Topic: Finance, Banking & Monetary Policy

Bailouts: Where Will They End?

“There’s no logical end to it,” Cato Senior Fellow Gerald P. O’Driscoll Jr. said to Neil Cavuto on Fox Business. He’s talking about the incredible expanding bailouts. It started with Bear Stearns in March and then homebuilders in April. Then Fannie Mae and Freddie Mac in September, and after that the deluge. AIG, announced at $85 billion but quietly increased to $123 billion so far, and the $700 billion centerpiece and then money market funds and then bank nationalizations and an increase in the federal guarantee to bank depositors. Where will it stop?

Friday’s papers noted that the head of the FDIC said that the federal government might start guaranteeing home mortgages. On Saturday we learned that insurance companies want to get a piece of the money. Yesterday the Treasury said that automobile companies–which already got their own $25 billion program–might also be eligible for the general “financial rescue plan,” and their success might encourage other industries to try to get in on it.

As I noted before, Congress is talking about “a second economic stimulus package, totaling $50 billion in the form of money for infrastructure projects, relief for state governments struggling with rising Medicaid costs, home heating assistance for the Northeast and upper Midwest, and disaster relief for the Gulf Coast and the Midwestern flood zone.” And Transportation Secretary Mary Peters wants “an $8 billion infusion” for the federal highway trust fund.

Where does all this money come from? The total cost is hard to estimate, because we don’t know how many of these guarantees will actually result in payments. But some analysts are talking about a total bill of $2-3 trillion. Given the underestimate on the cost of the Iraq war, we shouldn’t have confidence in any claims that it will be less. So where does the money come from? Even Obama doesn’t want to raise taxes that much. And if you tax Americans to bail out as many Americans as we’re now talking about helping, eventually you’re going to be taxing people to bail themselves out. In fact, the government is likely to borrow some of the money and have the Federal Reserve create more of it. That process seems to be under way, as Greg Mankiw and Jeff Hummel have discussed. How can that astounding and unprecedented increase in the monetary base not lead to inflation, even hyperinflation? We’ve already decided to tax the prudent and thrifty to bail out the imprudent and irresponsible. Now the prudent may face a danger even worse than taxes: inflation that erodes their hard-earned savings.

Howard Baker famously called Ronald Reagan’s tax cuts a “riverboat gamble.” This is more like a “Celebrity Solstice gamble.”

Members of Congress Who Voted for the Financial Crisis

In late 2000, with the budgeting and spending process in collapse, Congress hurriedly passed a mammoth spending bill called the Consolidated Appropriations Act, 2001. It contained a provision preempting state regulation of financial derivatives under gambling or “bucket shop” laws. The result less than a decade later was the out-of-control market for credit default swaps that has caused so much financial, and perhaps economic, chaos.

One hundred fifty-five members of Congress who voted for the Consolidated Appropriations Act and the preemption of state law are still serving and are up for election next week. Twenty-two senators who stood by as the bill passed by unanimous consent are also up for election Tuesday.

Details are in a WashingtonWatch.com blog post entitled “Did Your Representative Cause the Financial Crisis?

Many gambling laws are nanny-statism, of course, but if they’re going to go away, they should be repealed by the legislatures that wrote them. This federal preemption gave special permission to certain parts of the financial services industry to run a huge gambling operation masquerading as a market in real assets.

All this is a good illustration of why it’s harmful for Congress to let the annual budgeting and spending process go off the rails. Maybe voters will hold some of their representatives accountable.

Alan Reynolds’ Critique of Obama and McCain Tax Plans

Peter Ferrara writes that, “Obama’s tax increases will not produce nearly enough revenue to finance all his lavish spending proposals, as shown by a brilliant new paper from Alan Reynolds of the Cato Institute.” Brilliant or not, it’s serious paper I prepared for a Hillsdale College conference, which is now online (at the link to my name).

The Bailout: Secret Payments?

