Thursday, September 18, 2008
No doubt some bookie on Wall Street is taking bets on which institution will be the next beneficiary of a government bailout.
Perhaps next up is Washington Mutual, America's biggest savings and loan company, which may need $24 billion in mortgage guarantees to survive long enough to find a buyer -- if it can. Maybe it will be Morgan Stanley or Goldman Sachs, both venerable Wall Street investment dealers investors appear to have lost faith in. Or it could be one of the hundreds of regional banks that are likely to join IndyMac Bancorp of California and Columbian Bank & Trust Co. of Kansas on the scrap heap of financial institutions mauled by the subprime mortgage monster.
With its "tough love" rescue of American International Group this week, Washington has clearly committed itself to further interventions. The $85-billion aid package, which will give the U.S. government an 80 per cent stake in the ailing insurance giant, was defended on grounds that a disorderly failure would further destabilize markets, result in higher borrowing costs, reduce household wealth and weaken economic performance. A similar rationale was used to save investment dealer Bear Stearns by engineering its takeover by JP Morgan in a deal that leaves U.S. taxpayers on the hook for up to $29 billion of the defunct firm's bad investments.
It seems like only yesterday that the government, after assuring the world they were adequately capitalized, took over Fannie Mae and Freddie Mac, which hold about half the mortgage debt in the U.S., an amount estimated at more than $5 trillion. That risk will now be borne by American taxpayers.
That bailout was easy for bureaucrats to justify. After all, the two mortgage companies were created by the U.S. Congress with a mandate to make it easier to realize the dream of home ownership for Americans. The notion that they were ever private entities was largely illusory. What's more, China's central bank holds more than $340 billion of Fannie and Freddie securities so a collapse of the institutions was unthinkable from a foreign policy perspective.
Lehman Brothers Holdings, which was pushed into Chapter 11, was the odd man out. U.S. Treasury Secretary Henry Paulson's "adamant" refusal to use government money to save Lehman was a one-off. Although Lehman's derivative entanglements are spread far and wide, the government's assessment was that it could be allowed to fail without jeopardizing international relationships -- and without triggering systemic economic collapse. This was political expediency more than fiscal pragmatism.
But as more institutions line up for government aid, determining which deserve a handout -- and which can be allowed to fail -- is bound to become increasingly arbitrary and problematic. Why, for instance, should financial services companies receive government assistance while manufacturing firms are ignored (notwithstanding the $25 billion in loan guarantees the big three U.S. automakers are lobbying for)?
By offering bailouts, governments invite moral hazard by freeing financial institutions from any consequences of their reckless behaviour, failures of due diligence and greed.
Some argue that more regulation is required to prevent a repeat of today's credit crisis; that it would never have happened had rules been in place to restrict mortgage-backed securities and their offspring.
But it is difficult to see how any regulatory regime could have contained the global market for financial derivatives.
The fact is that capitalist economies produce winners and losers. Every few years, the weak are weeded out in a stock market crash, a commodities bust, a technology meltdown, a credit crunch, a banking crisis or some other episode of financial distress. Economist Hyman Minsky argued that persistent financial and economic instability is normal in a capitalist economy. Financial systems, he said, are inherently susceptible to bouts of speculation that, if they last long enough, end in crises. His view, considered heretical by a majority of economists in the past, has gained legitimacy through the last few decades of upheaval.
Government intervention only delays the inevitable shakeout -- a cleansing process economist Joseph Schumpeter dubbed creative destruction -- and squanders tax dollars to prop up companies that have made the wrong bet at the wrong time and deserve their fate.
It should be made clear to private companies that they are entitled to reap the rewards of success but must suffer the consequences of failure.
Do you think governments should bail out private firms in financial distress?
Go to vancouversun.com/editorial to answer Yes or No.