Bailouts are bad, and failure can be good

Posted on September 27, 2008 | Type: Op-Ed | Author: Thomas C. Patterson
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It all started with the rescue of Bear Stearns. The government's reckoning that the foundational principles of our economic system could be ignored, just this once, was a colossal blunder. Now we have full-blown bailout mania.

It didn't have to happen. The lightly regulated securities industry had been remarkably stable from the Depression until the sub-prime mortgage crisis of 2007. There were occasional failures of securities firms, but government bailouts were never seriously considered.

The reason is that investment banks, unlike commercial banks, have unleveraged liquid assets in their accounts. They don't require federal insurance and its accompanying regulation. Even investment banks that are overextended and facing collapse jeopardize only their shareholders and creditors, while the account balances held by their clients are unaffected. Any domino effect on the economy as a whole is minimal.

In 1990, Drexel Burnham, a major Wall Street firm with more than 5,000 employees, went bankrupt. Federal support was requested, on the basis of possible economic impact, but was refused. As expected, the fallout from Drexel's collapse was little more than a blip.

The Bear Stearns meltdown occurred in a tense, politicized atmosphere, with markets careening wildly. Ignoring the lessons of history, the feds panicked. But the rescue of Bear hardly stopped the spread of economic malaise.

Instead, with a precedent set and the bar lowered, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson this month embarked upon an unprecedented spending spree, committing taxpayer funds to relieve investors of the consequences of poor decisions and keep homeowners in homes they couldn't afford. Without a coherent strategy, they volunteered taxpayers to assume the liabilities of AIG, Fannie Mae and Freddie Mac and help Bank of America to buy Merrill Lynch, while leaving Lehman Brothers to go belly up. Paulson explained on television that Lehman was "just in the wrong place in the line."

Free markets sometimes require amelioration to correct truly predatory behavior and unfair competition. But these bailouts strike at the heart of our economic success. They threaten our capitalistic system, which has made us the most prosperous and free nation in history.

Here's why the bailout is a mistake: Failure is as integral to the function of free markets as is success. It is through failure that outmoded or poorly performing forms are weeded out, thus making way for more dynamic players to take their place. It is the threat of failure that automatically rationalizes avoidance of excessive risk and does so much more efficiently than regulation ever could. Lacking the prospect of failure, businesses behave like Fannie Mae and Freddie Mac, constrained only by the permissions granted from Capitol Hill.

Although the Left is pretending otherwise, the mortgage crisis wasn't caused by lack of regulation. It was politicians who passed laws discouraging the credit checking of loan applicants and threatened banks that lacked enough high-risk loans on their books. It was politicians who created Fannie Mae and Freddie Mac to backstop questionable lending practices, allowed them to under-collateralize their liabilities and ignored their obvious excesses (including generous grants to left-wing advocacy groups like ACORN). The lowered interest rates mandated by the Federal Reserve further inflated housing markets, and the rest is history.

Of course, perpetrators such as Sen. Chris Dodd, D-Conn., and Rep. Barney Frank, D-Mass., dismiss any notion that they could share some blame. Instead, they're demanding more regulation of financial institutions - as if that would solve the problem. Excessive regulation will drive capital out of the country when we need it most.

No revenue increases are contemplated to cover the massive new obligations, $1 trillion or more, being transferred from imprudent banks and mortgage holders to taxpayers. So like entitlement spending, earmarks and everything else we don't have the decency to pay for ourselves, we're going to add the liabilities to the national debt, kick the can down the road and hope our children and grandchildren can figure something out.

Tom Patterson is a former state senator.

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