induced bubble of historic and global proportions?
Now that house prices have stopped rising and credit isn’t so easy to get, many Americans are finding they are like the grasshopper in Aesop’s famous fable about the ants and the grasshopper. Winter seems to be approaching, and unlike the ants that worked and saved, grasshoppers who worked and didn’t save have no reserves and aren’t ready. If winter hits hard, many Americans may look back and wish they hadn’t been so quick to get into debt.
Devin Foley is director of development for Center of the American Experiment
October 2, 2008 |
WHAT’S A FREE MARKETEER TO THINK?
Volume Six
October 3, 2008
Nearly a dozen days ago now, and in response to our nation’s financial emergency, I invited think tank and other colleagues from around Minnesota and the nation to address the question: “What’s a free marketeer to think?” What follows is installment Number Six of the ongoing series: three new columns, bringing the running total to 23. Please note they were all written before the House of Representatives passed, and President Bush signed, legislation earlier today aimed at alleviating crisis.
I extend my thanks this time around to American Experiment’s Peter J. Nelson; Robert P. Murphy of the Pacific Research Institute in California; and Matthew J. Brouillette of the Commonwealth Foundation in Pennsylvania.
The Center will continue publishing varied and provocative pieces like these as we receive them through next week. To read any of the previous volumes, see the links below or go to our website at http://www.americanexperiment.org/.
Many thanks, I welcome your comments – and whether today’s actions in Washington have calmed you down a bit or agitated you even more, may you have a good weekend.
Mitch Pearlstein
Found & President
Center of the American Experiment
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The 2000s in Retrospect By Peter J. Nelson Way back in January 1997, Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, led an FDIC-sponsored panel discussion on the 1980s banking crisis with Carter H. Golembe, the head of a banking research and consulting firm until 1989; William M. Isaac, chairman of the FDIC from 1981 to 1985; and John G. Medlin Jr., CEO of Wachovia Corporation from 1976 to 1993. In his introduction, Volcker complained that the title, “The 1980s in Retrospect,” instead should have read “Lessons for the Future.” The panelists indeed offered lessons for the future -- most of which have been ignored. Many of the lessons would seem grist for a panel discussion in 2017 or thereabouts about the 2000s in retrospect. But the first decade of the century is still not over and maybe some of the lessons can be applied to our current crisis, most notably in regards to the current debate over marked-to-market accounting. (“Marked-to-market” accounting rules force banks to use the current market value of their mortgage-backed securities on their balance sheets, which critics complain sets values too low because it neglects long-term returns.) The following quotes speak for themselves: 1. “Too-big-to-fail” Carter Golembe. “[T]he [FDIC] crossed its own Rubicon in 1972 with a loan to the first billion-dollar bank to face failure [the Bank of the Commonwealth in Detroit], offering as justification, among other reasons, ‘the effect its closing might have had on public confidence in the nation’s banking system.’ This was the beginning of the present ‘too-big-to-fail’ program, although the FDIC had in fact long been following a policy of attempting to treat every bank in difficulty, regardless of size, as ‘too-big-to-fail.’” Paul Volcker. “I agree with [the decision for the FDIC to assist in keeping Continental bank open.] . . . . But, in fact, it had a big effect -- that was the precursor of a lot of protection that happened afterwards. I can remember looking at television when I was out of office in 1990 and 1991 and 1992 -- and it would be in the press every day -- that so-and-so bank or savings and loan was close to insolvent and failing, and nobody seemed to care. Even when you had headlines about the weakness of an institution no depositors moved their money because they had been convinced that the government was going to take care of everything, so you had no market discipline. It drives the lesson that has been described here over and over again. How do you get some balance between the rescue and retaining some discipline? I don’t know whether we yet have the right answer.”
2. The FDIC
Bill Isaac. “I don’t think [the FDIC] should be in the regulatory business. I was willing to give up the FDIC’s regulatory powers when the Bush Task Force was deliberating these issues. I don’t believe it matters to the FDIC whether a bank opens a new branch or not, and I don’t think it matters to the FDIC whether a bank is in compliance with [the Community Reinvestment Act] and other such things. I don’t believe that the FDIC ought to be dealing with anti-trust issues on mergers and the like. I believe firmly that this agency needs to be focused on the forest, not the trees.” Carter Golembe. “[N]ot all deposit insurance systems in this country have relied on an insurance fund. The two most successful, in Indiana and Ohio -- 30 or 40 years in each case -- before the Civil War were the most successful insurance we ever had. They did not rely on a deposit insurance fund. They relied on cross guarantee by the banks -- Indiana, for example, did not have a bank failure in 35 years.”
3. Increasing the FDIC’s deposit insurance limit
Bill Isaacs. “One of the ideas that we thought made a lot of sense was the subordinated debt idea. We wouldn’t necessarily increase capital requirements, but we would mandate that some portion of it be in subordinated debt so that you would have sophisticated creditors overseeing banks and deciding who could get subordinated debt at what price and who couldn’t. I thought it made a lot of sense at the time. The reason why we thought it was an interesting idea was because we thought that other changes to the deposit insurance system were not in the political cards. It was unlikely that Congress, having increased the deposit insurance limit to $100,000 two years earlier, would reduce the deposit insurance limit below $100,000 again. So, why not go ahead and concede defeat on depositor discipline and try to impose it through sophisticated creditor discipline. I think it made sense at the time, and I think it still could make sense today.”
