Strikes Two and Three – Time for a New Batter


Two more expensive failures this week from our government. I am of course speaking of the Obama stimulus package which the Senate passed on Tuesday and the Treasury Department’s proposed plan for its continued effort to shore up our financial system, also unveiled on Tuesday. If someone had asked me to predict the worst possible scenario for these two efforts I would have suggested that a huge stimulus package (which fundamentally does nothing to help) and “more of the same” from Treasury (which doesn’t address the fundamental problems in the banking sector) would have been my picks. That is exactly what we received.

The stimulus bill is predicated upon the flawed view that the economy is in some sort of deflationary spiral, i.e. that the problem is fundamentally one of consumer panic, and for which the antidote is a government burst of spending. By putting money back into the pockets of Americans it is thought we can restore their confidence as they see that burst of spending stop economic decline. This of course ignores the question of how such spending is financed, through the sale of Treasury notes, in effect pulling that money from the pockets of consumers before putting it back, and mortgaging future taxpayers to do it.

On the other hand, there are real structural issues in the financial sector. But Treasury’s plan was almost universally panned across the economic spectrum, even before Treasury Secretary Tim Geithner had finished laying it out. Where he was specific enough to give details, the plan looked like a version of the pervious TARP, with Treasury providing capital to banks, albeit somewhat more “judiciously.” The plan was short on details where most needed, in the area of restructuring bad assets on bank balance sheets. For initial responses to the Treasury plan see naked capitalism posts “Geithner Plan Smackdown” and “Geithner Plan: Fiasco” and Andrew Sullivan’s Geithner Reax Part I and Part II.

Both efforts promise nothing substantive will change, and that the government will spend incredible sums attempting it.

It’s time for a new batter: the free market. Unfortunately, I am very pessimistic that this batter will get his chance at bat. There are two reasons for this.

First, the conventional wisdom being promoted is that the free market is the culprit that got us unto this mess. This is especially prevalent within the current administration. A question during Obama’s press conference on Monday night illustrates this point.

Q: Thank you, Mr. President.  In your opening remarks, you talked about that if your plan works the way you want it to work, it’s going to increase consumer spending.  But isn’t consumer spending or overspending how we got into this mess?  And if people get money back into their pockets, do you not want them saving it or paying down debt first before they start spending money into the economy?

THE PRESIDENT: Well, first of all, I don’t think it’s accurate to say that consumer spending got us into this mess.  What got us into this mess initially were banks taking exorbitant, wild risks with other people’s monies based on shaky assets.  And because of the enormous leverage where they had $1 worth of assets and they were betting $30 on that $1, what we had was a crisis in the financial system.  That led to a contraction of credit, which in turn meant businesses couldn’t make payroll or make inventories, which meant that everybody became uncertain about the future of the economy, so people started making decisions accordingly — reducing investment, initiated layoffs — which in turn made things worse.

This statement by Obama shows both his negative view of the free market, and his Keynesian view that the crisis is a problem of consumer confidence. One can hardly be expected to look to the free market for the best solution to the crisis, when free market forces are supposedly responsible. This was the basic narrative put forth both by the publicity of President Bush, and by then candidates Obama and McCain at the time of the crisis.

Upon further study though economists are coming to understand the role of government intervention in the housing market, fueled by the desire to stimulate home ownership, and resulting in the “originate to distribute” mortgage model, and the cheap money policy of the 2001-2005 Federal Reserve Board. Both of these interferences are key causes of the financial crisis.

The second reason that we won’t see the free market allowed to clean up this mess is that the free market will not preemptively step in while government is continuing to act in an arbitrary fashion. As long as government acts unpredictably, free market capital will sit on the sidelines.

Why is this?

The market is not a unified body acting in concert. It is made up of many small players, each acting to advance their own interests. Government, by contrast, is much larger and when it interferes in the market, it makes very large moves. Those moves are not necessarily profit driven and so are much less predictable. They ebb and flow according to political considerations. Thus, small, private, profit-driven interests will not act if such interests stand to lose in the wake of large, unpredictable actions taken by government.

So a banker maybe willing to buy distressed assets from an ailing bank, but only at a price that will net him a profit given today’s market conditions. When government steps in to buy these assets, at prices that show no concern for profit made, the private banker will stand back. He cannot outbid the government for these assets since he would lose money as well.

When a bank becomes insolvent and cannot raise new capital, it goes into bankruptcy. During bankruptcy new investors will provide capital, but only if the bank is restructured so that it has a healthy balance sheet. When government provides “bail-out” capital to banks without regard for their balance sheets, would-be private investors cannot follow along. Those conditions would assure them losses, just as the government is sure to lose their “bail-out” capital.

Just as government regulation takes away man’s ability to use his mind to further his own self-interest, so too, arbitrary regulatory actions, prevent individuals’ rational actions from resulting in outcomes that further their interests, and so they will rationally choose not to act. Irrational action drives out rational action. This one of the reasons why laissez faire is so important (and moral).

The best plans I’ve seen are merely variations of what would happen if the free market was cleaning up the mess. Banks would be forced to write down assets. Those that were insolvent would go into bankruptcy. In bankruptcy, debt holders would become equity holders, and assets would be sold off (presumably to banks who are healthy) in order to restructure balance sheets. The Luigi Zingales plan is a variation of this motif. Private bankers could do this, but until government chooses the free market path, it will not happen.

The free market did not cause the financial crisis. Fiscal “stimulus” will not work. Free market mechanisms are the only mechanisms that will fix the banking sector.

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