Does the federal government have too free a hand?
In 1792, the United States faced a financial crisis as the price of government bonds plummeted nearly 25% in a two-week span. Treasury Secretary Alexander Hamilton acted quickly, buying hundreds of thousands of dollars of government bonds and asking banks to accept bonds as collateral for their loans. As a result of the Treasury’s efforts, institutions like the Bank of New York were saved and the market soon stabilized. The Treasury’s actions in 1792 are particularly relevant today as current Treasury Secretary Henry Paulson oversees a financial rescue operation of his own. But unlike the relatively successful bailout in 1792, or even the more recent intervention in 1989, the $700 billion bailout of 2008 will fundamentally alter the way that financial markets operate. Unlike previous bailouts, the current plan puts the government in a unique position of picking winners and losers in financial markets and forebodes a high level of government involvement in the economy in the coming months and years.
History Lessons
A brief review of past bailouts illuminates the unique nature of the current proposal. After 1792, the next major bailout came in 1907, when the Treasury responded to a series of bank runs by injecting capital into the banking system. But historians credit the Treasury with a minor role in stabilizing the markets, as it was J.P. Morgan who brought the major players together and created a pool of capital to pay depositors. In 1933, Franklin Roosevelt created the Home Owners’ Loan Corporation (HOLC), an agency that bought up mortgages from struggling banks and helped home owners refinance their loans. Though some, most notably Hillary Clinton, have called for the establishment of a similar agency in response to the current crisis, no such steps have yet been taken.
The closest parallel to today’s situation is the crisis of the late 1980s, when the government bailed out failed Savings & Loans corporations. The government’s response to the failing thrift industry was to set up the Resolution Trust Corporation, which took over and sold real estate and other assets held by the failed S&Ls. While estimates vary, the S&L bailout cost taxpayers about $130 billion. Jeffry Frieden, a Harvard political economist, remarked in an interview with the HPR that there are “great similarities” between the 1980s and today’s crisis. Specifically, he points to the fact that broad macroeconomic policy trends—large tax cuts, profuse amounts of borrowing abroad, and a bubble in asset values—were extremely similar in both cases.
But the similarities end there. The government’s bailout in 1989 dealt with institutions that had already failed. Today the government is attempting to prop up struggling firms that are still operating. Additionally, because the thrifts had already failed, the government did not need to negotiate the prices of their assets, which is an aspect of the current proposal that many observers view as especially problematic.
A Further Step
The current bailout proposal therefore appears unprecedented; as Harvard economist Jeffrey Miron said in an interview with the HPR, America has “not had anything like the Treasury bailout.” Specifically, there are three unique aspects of the rescue package that are particularly troubling. First, because the firms affected are still in business, the government has an entirely different type of power than it had in past interventions. Unlike in the 1980s, the government now has some flexibility in deciding which firms to help and which firms to ignore. Investors experienced a taste of this discretionary decision-making when the Federal Reserve and Treasury cast a blind eye toward Lehman Brothers in September despite having saved Bear Stearns from collapse in March. Miron worries the current plan will “put the government in the position of picking winners and losers in financial markets.”
Second, nearly all commentators agree that the government will have to intervene quite substantially in the short-term for the bailout to be successful. If federal institutions are reluctant to relinquish this authority after the fact, the results could be disastrous as the current rescue could set a precedent for future intervention across the economy. While this is a danger attendant in all bailouts, it is especially troubling in this instance because the Treasury is receiving far more extensive powers than it has ever had. Miron warns that the bailout legislation “gives the government a lot of discretion to do things that it has either not had the power to do or has never done before.” If economic history tells us anything, it is that government attempts to manage large sections of the economy are in most cases unsuccessful.
Third, the bailout risks impairing economic efficiency by providing incentives for firms to curry favor with the government or even play with their balance sheets to extract more money from the public coffers. Says Miron: “I imagine there will be a huge amount of strategic behavior, of banks thinking about ‘how can I get the most out of these auctions…in a way that’s best for me, for my company?’ It’s not necessarily what’s ideal for the taxpayer or for the agency that’s doing this.” For its part the government may find itself injecting politics into its economic decision-making, which could take the shape of preferential rescues of firms that are based in the districts of influential Congressmen or belong to especially visible and politically important industries.
Not everyone agrees with this view and many caution against drawing long-term conclusions from a bailout designed specifically to create short-term relief. Proponents of the bailout also point to the success of the RTC, which was disbanded in 1995 with no substantial lingering effects on the economy. Frieden downplays the long-term implications of the bailout saying that it does not “tell us much about the future…because this is a package that’s intended to deal with the immediate crisis.” Miron disagrees, arguing that “it’s a further step…a substantial expansion of the degree to which governments intervene.”
Warning Signs
These concerns may be overly pessimistic, and eventual outcomes will certainly depend on future policy decisions and the reactions of markets to such interventions. But the federal government’s presence in the financial system may well be felt farther down the road. The Treasury and Federal Reserve have the ability to choose the firms they assist, and these decisions may well become highly politicized, while many companies will take advantage of federal assistance in ways that are detrimental to taxpayers. While such actions may be important to the immediate health of the American economy, the long-term prospects for modern financial institutions may prove dim if the overhang of the rescue package lingers longer than intended.