4. Bundling mortgages
John Medlin. “Also, and it is probably more popular now than back in the ‘80s, problems can arise from syndication or selling out pieces of loans, where the syndicator takes a nice fee for putting it together, but sells it off and keeps very little risk. A ‘syndication’ is sometimes characterized as a transfer of risk from someone who lacks courage to someone who lacks knowledge. There is an enormous amount of that going on today; most smaller banks do not have the capability to assess the syndicated risks they are putting on their books.” [Note: “Syndicating loans” is different than “bundling subprime mortgages,” but they share very similar shortcomings: The originator of the loan generally does not own the loan, which makes Medlin’s comment quite relevant to the current crisis.]
5. Marked-to-market accounting standards
Paul Volcker. “I think, pushed to an extreme, [marked-to-market] is nonsense for a bank. The idea that we have to be so precise about marked-to-market accounting for an institution that is supposed to take liquid funds and transform it into something longer, while we tolerate enormous uncertainties in accounting on other parts of the balance sheet and in industry generally, doesn’t make sense to me. An accounting profession that will tolerate company after company taking large accounting losses for prospective events or to account for past losses that didn’t appear on the balance sheet the day before, and doesn’t blink an eyelash, shouldn’t worry too much about marked-to-market accounting, in my opinion.” Bill Isaacs. “But if we had marked-to-market accounting back in that period, and if we had wanted to, we could have closed every savings bank in the country at a cost to the FDIC of tens of billions of dollars. That is what the numbers were. We had it documented in the savings bank task force. So, we could have shut them all down, marked-to-market, and spent tens of billions of dollars. I say the social cost of that would have been inordinately high.” Bill Isaacs. “But I think doing everything by the numbers without discretion is a mistake. People keep on pushing for marked-to-market accounting, prompt corrective action and the like, and the next time we have an ag-bank crisis or a savings bank crisis or an LDC debt crisis, I think we are going to regret we have those laws on the books. I think it is going to tie the regulators’ hands in a way that is going to precipitate a crisis, that could otherwise be avoided.” John Medlin. “Market value accounting -- it has its virtues, but at the same time, it is a problem in times of stress when you have to market at the worst possible condition when if you could disguise it for awhile, things would be okay.”
6. Big picture lessons
John Medlin. “We’ve talked a lot about public policies and to boil the problem down in a [two-part] one-liner: What we had, and to some extent what we still have, is the democratization of credit; the democratization and liberalization of credit to everyone, cheaper credit, more liberal credit. But in the final analysis, the socialization of the risks underlying that credit falls ultimately back on the people. We have some other things like that -- we have Medicare and we have Social Security which are actuarially unsound and ultimately will cause problems and deposit insurance is not a problem as long as times are good. It is only when we have unusual times like the ‘80s that it becomes a problem.” John Medlin. “Management practices -- banking can’t blame public policy, can’t blame the economy really for its problems. It can blame itself for failing to exercise proper private sector disciplines. We should have learned to expect public policies not to be very smart; in most times, very politically driven, very expediently driven. In the management side of this equation, we had competition in laxity. Unfortunately the dumbest and weakest competitors in the marketplace set the basic standards of pricing and credit terms.” Bill Isaac. “When you have a massive collapse of the real estate industry like we had on the heels of the S&L crisis and the tax law changes and everything else, you’re going to have some bank failures. You can’t prevent that. All you can do is try to contain them and spot some of the trends before they get too far out. I also think it is a regulator’s job to lean against whatever wind is blowing at the time. If everybody is doing really well and they are putting on a bunch of loans in real estate, that is the time to be saying, I wonder why they are putting on all those loans in real estate -- maybe we ought to be taking a much closer look at it. That is very tough to do -- to go into a major bank before it has obvious problems and say, you guys are making a lot of real estate loans and we are really worried about it and we think you ought to slow down.” John Medlin. “I think our greatest lesson from the ‘80s would be complacency, and probably our greatest risk today is complacency. Everything is wonderful; the economy is wonderful; public policies have gotten better in many respects, but have managements learned their lessons?” For the full text of this prescient panel discussion, see http://www.fdic.gov/bank/historical/history/vol2.html Peter J. Nelson is a policy fellow with Center of the American Experiment. October 3, 2008
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Let Entrepreneurs Fix the Problem Government Made
By Robert P. Murphy As the financial crisis intensifies, we hear ever more claims that emergency times justify government measures unthinkable a mere 14 months ago. Even some libertarians, who would cry foul if a third world dictator nationalized an industry, are calling for the government to take equity positions in major financial institutions.
Worst of all, an ostensibly conservative Republican administration is seeking to subordinate the capital markets to the whims of one man, Henry Paulson. In this Orwellian climate, genuine free marketeers need to take a deep breath and remember their principles.
Economic theory and historical practice have demonstrated beyond any doubt that decentralized free markets outperform centrally planned economies. Beyond the issues of incentives and corruption, there is the knowledge problem stressed by Friedrich Hayek: it is no use searching for just the right experts to put in charge of running entire industries, because such omniscient people do not exist. Only in an open, competitive marketplace can rival firms discover the cheapest ways to deliver superior products and services to consumers. Businesspeople make mistakes all the time, but the profit-and-loss test weeds out the bad entrepreneurs and allows the successful ones to gain more influence.
Many, if not most, policy analysts would agree that capitalism is a better social arrangement than socialism, and that free markets provide sustained economic growth showering prosperity on all citizens. Yet for some inexplicable reason, many of these same analysts lose all faith in the power of markets during times of crisis. All of a sudden, even many cynical right-wingers – let alone the liberals – believe that 535 people in Washington D.C. know better than legions of financial professionals in New York and Chicago. Yet this is just one of many contradictions in our current crisis.
