Bailout Nation (3 page)

H
istorically, excessive greed, recklessness, and foolish speculation were punished by the market. Speculators lost their capital, their reputation, and their influence. (Back in the day when skyscrapers had windows that opened, some even lost their lives.) Their pools of cash migrated to people who handled risk in a more intelligent fashion. This is—or perhaps was—the great virtue of capitalism: Money finds its way to where it is treated best. Capital gravitates to those who can balance risk and reward, and who can obtain positive investment results, without blowing up. It's no coincidence that the largest venture capital firms, the biggest hedge funds, and the longest-lasting private trusts know how to manage risk. They preserve their capital. They have a healthy respect for losses, and strive to keep them manageable. They do not, as so many have done recently, put all their money on a single number, spin the roulette wheel, and hope for the best.

The present system has lost its auto-correcting mechanism. As economist Allan Meltzer noted, “Capitalism without failure is like religion without sin—it just doesn't work.” While the profit motive is alive and well, with rewards potentially in the billions of dollars for some, there is no corresponding and offsetting risk of enormous loss. Any system that allows profits to be kept by a select few but expects the loss to be borne by the public is neither capitalism nor socialism: It is the worst of both worlds.

Government intervention thwarts this migration of capital. Instead of the relentless efficiency of the marketplace—I call it the back of Adam Smith's invisible hand—we have instead politically expedient shortcuts that bypass this process. In the end, this results in a misallocation of capital, and an embracing of risk and short-term motives that leads to utter recklessness. Hence, the mortgage broker who fudges the loan application, the bank that looks the other way to process it, and the fund manager that ultimately buys this crappy paper are all focused not on sustainable, long-term returns, but on the quick buck. As we will see, the implications for the broader economy have been dire.

T
he modern era of finance is now defined by the bailout.
Systemic risk
has become the buzzword du jour. History teaches us that these bouts of intervention to save the system occur far more regularly than an honest definition of that phrase would require. Indeed, systemic risk has become the rallying cry of those who patrol the corridors of Washington, D.C., hats in hand, looking for a handout. As we too often learn after the fact, what is described as systemic risk is more often than not an issue of political connections and politics. Perhaps a more accurate phrase is
economic expediency
.

The past generation has seen increasing dependence on government intervention into the affairs of finance. Industrial companies, banks, markets, and now financial firms have all become less independent and more reliant upon Uncle Sam. This is no longer a question of philosophical purity, but rather a regular occurrence of politically connected corporations—and their well-greased politicians—throwing off the responsibility for their failures onto the public. Any sort of guiding philosophy or ideology regarding free markets, competition, success, and failure seems to have simply faded away as inconvenient. No worries, the taxpayer will cover it.

Some people—most notably current Federal Reserve chairman Ben Bernanke and former chairman Alan Greenspan—seem to feel that it is the responsibility of governmental entities such as the Federal Reserve or Congress to intervene only when the entire system is at risk. The events since August 2007 have made it clear that this is a terribly expensive approach. Perhaps what the government should be doing is acting to prevent systemic risk before it threatens to destabilize the world's economy, rather than merely cleaning up and bailing out afterward. An ounce of regulatory prevention may save trillions in cleanup cures.

The United States finds itself in the midst of an unprecedented cleanup of toxic financial waste. As of this writing, the response to the credit crunch, housing collapse, and recession by various and sundry government agencies had rung up over $14 trillion in taxpayer liabilities, including bailouts for Fannie Mae and Freddie Mac, General Motors and Chrysler (twice, and soon to be three times), American International Group (AIG) (four times), Bank of America (three times), and Citigroup (three times). It has forced capital injections into other major banks, and government-engineered mergers involving once-vaunted firms Bear Stearns, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Washington Mutual (see
Table I.1
). It has led to the Federal Deposit Insurance Corporation (FDIC) receivership, nationalization and sale of Washington Mutual (now in the hands of JPMorgan Chase), and Wachovia, flipped over the course of a weekend to Wells Fargo.

Yes, that's $14 trillion (plus)—about equal to the gross domestic product (GDP) of the United States in 2007. And as 2008 came to a close, even more industries caught the scent of easy money: Automakers, home builders, insurers, and even state and local governments were clamoring for a piece of the bailout pie.

