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Of Interventions and Conservative Principles
Is the $700 billion authority necessary? Will it work? Is it morally justifiable?


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Donald L. Luskin

What’s a principled conservative to think of the Bush administration’s proposed $700 billion authority to allow the U.S. Treasury buy illiquid securities? On the one hand it would appear to be a necessary step to solve a systemic crisis in the U.S. banking system. On the other, it promises to be an enormous expansion of government power and commitment of taxpayer dollars.

To arrive at a principled view on this intervention, we must answer three critical questions: Is it necessary? Will it work? And even then, is it morally justifiable?

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Unfortunately, we are thwarted at the outset. There’s simply no objective way to know whether the banking system is as close to disaster as top officials at the Treasury and Federal Reserve claim. They themselves don’t really know. This is a “banking crisis,” they say. But then again, other politicians claim there is a “health care crisis,” an “immigration crisis,” an “energy crisis,” and so on.

There’s no doubt that there is serious turmoil in the banking system and financial markets. But that doesn’t mean the proposed extraordinary intervention by the government in private markets is justified, considering that throughout history we have periodically gone through convulsions worse than today’s and survived them without such interventions.

According to the Federal Deposit Insurance Corporation there have been 15 bank failures in the U.S. between 2007 and today. We had thousands over a few years in the late 1980s and early 1990s. Since the stock market hit an all-time high last October, the S&P 500 has fallen 23 percent. It fell more than twice that — 49 percent — during the last bear market, between March 2000 to October 2002.

Even if you grant that this really is a “crisis,” and that it justifies an extraordinary intervention, there can be no doubt that the $700 billion authority being sought for the purchase of distressed mortgage-related securities is far too great an amount. Of the $1.26 trillion in non-prime mortgages — that is, “sub-prime” and “Alt-A” mortgages — $743 billion is already either owned or guaranteed by Fannie Mae and Freddie Mac, companies that were shored up by a government rescue earlier this month. That leaves $521 billion, which means the Treasury’s $700 billion would be more than enough to buy them all. And that’s even if the Treasury paid full value. In fact, the Treasury will get a steep discount, considering that many of the mortgages in question are in delinquency or default. Does the Treasury really have to buy every single non-prime mortgage — even the healthy ones — twice over?

And if the Treasury’s authority were scaled down to something more in proportion to the size of the asset market it claims to address — say $350 billion — must that authority be granted all those dollars at once? Couldn’t we start with $100 billion and see how it goes, and go back later for more if necessary?

In order to restore confidence in these shaky markets, there’s no doubt the administration would claim that its commitment must be both large and irrevocable. But considering the enormous powers being vested in the discretion of a single unelected official — the Treasury secretary — markets may also find solace in the idea that there will be an accountable process for learning from mistakes and making appropriate corrections.

Which brings us to the next question: Will it work?

Nobody knows. On the face of it, it is plausible that the banking system could be reinvigorated by having unwanted assets taken off its books. With those assets gone, and replaced by government cash, banks could stop worrying about the bad decisions of the past and get back to the business of financing investment and consumption in the American economy.

Yet there is ample room for doubt. The officials advocating this — Henry Paulson and Ben Bernanke — are the same ones who, in similar haste, engineered interventions this year in the collapses of Bear Stearns, Fannie Mae, Freddie Mac, and American International Group. With each intervention the banking crisis has gotten progressively more severe. Experts differ on this, but it is my professional judgment that these interventions actually made matters worse, because of the unintended consequences that were nearly impossible to forecast at the moment of decision. We simply cannot know what unintended consequences might be unleashed in the process of a massive acquisition of mortgage assets by the federal government.

And it is a false comfort to compare the proposed $700 billion purchase authority to the Resolution Trust Corporation, the government program of the early 1990s that was created in the aftermath of the savings-and-loan crisis. The RTC was quite successful in managing the assets of insolvent banks and thrifts, and the administration’s current proposal bears little resemblance to it.

The present proposal is primarily about the government acquisition of unwanted assets from solvent banks. The RTC acquired its assets automatically when thousands of banks and thrifts became insolvent and fell under receivership by the FDIC and the Federal Savings and Loan Insurance Corporation. There were no troubling ethical questions about which assets would be acquired, from whom, in what priority order, and, most critically, at what price. All the RTC had to worry about was eventually selling the assets it already had.

And assuming that it is necessary, and assuming that it is likely to work, is this epoch-making intervention in private markets morally justifiable? Die-hard conservatives — especially deficit-hawks and free-market libertarians — would say no. But some mitigating circumstances should be considered.

It seems at first blush that spending $700 billion to buy mortgage-related securities would be a budget buster. But remember, this is not government “spending.” It is government “investment.” The Treasury would issue bonds, pay a low interest rate on those bonds, and use the proceeds to buy mortgage-related bonds that pay a high interest rate and can probably be sold at a profit in the future.

It also seems at first blush that the government ought to not bail out banks that made terrible investments they now regret. But remember, many of these bad investments were the result of government meddling. Would we be experiencing a sharp housing downturn, and a wave of mortgage defaults, if the Federal Reserve had not created a housing bubble and a mortgage bubble in the first place by artificially lowering interest rates to 1 percent in 2003 and 2004? And how much was the housing bubble inflated by the highly leveraged mortgage buying spree of government-sponsored and government-influenced Fannie Mae and Freddie Mac? Shouldn’t the government shoulder some responsibility for its own mistakes?

As the week goes on, and as more details become known about the form the intervention legislation will take, it could be that the principled conservative who supports the administration’s plan today will find that he must ultimately oppose it. It’s hard to object to calls by Democrats for more oversight and accountability. But the Democrats are threatening to poison the legislation as they attempt to grab equity stakes from, and control executive compensation at, the companies that would sell securities to the Treasury under the program. And they are larding the program with pork to further subsidize the already heavily subsidized housing industry, turning some of what should be government investment into government spending.

In the end, each principled conservative will have to use his or her own judgment to weigh the imponderables here and come to a conclusion, yeah or nay. As of this writing, I’m inclined to support the administration’s proposal, although I wish it could be made smaller, at least at the outset.

One thing I know for sure: While the administration and Congress wrangle over the details, markets will continue to flail. It’s going to be a rocky week. Let’s hope it has a happy ending.



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