For example, we are told that the housing boom was caused by cheap credit and lax oversight, where greedy lenders made it too easy for unqualified applicants to receive loans. But at the same time, we are told the limits on Fannie and Freddie, as well as the FDIC, must be relaxed, and that taxpayers must spend $700 billion in order to “unfreeze” the credit markets; that is, to get easy credit flowing to borrowers as it has been in the recent past.
We are told that the government must enact bold measures, lest we relive the Great Depression. Yet at the same time, we are told that the measures we need to take are precisely those adopted by Franklin Roosevelt in the 1930s. Indeed, this is why so many news articles over the last year have included variations of the phrase, “a government power not used since the New Deal.”
Prior to the Great Depression, economic downturns in the United States were relatively quick, typically lasting 18 months or so. The worst was the depression starting in 1893, which lingered four or five years, depending on the economic historian. It was under the New Deal – when the federal government adopted unprecedented measures to prevent business failures and to prop up wages – that a sharp initial downturn endured for a decade. When Roosevelt took office in 1933, unemployment stood at a staggering 24.9 percent. And yet, despite claims that Roosevelt “got us out of the Depression,” the unemployment rate was still 19 percent five years later in 1938.
Poor government policies, including very low-interest rates and efforts to promote mortgages for unqualified applicants, contributed to the housing boom of the mid-2000s. And after the government contributed to the problem, its efforts to fix things are even worse. For example, hundreds of billions in corporate welfare to bail out overleveraged financial institutions will only ensure that they take unwarranted risks in the future as well.
Resources were misallocated during the credit bubble, and the economy needs a period of liquidation before its normal growth can resume. Policy analysts, above all those who claim to support the free market, should tell the government to stop meddling with the correction and instead let private-sector entrepreneurs fix the mess that the politicians made.
Robert P. Murphy is a Senior Fellow in Business and Economic Studies at the California-based Pacific Research Institute and author of The Politically Incorrect Guide to Capitalism (Regnery 2007).
October 3, 2008 |
Marx was Right (Groucho, that is)
Matthew J. Brouillette
Washington's response to the current financial trouble is affirming Groucho Marx's definition of "politics": "The art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies."
To be sure, we are in a financial mess. Too many banks lent money to credit-risky consumers they shouldn't have lent money to, and too many consumers borrowed more money than they could afford to borrow. But the remedies being proffered by our politicians will likely miss the mark, once again.
Why? The very people who created our current problems think they can now solve it by doing more of the same. Indeed, politicians who have consistently used the heavy hand of government in our economy are claiming that more government intervention and manipulation of the market is the solution. They want us to believe that throwing more gasoline on a fire will put out the flames.
The reality that most in Washington, D.C. refuse to acknowledge is that our current financial woes are a direct result of the federal government's encouragement and financial backing of poor lending practices. Through a variety of political decisions by both Democrats and Republicans – including loose monetary policy, the Community Revitalization Act which forced banks to loan to credit risks, and using Fannie Mae and Freddie Mac to encourage subprime loans – the fundamental cause of the current crisis has been government created.
It is equally important to recognize that our market economy is not to blame for this mess. Many politicians, like House Speaker Nancy Pelosi, have erroneously focused their criticism on capitalism, claiming that the problem is the result of "no regulation, no supervision, no discipline." Although such rhetoric may sell on the campaign trail, it denies the fact that the current trouble is occurring in one of the most heavily regulated and supervised sectors of the financial industry. Indeed, Fannie Mae and Freddie Mac couldn't have been any more of a government regulated and supervised entity, yet it still collapsed.
But instead of allowing the banks who made bad decisions to fail and consumers who borrowed more than they could afford to take personal responsibility, politicians will further distort the economy. It will be the fiscally prudent banks that will eventually be over-regulated and the credit-worthy consumers who will ultimately pay the price.
There is no pain-free choice. The choice isn't about whether or not we will experience some financial tragedies, but whether or not we believe that the same government actors who significantly contributed to the problems we face today can actually come up with the solution. Chances are they won't.
We must recognize that comparisons to the Great Depression are greatly exaggerated. As Allan Reynolds of the Cato Institute points out, "we have had little more than a dozen bank failures this year compared with more than 5,000 in the 1930s, and nearly 3,000 in the 1980s." Even more important is that the failure of those banks occurred after government "did something" – namely, increased taxes, increased tariffs, and created the Reconstruction Finance Corporation.
The only appropriate analogy to the events before and after the October 1930 collapse is that President Bush, like President Hoover, plans to heavily intervene in the economy. Bush, like Hoover, is criticized as having been a hands-off, market-oriented, do-nothing president. But the historical record has shown that both presidents have been strong government interventionists rather than free market advocates.
Politicians have a horrible track record of being effective economic planners. We shouldn't allow government to spread losses to the rest of the economy.
What, then, should government do?
The answer is to embrace free-market solutions and allow the market to ferret out the bad actors and the bad debt in the marketplace. There are a number of proposals that would do this, including altering current accounting regulations such as "mark-to-market," lowering taxes on investments, and privatizing Fannie Mae and Freddie Mac. These are a few policy changes where government can "do something" without doing damage.
Unfortunately, panicked politicians are running away from these solutions. They are instead proving Groucho Marx was right by incorrectly diagnosing the problem and applying the wrong remedies.
Matthew J. Brouillette is president and CEO of the Commonwealth Foundation in Harrisburg, Pennsylvania.