The implications of this are significant. The current bout of bailouts—the banks and brokers, airlines and automakers, lenders and borrowers in the housing industry—will have significant, long-lasting repercussions.

So far, they have turned the United States into a Bailout Nation.

And that's just the beginning.

Source
: By permission of John Sherffius and Creators Syndicate, Inc.

—Herbert Spencer, English philosopher

 

 

A
merica's relationship with bailouts has been a complex and nuanced affair. It has evolved gradually, morphing through var ious phases over time. The United States has had several distinct bailout eras, and each has seen an incremental shift in the attitudes toward government rescues. Philosophically, the country has moved from finding the mere idea of a government intervention to any corporation abhorrent, to begrudgingly accepting interventions as a rare but necessary evil. Since the late 1990s, bailouts have been embraced around the world as a near-normal responsibility of government to save the financial markets from themselves. Most recently, a backlash has been building against bailouts as a reward for dumb and irresponsible behavior.

Let us consider an earlier period in U.S. history—the nineteenth century to the pre-Great Depression era. The popular attitude toward both governments and corporations was very different at that time from today. Government was much smaller, and was not seen as a lender of last resort to either banks or industry. A general suspicion of corporate entities was commonplace among the populace, and there was a near-adversarial relationship between the government and the larger corporate interests.

The federal government's involvement in companies in the nineteenth century was more as an incubator than a rescuer. There wasn't much in the way of venture capital funding then, and a few start-ups sought and received modest amounts of government assistance. Railroad and telegraph firms were given easements and rights of passage, facilitating the government's desire for expansion into the West. Later on, telephone companies also enjoyed government largesse. Eminent domain was used to purchase properties for the benefit of companies as varied as mining, cattle ranches, railroads, and telegraph firms. In each of these early examples, the government's cash outlays were quite modest, and often facilitated a broad public good.

Rather than betting on any single company, the government found it to be in its own interest to jump-start a sector and then allow a brutal Darwinian competition to take place. Ultimately, that left standing only a few survivors as the rest of the industry fell by the wayside. Automobiles, computers, electronics—history is replete with examples of the U.S. government staying out of the way of a competitively developing industry. The government left these companies to follow their own natural life cycle via the mechanics of the free market. In
Pop! Why Bubbles Are Great for the Economy
, Dan Gross details the thousands of railroads, telegraph companies, automakers, and Internet companies that boomed and then eventually went bust.
¹
In most industries, this process leaves behind a valuable infrastructure for subsequent companies to build upon. This was Joseph Schumpeter's “creative destruction” at work.

The groundwork for modern bailouts was laid in the early twentieth century, when in 1913, the Federal Reserve System was created. As we will see in a later chapter, this had major implications a century later. As originally envisioned, it was imbued with only modest monetary and fiscal powers. Eventually, these powers were expanded dramatically.

The next phase took place in the 1930s and 1940s, between the Great Depression and World War II. The widespread economic turmoil and political discontent forced the government to engage in a series of economic stimuli designed to generate jobs, income, and economic activity. While some political historians have described this as a bailout, it was not directed toward any specific corporation or economic sector. The public works programs of the Depression era were designed to impact the entire economy, stimulate growth, and reduce the 25 percent unemployment rate.

The latter years of this second era preceded World War II. The U.S. steel industry had previously enjoyed a booming decade in the 1920s, but had collapsed during the economic crisis. The United States, anticipating the possibility of its entry into World War II, recognized the importance of a viable industrial manufacturing sector. Without a healthy steel industry, the country would've been hamstrung in its attempts to build ships, tanks, planes, and other tools of warfare. The munitions industry also received much of Uncle Sam's largesse, as did the metals companies and the rubber industry. Indeed, the ramp-up to World War II saw an enormous amount of government assistance to companies that were war-related.

Were these truly bailouts? It's hard to call any nation's national defense buildup in wartime a true bailout.

After World War II, the United States entered a long period of economic expansion. The building of suburbia, the automobile industry's enormous growth, the expansion of major cities, and the entire postwar baby boom led to salad days for corporate America. There was no further government involvement in corporate America until the rescue of Lockheed Aircraft Corporation in 1971.

What made the Lockheed bailout so pivotal was its status as the first public bailout of a major corporation—and only that corporation. The Lockheed rescue became the blueprint for most future bailouts over the next half century.