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September 27, 2008

Did Secretary Paulson Create a Self-fulfilling Prophecy?

Congressman John Shadegg (R-AZ) thinks so.

Is a bailout necessary to save the economy at this point from complete collapse — from a major failure of multiple institutions at the same time?

I think that’s the most difficult question that could be posed under these circumstances, and it’s the question that I have struggled all week to find the answer to. I have talked to a lot of smart people who know Wall Street, know banking, know the economy quite well, and you hear different opinions. Some will tell you that it is absolutely essential. Quite frankly, I’m skeptical about that.

But I think that in some ways the question doesn’t matter any more. Because Secretary Paulson chose to raise the matter in the way he did — that is, to go public in a very high-profile way, not just with his concern, but with a kind of Chicken-Little, the-sky-is-falling kind of demand — it became a self-fulfilling prophecy.

That is to say, once the secretary of the Treasury announces to the world that there is a pending financial collapse, perhaps as great as the Great Depression, and Congress must act — he has sent a signal that essentially tells world markets that Congress must act. I will tell you that has been one of the most frustrating things about this since the very beginning...

I can’t tell you how many members of Congress were stunned at that news, and were stunned that none of their local bankers were calling them. And then they called their local bankers, as I called my local bankers, and my local bankers said, “I think things are just fine.” I talked to one banker who said, “Gosh, we’ve got money, and we’re liquid, and we’re making a profit. And we’re in the market selling loans, and we’ve got competitors trying to sell loans against us.”

So, at that point, there’s a disconnect. Secretary Paulson is claiming that this is a catastrophe of generational proportions that could go worldwide. And none of what we were hearing back home matches that. And I’m not speaking just for myself, but also for many of my colleagues who were making similar calls. They weren’t being called by their bankers, or by any of the businesses back home saying, “I can’t borrow any money”.... If, in fact, Paulson had struck a chord with the American banking community, wouldn’t you think that after he announced on Friday that there was a crisis of liquidity that threatens the entire nation’s financial solvency and Americans’ jobs from coast to coast, that my community bankers in Arizona wouldn’t have been picking up the phone by Monday morning, if not over the weekend, to say that “I share the Secretary’s concerns”?

I don't think Paulson made this up out of whole cloth (obviously not!), but he did hit the panic button and Congress has obliged him. Part of the job of the government agencies involved in the economy is to maintain for Americans a certain level of confidence. Paulson is saying that he's not confident of his ability or of private actors to keep things running. He's passed the buck. Now Congress has almost no choice but to act, at a minimum to give the impression that at least someone in Washington thinks we can avoid a second Great Depression.

Is a bailout capitalism? Well, yes and no. Ours is a mixed economy where government involvement in the markets is mainly accomplished by buying, selling, and lending to private actors. Direct intervention is rare. Even in this instance, where the proposal is for government to purchase opaque mortgage backed securities, the point is to determine their actual value and auction them back into the market. Perhaps the least capitalist provisions involve long-term caps on executive compensation of participating financial institutions and allowing mortgage instruments to be re-written to favor defaulting mortgagors.

But let's not kid ourselves. President Bush and Senate Republicans who back the bailout are putting their capitalist principles on hold. It's a pragmatic choice and its justifications come in a few different flavors.

First, there are the folks who say government is already so intertwined with the market (especially the firms in question here) that further intervention is justified and not a betrayal of anything. Government broke it, so government should fix it. This argument suffers when we look at just how much new power the bailout gives to Congress and to various executive agencies. This isn't just a modification of the broken regulations that led to the problem. This is a long-term imposition.

Second, there are the folks who comfort themselves with the thought that the bailout could potentially make a profit for the government and taxpayers. That sounds pretty capitalist, doesn't it? As I wrote the other day, people predicting a profit are wildly speculating on an investment scheme that already failed once. The point of the bailout is not profit-making and decisions by the government over just what price it will put to a particular toxic asset will be made according to how much that financial institution needs to stay afloat, not how much the government thinks the toxic asset will be worth at auction.

It's looking more likely that the the bailout will couple government purchases of toxic assets with equity warrants; that is, contingent shares in the financial institution selling them (value set pre-bailout). The idea is that if the government fails to break even on its resale of the toxic asset, it takes shares in the financial institution. Institutions which stand to forfeit stock of greater value than the toxic asset are therefore more likely to just buy back the toxic asset rather than lose the stock. Presto-chango, a risk-free investment scheme!

...Assuming, of course, that the institution still exists when the government tries to resell the toxic asset and assuming that the value of the institution has increased since the bailout. Given what I expect will be the government's spectacular failure to accurately price the toxic assets and the likelihood that even with the bailout several institutions will collapse, at the end of this we're not looking at a profit. Especially if Dems get their way about siphoning money to special programs.

Third, there are some who insist that we are preserving private financial systems in order to keep the next government (potentially a Democratic one) from taking over the financial system completely. In other words, a defensive action, but one which requires us to ignore the core principle that the market works best when it punishes failures and rewards successes. Here, the argument is that we have no choice but to protect failures from their own mistakes. The problem is that this incentivises failure. It tells those firms and industries who believe rightly or wrongly that they are "too big to let fail" that they can be more reckless than they otherwise would be.

This bailout will beget more bailouts. Count on it. Each time we are asked to save another firm or industry, we will be told that the future of our economy depends on it. Each time, we will be asked to put capitalism on hold.

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posted by Gabriel Malor at 01:20 PM

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