October 3, 2008 |
WHAT’S A FREE MARKETEER TO THINK?
Volume Seven
October 8, 2008
As you perhaps have memorized by now, two weeks ago, in response to our nation’s financial emergency, I invited think tank and other colleagues from around Minnesota and the nation to take on the question: “What’s a free marketeer to think?” What follows is installment Number Seven of the remarkably well-received series: three new columns, bringing the running total to 26.
I extend my thanks this time around to Greg Kaza of the Arkansas Policy Foundation; Roger Conant of CRI, Ltd. in Minneapolis; and John McClaughry of the Ethan Allen Institute in Vermont.
We will bring the project to a close with another four pieces or so on Friday. To read any of the previous volumes, see the links below or go to our website at AmericanExperiment.org.
Many thanks, and as always, I welcome your comments.
Mitch Pearlstein
Found & President
Center of the American Experiment
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Transparency, Government-Sponsored Enterprises and Financial Derivatives By Greg Kaza The states, in the 1990s, were innovative laboratories for market-based conservatives and libertarians.
In December 1994, Orange County, California lost $1.6 billion and was forced into bankruptcy when interest-rate sensitive financial derivatives collapsed after a series of Federal Open Market Committee rate hikes. The derivatives included structured notes issued by government-sponsored enterprises (GSEs) like Federal National Mortgage Association (Fannie Mae). Taxpayers demanded a policy response, and Michigan lawmakers responded by mandating transparency for government units. The law, signed by Republican Gov. John Engler (1991-2003) requires government units using derivatives to disclose them in reports subject to the Michigan Freedom of Information Act. It permits derivatives’ legitimate use to hedge but creates a disincentive against the bad behavior that forced Orange County into bankruptcy.
Sunshine (transparency) is a powerful disinfectant, and should be advanced in Washington. I noted in a 2004 article for Pensions, a London-based academic journal (http://www.palgrave-journals.com/pm/index.html) that Michigan’s action was unique among the 50 states. It can serve as a model for other market advocates.
Why do derivatives matter in the ongoing crisis that has exposed cracks in the U.S. credit structure? The misuse of derivatives by GSEs including Fannie Mae contributed to an epic housing bubble that has collapsed, leaving failed financial institutions in its wake. Fannie Mae, the second largest borrower next to the U.S. government itself is at the heart of a financial debacle where profits have been privatized and losses socialized by American taxpayers. Market advocates should stand with taxpayers and shareholders, not Washington GSE’s like Fannie Mae.
Markets work best when there is an umpire and transparency. The umpires (regulatory authorities) have been calling strikes on Fannie Mae’s suspect use of derivatives for years. Consider the following:
● The Office of Federal Housing Enterprise Oversight criticized Fannie’s accounting under Statement No. 133 ("Accounting for Derivative Instruments and Hedging Activities") in September 2004. The OFHEO report, released in 2006, found “an arrogant and unethical corporate culture where Fannie Mae employees manipulated accounting and earnings to trigger bonuses for senior executives from 1998 to 2004.”
● OFHEO found Fannie Mae implemented No. 133 “in a manner that placed minimizing earnings volatility and maintaining simplicity of operations above compliance with GAAP.” OFHEO found Fannie Mae “did not assess and record hedge ineffectiveness,” and “applied hedge accounting to hedging relationships that did not qualify.” Fannie Mae treated “many hedge relationships as perfectly effective when they were not, improperly ignored ineffectiveness in hedge relationships, and failed to perform assessment tests.” Fannie Mae applied the “short-cut” method or the “matched terms” method “for a broad range of hedge relationships where those methods were inappropriate.
● The Securities and Exchange Commission ordered Fannie Mae to restate its earnings (Dec. 15, 2004), noting its accounting practices “did not comply in material respects” with Statement No. 133. No. 133 requires certain derivatives to be carried on the balance sheet at fair value. The SEC noted:
“Fannie Mae internally developed its own unique methodology to assess whether hedge accounting was appropriate. Fannie Mae's methodology, however, did not qualify for hedge accounting because of deficiencies in its application of Statement No. 133. Among other things, Fannie Mae's methodology of assessing, measuring and documenting hedge ineffectiveness was inadequate and was not supported by the Statement.”
Congress should pay heed to the umpire’s call. Market advocates must insist that any new financial architecture provide for increased transparency of derivatives used by GSEs. They should note economist Joseph A. Schumpeter’s observations about the evolutionary role of financial architecture in market economies. The financial architecture underlying an advanced market economy like the U.S. must be built on a rock solid foundation, not a GSE’s shifting political sands.
Greg Kaza is executive director of the Arkansas Policy Foundation and author of the 1996 Michigan transparency act.
October 8, 2008
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The Inevitable Apocalyptic Crash
By Roger Conant
After the 1974 crash, the government effectively promised that it would eliminate further recessions. It proudly kept that promise. Every time the markets stumbled, the Fed would throw massive amounts of cash at the economy. Thus, the 1987 slowdown was terminated in just a couple of months. The accompanying property boom and bust, which had been fueled by the savings and loans abusing their enhanced lending authority, was turned into a continuing boom by the government´s mitigation of losses through such vehicles as the Resolution Trust Corporation.
In 2000, the fed injected massive amounts of cash to avert the Y2K crash that showed no signs of occurring.
Financial risk had been eliminated! Wall Street celebrated. Conservative investors were fools. Leverage became the name of the game. No investment was too risky because there was no risk. Banks created structured investment vehicles to hide their violation of capital requirements. New, highly profitable instruments like collateralized debt obligations were invented that accomplished nothing except to hide risk by pushing it around.
