TARP Is a Moral Abomination

I have the "opposing view" column in USA Today this morning, and my job was to explain why the politicians who voted for the Wall Street bailout deserve the scorn of voters. I made two points. First, there was no need to bail out specific firms - even if one thought the government needed to inject capital in the system. Second, it is grotesquely immoral to use the coercive power of the state to take money from poor people and give it to rich people.

Beltway insiders and members of the political establishment are mourning these developments, asserting that the TARP martyrs are noble and courageous officials who did the right thing despite the risk to their careers. The obvious implication is that ordinary voters are a bunch of yokels who did not understand the steps that were needed to rescue the financial system and the economy from collapse. This self-serving narrative is wrong. The anger at TARP is not because it injected money into the financial system. Voters are upset because funds were used to bail out specific companies. Defenders of the status quo claim this was a necessary feature of rescuing the entire system, but that is false. Politicians had the option of choosing the "FDIC resolution" approach, which also injects capital into the banking system but only as part of liquidating insolvent institutions. This means that existing management and shareholders get wiped out. Indeed, this is precisely what happened with Washington Mutual and IndyMac. And it was the approach that was used during the savings-and-loan bailout 20 years ago. The Federal Deposit Insurance Corp. resolution approach should have been used with all insolvent institutions, regardless of how many lobbyists they employed or how much campaign cash they had funneled to Washington. TARP was also a terrible piece of legislation because it meant that politicians, rather than market forces, determined which companies survived. It also was a moral abomination. Government-coerced redistribution is never a good idea, but the worst type of welfare is when poor people are forced to subsidize rich people.

Why the So-Called Financial Reform Bill Is the Status-Quo Bailout Bill

Nicole Gelinas has been one of the most astute observers of how government has screwed up the financial system and her column in the Washington Examiner is an excellent summary of why the Dodd-Frank bill is a step in the wrong direction.

For 25 years, Washington has done everything in its power to subsidize Americans' profligate borrowing habits. Debt became the fuel for economic growth. Washington subsidized the financial industry's borrowing through implicit guarantees against loss. The feds first started rescuing creditors to "too big to fail" banks in 1984. Since then, it's become clear to lenders -- Wall Street's global bondholders and trading counterparties -- that the government would save them anytime a large financial firm foundered. Indemnified against losses, bondholders could lend nearly infinitely to Wall Street. Wall Street found creative ways to lend that money right back to the public, through mortgage brokers and credit card marketers. ...The Dodd-Frank bill is a monument to the status quo. Despite promises that the bill will end bailouts, it enshrines bailouts into law. It provides for an "orderly liquidation authority," for example, which allows "systemically important" financial firms to escape bankruptcy and to escape, too, consistent losses for their creditors. It also sets up a fast-track procedure through which the White House can ask Congress for guarantees for Wall Street's lenders in a future crisis. In effect, the government is saying to Wall Street's lenders: Carry on as you did before 2008. Ordinary Americans, though, understand that they can't go on as before. Since 2008, they've started paying their debt back. The process is painful. As Americans borrow less, they spend less and pay less for houses. But as Americans pare back their debt, the economy will begin to heal permanently. As house prices fall, for example, because less borrowed money exists to send them higher, Americans will have more money left over after paying the mortgage. They can invest that money in the stock market for retirement. Those funds, in turn, will go to entrepreneurs who create jobs outside of the financial industry. The Dodd-Frank bill would pervert this healthy process. It would pit Washington's too-big-to-fail subsidies and Wall Street's creativity against Americans who are trying to do the right thing for themselves and the country.

The Right Way for Banks to Bail Themselves Out

The politicians are urging big taxes on banks, using rhetoric designed to trick people into thinking that this is a way to make the banks pay for their own bailouts. But a general tax on all banks simply means that well-run banks subsidize the reckless banks - a problem that may get worse over time because of the moral hazard problems that seem to get worse every time politicians get more power over the industry. Greg Mankiw of Harvard has a more appealing idea, which would require automatic conversion of bonds to equity when a bank gets in trouble. This means, for all intents and purposes, that a bank would only be in a position of bailing itself out, so there is no risky cross-subsidization. And since bondholders presumably would not want to be converted into shareholders, there would be greater incentive to monitor whether the bank is being operated in a prudent manner. I'm not an expert on the specifics of the banking system, so I won't pretend to know enough to give this my unqualified blessing, but I know it is a far better approach than the blank-check bailout/intervention authority in the legislation on Capitol Hill:

There has been much talk about restricting the use of financial derivatives. Unfortunately, writing good rules is not easy. Derivatives, like fire, can lead to disaster if not handled with care, but they can also be used to good effect. Whatever we do, let’s not be overoptimistic about how successful improved oversight will be. The financial system is diverse and vastly complicated. Government regulators will always be outnumbered and underpaid compared with those whose interest it is to circumvent the regulations. Legislators will often be distracted by other priorities. To believe that the government will ever become a reliable watchdog would be a tragic mistake. ...Much focus in Washington has been on expanding the government’s authority to step in when a financial institution is near bankruptcy, and to fix the problem before the institution creates a systemic risk. That makes some sense, but creates risks of its own. If federal authorities are responsible for troubled institutions, creditors may view those institutions as safer than they really are. When problems arise, regulators may find it hard to avoid using taxpayer money. The entire financial system might well become, in essence, a group of government-sponsored enterprises. ...My favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance. Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance. But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.

The Greek Bailout

I get a lot of email asking me about Greece, especially since I don't give the issue much attention on the blog. I am paying close attention to what's happening, especially since Greece is a canary in the coal mine. But I generally try to avoid being repetitious, and anything I say now would replicate what I said in my initial blog post in February. Simply stated, if you subsidize bad behavior, you get more bad behavrior. But now that a bailout request is official, I suppose some additional commentary is appropriate. The editorial page of today's Wall Street Journal has some solid analysis on how rewarding Greece will exacerbate rather than solve Europe's fiscal problems:

...a bailout would, of course, end nothing. What it would do instead is open a wide new world of moral hazard—for Greece, for the countries providing aid, and for the future of the entire euro-zone. The Greek government has played the victim for all it's worth over the past several months, insisting that the same credit markets that finance its extravagant spending were charging too much in interest. But on Thursday, following another upward revision to its budget deficit, bond yields soared and forced Mr. Papandreou's capitulation. ... a bailout comes with baleful consequences for the entire euro-zone. Further austerity demanded as a quid pro quo might take some domestic political heat off Mr. Papandreou, but the IMF's policy history does not bode well for future economic growth. The EU countries expected to shell out €30 billion for Greece have their own debt challenges. If Greece is bailed out, the markets will rightly conclude that a line has been crossed, and that Portugal and even Spain will be rescued too. Even the Germans don't have that much money. ...Mr. Schäuble is so worried about Berlin's finances that he opposes tax cuts for Germans, but he nonetheless wants to bail out a spendthrift Greece. ...Greece represents only 2% of euro-zone GDP. While European banks would take losses on any Greek debt restructuring, those losses would not by themselves be catastrophic. But that wouldn't be true if the sovereign debt panic spreads to Portugal and Spain. Far better for the EU to draw the line now, force Greece and its creditors to take their pain, and demonstrate to markets that there won't be a rolling series of bailouts. To adapt Mr. Schäuble's Lehman analogy, better to stop the moral hazard at Bear Stearns, lest Spain become Lehman Brothers.

George Will Says No VAT Unless 16th Amendment Is Repealed

As usual, some very sound thoughts - on both the value-added tax and the income tax - from George Will:

When liberals advocate a value-added tax, conservatives should respond: Taxing consumption has merits, so we will consider it — after the 16th Amendment is repealed. A VAT will be rationalized as necessary to restore fiscal equilibrium. But without ending the income tax, a VAT would be just a gargantuan instrument for further subjugating Americans to government. ...Because the income tax is not broadly based, it radiates moral hazard: Its incentives are for perverse behavior. The top 1% of earners provide 40% of that tax's receipts; the top 5% provide 61%; the bottom 50% provide 3%. So the tax makes a substantial majority complacent about government's growth. Increasingly, the income tax is codified envy. A VAT is the political class's recourse when the resources of the minority that is targeted by the envious are insufficient to finance ravenous government.

Volcker Is Right about "Resolution Authority"

As I noted a few days ago, Paulson's bailout was the worst possible way to do a bad thing. To the extent that the government had to inject money into the financial system, I explained, it would have been far better to use the "FDIC Resolution" approach, which at least addresses the moral hazard issue by wiping out shareholders and getting rid of incompetent management. Paul Volcker made the same point in yesterday's New York Times:

The phrase “too big to fail” has entered into our everyday vocabulary. It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks. ...To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new “resolution authority.” Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization. To help facilitate that process, the concept of a “living will” has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts. To put it simply, in no sense would these capital market institutions be deemed “too big to fail.” What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail.

Government-Subsidized Risk Is a Bad Idea

Kudos to Nicki Kurokawa, a former Cato employee, for this short but substantive video explaining “moral hazard.” She notes that government-subsidized risk played a pernicious role in the housing bubble and financial crisis, and warns that “too big to fail” may create similar problems in the future.