fall 2007, the United States economy was rolling along in a healthy fashion having enjoyed 24 consecutive quarters of positive Gross Domestic Product growth. The Standard and Poors Index was over 1,500 and unemployment was below 5%. There was essentially no inflation. These were all good numbers and normally indicative of a health economy (Bloomberg Business Week).
Roughly 12 months later everything had changed. Treasury Secretary Henry Paulson surprised everyone by announcing that the Government was intending to intervene in the U.S. economy by holding reverse auctions where the troubled assets of several domestic financial institutions would be bought (Landler). As matters worsened quickly, the proposed auction concept was expanded to the point that the Government would actually purchase equity positions in some of the country's largest banks. The argument offered by Paulson was that such measures were needed to stabilize the troubled financial markets, avoid bank failures, and prevent a credit freeze.
Paulson had no sooner announced these measures when the rest of the economy also seemed to fall apart. The stock market prices fell sharply, housing prices continued the slide that had begun in late 2006, and retail sales contracted. It was as if the entire economy had come to a complete standstill at the same time.
There is no lack of opinions on what caused this sudden turn in fortunes for the U.S. economy (Zeckhauser). Financial experts and politicians have offered all sorts of explanations such as excessive risk-taking by the private sector, inadequate or inappropriate regulation, deficient financial management, and so on but the one factor that is discussed the least may be the single most important one: misguided federal policies.
Since the end of the Second World War the U.S. Government has promoted the idea of homeownership (Carliner). Over those years the Government has designed a number of programs and developed policies that have resulted in the creation of a number of several powerful and influential agencies. Some of these agencies include the Federal Housing Administration, the Federal Home Loan Banks, Fannie Mae, Sallie Mae, and Freddie Mac. Each of these agencies was created in some fashion to assist in the policy of promoting home ownership. Additionally, the Internal Revenue Service participated in the promotion through the allowance of home interest deduction, favored treatment of capital gains on housing, and the inclusion of the Homestead Exception in the bankruptcy code.
For many decades the Government's housing promotion policy had no noticeable negative effects. The reason for this is that where the Government did intervene in what should have been free market activities it did so responsibly. This all changed, however, as the Government began to involve itself in the promotion of homeownership for low-income households (Shay). At some point in the 90's, the Department of Housing and Urban Development suddenly began applying pressure on the private lenders to provide mortgage loans to those who had traditionally been unable to procure such financing. Adding to the problem was the fact that political pressure was also being applied to government agencies like Fannie Mae and Freddie Mac to finance the same high risk individuals. By late 2003 and early 2004 the result of these pressures was the creation of thousands of mortgages to individuals with extremely poor credit histories.
A second federal policy also contributed to the situation. Unbeknown to many taxpayers, the U.S. Government has been bailing out institutions involved in private risk-taking for some time. This has been the Government's policy for some time as several different banks have been provided with funds in order to protect them from going under. These bailouts have been going on for some with little fanfare (Gup). This practice of providing bailouts to potentially failing financial institutions seemed to create an expectation among the industry that the government would step in if necessary to cushion any potential losses from risky investments. With the Government encouraging financial institutions to expand their involvement in high risk mortgage debt and, at the same time, indicating that they were willing to bail out those who might fail as a result, financial institutions had every incentive to continue participating in the high risk mortgage market. The industry could not continue in this fashion and a crash was inevitable but no one was willing to admit it. There was too much money being made and no one was willing to step forward and cry wolf. As long as housing prices continued to rise the situation could continue but once housing prices began to decline it was only a matter of time before the financial institutions would begin tightening the market.
The federal policies mentioned herein were not the only cause of the major bailout that was eventually required in the early days of the Obama administration. Wall Street greed, inadequate and inappropriate regulation, and failures of the rating agencies all contributed to the situation as well. The long-standing federal policy of promoting homeownership, however, was at the center of the controversy. It is implausible that greed, improper regulation, or rating failure would have been able to orchestrate the problems that faced the nation's financial institutions at the time of the 2009 bailout. Greed and regulation failure certainly contributed but it was federal policy that created the original problem.
The bank bailout plan offered by Treasury Secretary Paulson was intended to provide failing banks with sufficient money to improve their balance sheets which in turn would allow the bailed out banks the opportunity to lend money to the public (Manns). The logic offered for the bailout was that these failing banks were adversely affected by the falling housing market as the assets they were holding to guarantee the high-risk mortgages that they had granted were declining in value.
In the public discussion that occurred regarding the need for a bailout there were few who questioned that there were many financial institutions that were in danger of failing. The potential of financial failure, however, is not a basis for granting wholesale bailouts. Financial failures are a reality of capitalism. Businesses of all kinds make good and bad investments and, as a result, businesses enjoy profits and suffer losses every day. That is how the system works and the government cannot be placed in a position of bailing out every business in America that is in danger of failing.
The argument that was advanced by the troubled financial industry in the fall of 2008 was that allowing a significant number of financial institutions to fail would harm, and possibly, cripple the nation's economy (Zumbrun). The industry claimed that a failure by one bank impacts on other banks to the point that a complete credit freeze was a likely. As the bailout occurred, this theory was never tested but, regardless of the possible effects, the bailout was not sound policy.
The first thing that must be considered when reviewing the possible effect of bank failures is the fact that the Federal Deposit Insurance Corporation would have prevented any significant loss being felt by the depositors thus preventing their being any run on the banks occurring (Ashcraft). At the time of the Great Depression, this occurrence crippled the U.S. economy and made it difficult for the financial market at the time to re-stabilize itself. Analysts at the time of the present bailout were suggesting that a similar thing might happen but the FDIC program was designed to avoid such contingency. Additionally, the United States bankruptcy code has been designed over the years to supervise the activities of financial institutions that are on the brink of failing (Morrison). The image of hundreds of banks suddenly shutting their doors and ceasing to operate is merely a scare tactic to induce emotional reactions from the public. The bankruptcy Court would have stepped in and either appointed trustees to operate the failing banks until such time as they became viable again or forced a liquidation of the failed bank's assets to a healthier bank or financial institution. In either case, the individuals suffering the losses would be the investors, either shareholders or bondholders. The monies on deposit would be protected under the insurance provided by the FDIC. This is the way the system is supposed to work. Depositing money into a bank is not considered to be an investment. There is not expected to be any risk. Buying shares in a bank or purchasing a bank's bonds is, however, considered an investment. There is supposed to be risk involved. If the government is going to provide bailouts to troubled financial institutions, where is the supposed risk?
What the bailout has effectively done is, once again, completely altered the playing field in regard to how the government treats the wealthy and privileged classes in the United States. The bailout, in effect, serves as an insurance policy for the wealthy that guarantees the viability of their "investment" in our nation's financial institutions.
The first way that this is done is that the bailout perversely takes the money provided by taxpayers and transfers it to…