Property values were sure to go up forever. Therefore, the only smart tactic was to borrow more to buy more property. As financial risk had been eliminated, diversification was stupid, regulation unnecessary.
The results were as widely recognized as they were ignored. Aggregate savings were negative. Housing became unaffordable. Personal and corporate balance sheets were bloated with debt. As a country, we fueled our appetite for risk by borrowing heavily from friends and enemies abroad.
But, of course, since risk is immutable it hadn´t gone away. It had merely been deferred. By this year, the financial pressures had grown so strong that even our great and magnificent government could no longer resist them.
The great un-leveraging that had to occur is now occurring. In truth, despite the inevitable pain experienced by some, it isn´t all that serious. Some overleveraged businesses have failed. Some Wall Street zillionaires will see their earnings reduced to sustainable levels. Asset prices are dropping towards their true underlying values. Housing prices have declined to their levels of a couple of years ago and, accordingly, housing is becoming affordable again. The great benefit is that we are all relearning the basic truth of finance: risk can only be contained, it can´t be ignored.
But let us imagine that the government´s bailout is a total, immediate success. The stock market recovers all its losses within days. Housing prices return to record levels. Financial instruments in default regain their prime status. Wall Street executives buy even bigger yachts. All is well again. The celebration continues.
The result? Risk again will be viewed as an anachronism. Leverage will come thundering back and balance sheets will become even more bloated. As a society we will borrow and spend more and more.
But, of course, risk will not have gone away. It will still be there, sure to return with even greater force. The next time, nothing will stop it. It will crush us all.
The lesson to be drawn is that the expression of risk is an inevitable part of our economy. The only way it can be controlled is to let downturns run their course. Such downturns are the precursors of booms. (As the great economist Milton Friedman and others have shown, the Great Depression of the 1920s was a whole other thing, with no relevance to our present situation.)
After the 1974 crash, the economy entered into a 30-year period of unparalleled prosperity. The way to ensure the next prosperous period is to let the present shakedown clear out our economic cobwebs. Accordingly, the newly enacted bailout bill is a mistake of historic proportions, assuring an incomplete correction and thereby setting the stage for the now inevitable forthcoming apocalyptic crash.
Roger Conant, who is trained as an economist, is president of the financial consulting firm CRI, Ltd.
October 8, 2008
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Jefferson, Jackson and Van Buren Would Have Understood
By John McClaughry
Reviewing the economic carnage of the last few months, where socialism has again been summoned to the rescue of what passes for capitalism, a committed free marketeer would have to say that we ought not have allowed government to entice and force people to alter their behavior in a way likely to promote this kind of calamity.
For instance, we ought to have demanded a monetary unit of value impervious to political meddling: say, a unit measured by a market basket of real commodities (trade-weighted quantities of plywood, zinc, pork bellies, petroleum, gallium arsenide, gold, etc.). Then a politically created central bank could not manipulate interest rates to a level that made credit so cheap that irresponsible mortgage lending took off like a rocket.
We ought never to have required private banks, in return for regulatory approvals, to make high-risk loans to borrowers with very small likelihood of repaying them (cf. Community Reinvestment Act.)
We ought never to have put an implied but well-publicized government guaranty behind such “private” money making institutions as Fannie Mae and Freddy Mac.
Having created such institutions, our political leadership (Clinton) ought not to have directed them to make high-risk loans to appease clamoring voter blocs.
Our fiduciary code ought to have prohibited depository institutions from investing in other institutions whose “value” is almost entirely pieces of paper representing still more pieces of paper representing, hopefully, some ultimate thing of value.
Our common law ought to have required guarantors (credit agencies) to have and publicize their holdings of assets sufficient to cover losses guarantied against.
That’s just a quick summary for openers. What we should have not have done is allow our government to erect a politician- and lobbyist-promoted array of opportunities for sharp operators to pocket gains, leaving losses to the ultimate suckers, the bewildered and angry taxpayers.
Presidents Jefferson, Jackson and Van Buren would have understood.
John McClaughry is president of the Ethan Allen Institute in Concord, Vermont.
October 8, 2008 |
WHAT’S A FREE MARKETEER TO THINK?
Volume Eight
October 10, 2008
This being the eighth and final installment of “What’s a Free Marketeer to Think?,” I had hoped the series would end on a happier note than the week has proven. Then, again, as Dow drops go, today’s was barely a blip – perversely good news for which I truly do give thanks.
As you may recall, a few weeks ago, in response to our nation’s financial emergency, I invited think tank and other colleagues from around Minnesota and the nation to take on the question above. The first set of responses ran on September 23, and we’ve been publishing packages regularly since then. Today’s five columns bring the total to 31; a larger number, frankly, than my colleagues and I first assumed. Nerves clearly have been hit, in multiple ways.
I extend my thanks this time around to Lew Uhler of the National Tax Limitation Committee; Greg Blankenship of the Illinois Policy Institute; Dean Riesen of the Goldwater Institute; David Strom of the Minnesota Free Market Institute; and American Experiment’s Peter Nelson.
To read any of the previous seven volumes, see the links below or go to our website at AmericanExperiment.org.
Many thanks, and as always, I welcome your comments.