From the WashingtonWatch.com blog:

Just two weeks after the passage of the bailout bill, and one day after a Treasury Department official declared, “we are committed to transparency and oversight in all aspects of the program,” the Treasury Department began covering up the amount it would pay to New York Mellon Bank to act as a financial agent in the bailout.

Spending $700,000,000,000.00 in taxpayer money is not business as usual. And hiding the terms of government contracts shouldn’t be business as usual anyway.

Non-Myths about the Financial Crisis

A paper by three Minneapolis Fed economists is making the rounds – disputing any funding crisis for non-financial corporate firms. IMHO, this is a very disingenuous paper.  All of these so-called myths are really non-myths. Basically, the paper’s focus on “bank lending” is mistaken.  Focusing on total borrowing by non-financial sectors shows the accurate picture.

Myth 1. Bank lending to nonfinancial corporations and individuals has declined sharply.

The financial market crisis is in the non-bank financial sector, not in the banking sector.  And the authors say (correctly) that the majority (80 percent) non-financial sector borrowing is not from banks.  So why focus on bank lending to the non-financial firms to see if there’s a credit crunch?

Myth 2. Interbank lending is essentially nonexistent.

If that’s not true, so what? (See response to Myth 1.) Banks are more tightly regulated by the Fed (compared to non-bank financial companies by the SEC).  So banks did not hold the riskiest mortgage backed securities (although they originated and sequestered such assets in off-balance sheet entities and “adverse selected” the best ones for their own portfolio, selling the rest to non-bank financial and other firms).  So, again, the banking sector is not where the financial market crisis occurred – it happened in the non-bank financial sector.

Myth 3. Commercial paper issuance by nonfinancial corporations has declined sharply and rates have risen to unprecedented levels.

But Federal Reserve Board data on total commercial paper borrowing by non-financial sectors took a huge hit in the 2nd quarter of 2008  (see Flow of Funds, Table F.2 from release Z.1 September 18, 2008, line 3).  Thus, it’s not surprising that bank credit to non-financial companies may be increasing: Those companies may be drawing more heavily on their lines of credit with banks because non-bank sources of borrowing are constricted. So, where’s the mystery?

Myth 4. Banks play a large role in channeling funds from savers to borrowers.

Again, non-bank financial (and other) companies supply the overwhelming share of non-financial sector borrowing. And the non-bank financial sector is where the financial market crisis is occurring.  So, there IS a funding crisis for non-financial firms. Get with it, Minneapolis Fed!

Preventing Another Great Depression

Pundits are using the financial markets mess to raise fears of another Great Depression in order to justify large-scale federal intervention. But government interventions, not markets, cause great depressions.

What markets do naturally when left alone is grow. Sure, people in markets make mistakes and markets sometimes experience panics, but if prices are allowed to adjust, recessions are short-lived and stability and growth returns.

Why do markets naturally grow when left alone? Because of people’s “propensity to truck, barter, and exchange one thing for another,” as Adam Smith noted. Since voluntary exchange is mutually beneficial, that propensity gives rise to what can be called a surplus, profits, or economic growth. Growth results from simply allowing individuals to seek their economic advantage within the rule of law.

As I note in this summary of the causes of the Great Depression, the U.S. economy experienced a sharp contraction in 1921 with the unemployment rate rising to 12 percent and output falling 9 percent. But the economy bounced back quickly as the government stood aside and let prices adjust and profits recover.

A decade later, the government adopted vastly different policies, which prevented the economy from adjusting and recovering from the monetary contraction that precipated the Great Depression. As I discuss, there were six key reasons for the severity and duration of the Great Depression:

1) Monetary contraction and bank regulations.

2) Tax increases.

3) International trade restrictions.

4) Mandated high prices.

5) Mandated high wages.

6) Harassment and demonizing of businesses.

This 2004 study by UCLA economists provides recent academic support for a number of these points. The Forgotten Man by Amity Shlaes also provides interesting insights into the depression.

Today, policymakers are starting to make some of these same mistakes again. Will they stop before they turn today’s recession into a full-blown depression?