Memo to Congress: Important Mandatory Reading

Posted on September 30, 2008

If you are a member of congress and you read this blog, make extra sure to read this article entirely. I don’t know much on economics, but I know enough to know that a partially socialized system created this mess and bailing it out with money from my pocket will only encourage what caused it in the first place. It won’t fix anything, only dip more into socialism and actually make things worse. You can’t fix bad government with more government…or as Ronald Reagan said, “government is not the solution…government is the problem.” A real economist explains it much better:

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy’s allocation of its financial resources.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Further, the current credit freeze is likely due to Wall Street’s hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

The costs of the bailout, moreover, are almost certainly being understated. The administration’s claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.

If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.

The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

Sadly, no one from either house of Congress likely read my blog.

P.S: Grover Norquist writes a letter to Bush:

Dear Mr. President:

Now that the financial services package is back to the negotiation stage, I wanted to suggest several unilateral steps that could be taken by you to address the root causes of the financial panic. In order to make this bailout the last one, there are several necessary steps that should be taken by the Executive Branch:

1. Repeal the Clinton-era regulations encouraging reckless lending practices under the Community Reinvestment Act (CRA). In the 1990s, the Clinton Administration used the CRA as a club to pressure lenders into giving loans to marginally-qualified borrowers. The government should not be in the business of pushing lenders into making loans they would not make in a free market

2. Direct the SEC to make mark-to-market accounting voluntary for distressed assets. The mark-to-market accounting regime forces companies to value assets at less than their intrinsic value, merely to reflect current market uncertainty. In order to contain the bailout and protect taxpayer dollars, companies should be able to use book accounting for assets deemed by the Treasury as “distressed”

3. Direct the Treasury Secretary to determine that capital basis can be adjusted for inflation by taxpayers. There is a body of legal thought which holds that the Treasury Department can do this by executive action. In order to free up needed capital and unlock frozen assets more easily, the Treasury should make this common sense change to tax rules. If there is a legal brief which details Treasury’s objections to capital basis indexation, it should be released for public dissemination.

It’s important to note that all these actions can be done unilaterally by the Executive Branch. There are other reforms which require legislative action (note especially the House Republican Study Committee package), but the above executive steps would do much to alleviate the panic, assure markets, and protect taxpayers.

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