Mitch Pearlstein
Found & President
Center of the American Experiment
P.S. As a perversely surreal coda to the series, you might like to take a look at a Dinner Forum presentation by James Glassman that we published in American Experiment Quarterly in the Summer of 2000: “Dow 36,000: Are Stocks Actually Undervalued?” Oh, well. |
Government Must Not Prolong the Market-Cleansing Process
By Lewis K. Uhler Abuse of the public treasury is not a new phenomenon. Taxpayers have been the creditors of last resort for Chrysler, the savings and loans, defense contract overruns, the Boston “Big Dig” debacle, and countless other government excesses. But the so-called mortgage (Wall Street) bailout we’ve just experienced carries us into new territory – and scary challenges.
It would be one thing for the president – or the Congress – to initiate and manage the response to the alleged crisis on Wall Street. But to allow a hired hand – the Secretary of the Treasury (and his as-yet-unknown successor) – to initiate a bailout for his Wall Street cronies, and to control without any peer oversight or court review (as Henry Poulson initially proposed) the expenditure of $700 billion or so of taxpayer resources, is a new level of fiscal dereliction. Why the president would endorse a plan that leaves him out of the loop in managing the response of his own administration is the final confession that he is not serious about fiscal discipline in his remaining days in office.
There is no mention in the Constitution of a Department of Treasury or a Secretary of the Treasury. To give a person who holds such a non-constitutional office the power to bind our nation and its treasury to obligations for which there is no constitutional authority is patently absurd.
With respect to the details of the bailout, we should recognize that the problem was created by government policy and inaction. ● Government’s insistence, through the Community Reinvestment Act, that unqualified buyers be given mortgages set this problem in motion.
● Freddie and Fannie responded to their liberal political mentors – Rep. Barney Frank and Sen. Chris Dodd – and made tons of bad loans.
● Interest rates were kept low by the Fed, encouraging speculators to enter the market; as a result they joined in bidding up prices to unsustainable levels. (It’s estimated that speculators represented an unprecedented 25 percent of home buyers during this housing bubble, creating an oversupply of homes and assuring the foreclosure rate we have been experiencing.)
● The cartel of government-licensed rating bureaus obviously failed to do their jobs of properly rating the sub-prime mortgages which were securitized and sold around the world.
The bailout need not risk a heavy loss for taxpayers if some simple principles guide government action. ● Change the “mark-to-market” rules so mortgage “packages,” which contain mostly performing loans (only about 7 percent of home loans have run into trouble) are not put on the block at fire sale prices and do not artificially undermine otherwise healthy companies.
● Let precarious financial institutions file for Chapter 13 bankruptcy and do a “workout” over time, as the bankruptcy law encourages, thus saving value for shareholders and for employees whose retirement may ride on the outcome.
● Loan funds to financial institutions that are having problems rather than buy their assets, reducing taxpayer exposure and maintaining the viability of the private companies.
Above all, government involvement/interference must not prolong the market-cleansing process vital to rapid recovery. Housing prices are testing the bottom now. Turnaround can happen quickly if government doesn’t abort the process. Markets work. Our elected and appointed officials must once again accept that – and get out of the way.
Lewes K. Uhler is president of the National Tax Limitation Committee in Roseville, California.
October 10, 2008
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Free Marketers Must Remain Vigilant By Greg Blankenship Much ink has been spilled in the last year or so about the conservative movement running out of ideas. Terms like “sclerotic” have been thrown around by David Brooks of the New York Times to describe conservative think tanks. The same can be said of the conservative press, according to a New Yorker article by George Packer last May.
But as we see from the reaction of the press and our politicians to the financial crisis that currently challenges us, conservative ideas of free markets and limited government are very much in need of defending.
The broadsides from the Obama presidential campaign blaming de-regulation for the fiasco need to be addressed. After all, much of this crisis can be laid at the feet of politicians of both parties because of their meddling in the housing market. Finance professionals and investors share the blame by acting irresponsibly in their efforts to make a quick dollar and consumers for purchasing more than they can afford.
This alone should rouse the free marketeer to defend the free enterprise system by pointing out that meddling in markets set the stage, not unfettered capitalism. It also suggests that ideas such as prudence, thrift and moderation should be reinforced. Risk taking is an important part of capitalism, and bubbles are going to occur in an imperfect world. But it is moderation and rationalism at the heart of free market ideas that mitigate crises and relegates moral hazard to academic discussions rather than actual practice. Now is the time to reinforce these ideas.
Our critics in the movement seem to have put forth the idea that we’ve somehow reached the end of conservative history – an idea only too readily adopted by our friends on the left. We’ve run our course and we are bereft of ideas is how the story goes.
Yet somehow everyone seems to be missing that the other side isn’t offering anything new. The politics of the left, as Amity Shlaes informed us in The Forgotten Man, haven’t changed since FDR. Their fixes for the financial system are more of the same: Scapegoating, demonzing, increased regulation and redistribution of wealth. Once hidden behind environmentalism and other fads, the champions of statism, as a result of this crisis, have been flushed into the open.
Why should we stop defending ours ideas? Should Sen. Obama assume the presidency, he assuredly will not be a Bill Clinton or Tony Blair. Both accepted much of the Reagan and Thatcher revolutions. While some items were rolled back, none of it was wholly rejected. Obama does wholly reject the underpinnings of these revolutions. He intends to raise capital gains taxes, introduce more regulation and do nothing about some of the highest corporate income taxes in the world – all as America tries to climb out of this financial crisis and what many believe to be an inevitable recession.
High tax rates, a credit crunch, and the energy crisis were combated with our ideas in 1980. They worked. Now, we seem bent on a different approach that won’t work. At the same time we are told to try something new because the current election doesn’t look so good. I’m sorry, but that isn’t a good enough reason.
No, now is not the time to abandon our missions and our ideals for some abstract new coalition or new conservatism. This is not the end of conservative history; it’s just the beginning of a new round in the fight between liberty and statism and free marketeers should embrace this challenge.
There is an old cliché that says the Chinese symbol for both crisis and opportunity are the same. For the vigilant free marketeer we have before us a new opportunity. We should take it.
Greg Blankenship is president and founder of the Illinois Policy Institute in Springfield.
October 10, 2008 |
Confidence, Credit and Growth By Dean Riesen As a free-market bank director and commercial real estate investor, I find these challenging times. We face a massively complex problem that is the result of human nature, the acceleration in the past ten years of extremely complex financial engineering, and significant government interference in markets. The core problem was a residential real estate ‘bubble’ like no other we have ever experienced. This was facilitated by the easy money strategy of the Federal Reserve under Alan Greenspan, who largely ignored asset inflation as an economic problem. The government magnified the easy money problem with its mistaken social engineering policy of making housing more “affordable” by weakening traditional lending standards through its government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, egged on by Democrats Barney Frank, Charles Schumer, and Christopher Dodd. The GSEs created massive demand for a product (sub-prime debt) that didn’t really exist. This led the “free market” of mortgage originators, home builders, and home buyers to an orgy of construction and expansion. These mortgages were then ‘engineered’ into all sorts of very new and complex vehicles that were then sold and traded around the world in a way that has caused the inevitable bubble busting to infect the entire global financial system with a very serious disease which has all but shut off global growth. Adding insult to injury, this is happening in the middle of a very contentious Presidential election making it very difficult to sort out reality from fiction. The reality is that Democrats led the charge to expand the mortgage purchases of GSEs, criticizing Republican attempts to regulate these public-private monsters. ● On September 10, 2003, Rep. Barney Frank told a hearing of the House Financial Services Committee: “The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially . . . .”
● Two weeks later, Congressman Frank, who now chairs the Financial Services committee, said: “I do not want the same kind of focus on safety and soundness that we have in the OCC [Office of the Comptroller of the Currency] and OTC [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing . . . .”
In 2005, Republicans (now in control of the Senate), passed a strong reform bill out of the Senate Banking Committee that could have prevented much of the financial disaster, only to have Democrats prevent it from coming to a floor vote. Sen. Barack Obama did not support the bill or oppose his party’s efforts to keep it from coming to a vote. Sen. John McCain said at the time: “If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system and the economy as a whole.” So in somewhat of a role reversal, we had Republicans trying increase regulation and Democrats opposed. Of course Republicans were trying to regulate government in the form of GSEs and prevent it from distorting the market. Democrats were trying to protect a piggy bank that made massive contributions to their favorite groups like ACRON and Jessie Jackson’s organizations as well as their political campaigns. (Senators Obama, Schumer, and Christopher Dodd and Representative Frank are among the top four recipients of political contributions from GSEs.) Senator Obama still lists Franklin Raines, former CEO of Fannie Mae and someone who should probably be sitting in a federal prison for massive accounting fraud, as an adviser to his presidential campaign. So from my perspective the government had a major role in creating the mess we find ourselves in and, therefore, must be part of the solution. The crisis has reached the stage where banks are afraid of each other. Credit is becoming difficult to find, which means there won’t be economic growth and in reality economic contraction is more and more likely. There is no market for many securities because there are no buyers. It doesn’t mean they aren’t worth anything. The government will now be involved in helping to create a “market” for the distressed securities allowing banks to rebuild their balance sheets which, in turn, will lead to confidence to lend money which can then lead to economic growth. There is clearly a risk that government will create additional problems in the functioning of the free market but it’s a risk we must take since the market has gone on strike. We must watch closely to ensure it does the least amount of damage to the functioning of future free markets. Dean Riesen is a member of the board of directors of the Goldwater Institute in Phoenix. October 10, 2008 |
“Regime Uncertainty”
By David Strom There is lots of blame to go around for how our credit markets got into the current mess.
Counterproductive government regulations, poor judgment by investment bankers and mortgage brokers, and an irrational belief that housing prices never fall all played a major part in getting us to where we are today. Do I even have to mention the easy money policies of the Federal Reserve earlier in the decade?
But it has become increasingly clear that the transformation of the credit problems of last year into the crisis of today has one main author – the federal government.
For months, the markets had been nervous about the fallout from the popping of the housing bubble, and rightly so. Major financial institutions had taken a beating to their balance sheets and by early this year it was clear that some would not survive the shakeout in the industry.
It is unsurprising that the Fed and Treasury would try to head off a full-blown crisis by trying to ensure that the fallout from the expanding financial woes would occur in an orderly fashion. That’s why they intervened in the Bear Stearns liquidation, and took over Fannie Mae, Freddie Mac, and AIG. These moves were intended to ensure that “systemic risk” to the financial system was avoided by propping up indispensible players.
The problem is that it didn’t work – nor did the passage of the $700 billion bailout package.
Looking back there’s a pretty simple reason why these extraordinary measures failed to prevent the ongoing meltdown of the financial system: In the eyes of investors the federal government has replaced one systemic risk – the possible default of major financial institutions – with another – the sudden evaporation of their investment values through a government takeover of whatever financial institution they might choose to invest in.
Recent government actions have made private investment in financial institutions – precisely what is needed to recapitalize shaky banks and investment firms – extremely risky. A government “bailout” can put your capital at risk just as much as any prospective failure of that same institution (just ask the stockholders of Bear Stearns or AIG).
By intervening so directly in the financial markets the federal government has caused what economist Robert Higgs of the Independent Institute called “regime uncertainty” in describing the perverse effects of government interventions in the economy during the Great Depression.
Under conditions of regime uncertainty investors stay on the sidelines because they are don’t know what the prevailing rules in the markets will be in the future. Changes in government policy – especially changes that seem to occur in a rapid fashion – erode the confidence that investors need in order to decide whether or where to deploy capital in the market.
The great irony is that the actions of the Fed and Treasury that were intended to shore up confidence in the financial markets seem to have had the opposite effect. What had been a serious but relatively slow moving problem morphed into a full-blown, fast-moving crisis. It seems clear that whatever dangers the government saw in doing nothing, nobody anticipated that the results of the recent interventions would be such a catastrophic collapse of confidence in the market.
Regime uncertainty is surely at least partly to blame. Until investors clearly understand the exact consequences of government interventions in the marketplace they would be irrational to jump right in and start investing their own money. Even bargain hunting becomes irrational because a company that appears to be a bargain today might be nationalized by the government tomorrow.
By intervening in an ad hoc manner the federal government has destabilized the current financial regime without providing any clarity at all about what the new rules of the game will be. It is vital that private investors get clarity about what those rules will be, because until they do private capital will remain mostly on the sidelines.
David Strom is president of the Minnesota Free Market Institute.
October 10, 2008 |
Five Questions By Peter J. Nelson
As much as I continue to pore over news stories, blogs, and academic papers, at least five fundamental questions regarding the so-called bailout remain unanswered.
● First, why was everyone so sure that credit markets would seize without immediate action from Congress? In other words, what was the rush?
● Second, and related to the first, if credit dried up from banks, why wouldn’t substitutes quickly emerge to meet that demand and, thereby, profit from higher interest rates?
● Third, when the oil-for-food program in Iraq couldn’t keep track of $65 billion used to buy oil—a commodity with a set price—how can anyone reasonably expect to oversee a $700 billion program used to buy bundles of junk mortgages that the smartest investment bankers can’t properly value?
● Fourth, the bailout intends to pay fair market value for mortgage-backed securities, which means a bank’s balance sheet remains the same as before. If a bank’s asset levels remain the same, is this really the most effective way to expand credit?
● Fifth, won’t the bailout encourage riskier behavior in the future by establishing a precedent that the government will bail out bad investment decisions?
Normally when I can’t find answers for myself, I start looking or asking around for advice from people with more expertise on the matter. Unfortunately, those whom I normally tap for sound economic advice do not see eye to eye. The Heritage Foundation (a conservative think tank in DC), the Wall Street Journal editorial board, Steve Forbes, and even Jack Kemp all supported the bailout while the Cato Institute (a libertarian think tank in DC), a slew of academic economists, and Newt Gingrich opposed it.
Though conservative supporters all expressed grave reservations, many accepted the immediacy of the crisis and believed the bill would be far better than no bill. In contrast, the academics agreed a crisis exists that needed “bold action,” but they were highly critical of the bailout and charged that it was an unfair subsidy to investors, ambiguous in its mission and oversight, and damaging to the long-term health of capital markets.
So, what is a free marketeer to think?
The answer seems to be that a free marketeer can think quite broadly on the topic.
Unable to find satisfying answers and with no consensus among my advisory council, I’m left to decide with my gut, with instinct, with feelings.
At the outset of the crisis, my gut resounded with a clear no. Let’s just say my gut had a trust deficit when it came to Paulson, Congress, the president, and Wall Street.
Without knowing many facts, it was clear Treasury Secretary Paulson could not be trusted after he proposed removing the bailout from judicial review, as if constitutionally guaranteed oversight would be too meddlesome for his unprecedented socialization of private debt. Moreover, the biggest cheerleaders for this bailout came from Wall Street types like William Gross, the chief investment officer at PIMCO, and Kenneth Lewis, the CEO and president of Bank of America. Forgive me if I don’t trust Wall Street at this juncture.
Initially, the number of free market believers—people I’ve long trusted—who were out lobbying for the bailout mitigated my trust deficit.
But today, my gut is again shifting to a trust deficit. You see, the New York Times just reported that the bailout, on top of giving Paulson the power to buy toxic securities, gave Paulson the power to buy a stake in troubled banks.
What? Since when did the government’s direct purchase of stock in banks become part of the deal?
The option was certainly discussed, and it was actually the preferred option among many academic economists. Injecting banks with capital by buying newly issued stock gets to my point in the fourth question above: the bailout as sold does nothing to change a bank’s balance sheet. Buying an ownership stake does.
But as Justin Fox, Time Magazine’s business and economics columnist, states in his blog: “That wasn’t how Treasury initially advertised its Troubled Asset Relief Program. It was sold as a way to get the market for mortgage securities moving (or, to use the jargon, ‘liquid’).”
To say the least, it’s unsettling that the most significant and most debated counter proposal to the bailout ended up in the final bill without anyone taking notice. The Secretary of the Treasury now holds even more discretion over $700 billion than even the closest observers thought possible.
My gut now rumbles with the worrisome notion that America might be giving way to a new era: one that more broadly accepts government’s heavy hand as a backstop to people and corporations that make foolish bets and precludes the kind of prosperity that can only exist under the discipline of free markets.
Peter J. Nelson is a policy fellow with Center of the American Experiment.
October 10, 2008 |
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