The Bailout Was a Wealth Transfer Scheme

The Emergency Economic Stabilization Act of 2008 created the $700 billion bailout (plus $100 billion in add-ons) Troubled Assets Relief Program (TARP), a wealth transfer scheme so brazen as to leave one breathless. Another Fed bubble had popped; losses in the real estate mortgage meltdown were real; they had already taken place. The only real question was who would be made to eat those losses: the investment banking community that earned millions in fees each year in the debacle and their offspring, young and yet-to-be-born, who would go through their entire adulthood burdened by heavy debts.

The loss transfer scheme met with more than a cold shoulder from the public. It met with outright hostility. One New Jersey congressman said his calls were running 50-50: 50 percent no, and 50 percent Hell no!

The bailout also generated the derision it deserved. One blog posting described it succinctly: Taking money from people who made good investments and giving it to people who made bad investments will make good investments in the future and the people who made good investments will keep making them even though they will have less money to do so.

The lame-duck president let Secretary Paulson call the tune, while he tap-danced through a couple of White House performances: ...without immediate action by Congress, America could slip into a financial panic. (His first treasury secretary, Paul O'Neill, said of the president at the time, I don't think he understands or knows much about any of this and it shows.) Paulson, the former Goldman Sachs CEO, was determined to reliquefy Wall Street even at the risk of the treasury's solvency. The bailout was sold to the governing classes under the guise of reinflating the mortgage market, an act of self-evident futility. If the last bubble could be reinflated, people would still be coughing up million s for dot-com business plans scrawled on cocktail napkins and the NASDAQ index would still be over 5,000. Unlike their counterparts in the Senate, members of the House, closest to the people and all up for reelection in a month, resisted the bailout at first go-around, but the pork fest of more giveaways, the heavy arm twisting, and talk of opponents being blamed for the next Great Depression prevailed. One representative, Brad Sherman, D-CA, claimed on the House floor that members were told without the bailout there would be martial law in America. And so the Paulson plan passed, a mechanism to transfer the losses from institutions that in the expectation of gain willingly undertook the risk of loss to those who had no opportunity for gain or willingness to undertake loss.

If the idea seems antithetical to the American way, it is. Philosophical consistency is not to be expected from politicians, but shouldn't shame for supporting the giveaway have spread rampantly among Republicans? After all, the 2008 Republican platform had just been passed at the beginning of September. It addressed the mortgage meltdown in these terms: We do not support government bailouts of private institutions. Government interference in the markets exacerbates problems in the marketplace and causes the free market to take longer to correct itself. And what about modern-day conservatives who some years before opposed Hillary-care, insisting that socialized medicine is a mistake for the body politic? How then had socialized investment banking become overnight a prescription for economic health? When foreign heads of state, from Iran's President Musaddiq, who was toppled for it in 1953, to Putin in Russia or Chavez in Venezuela, nationalize their country's oil, they become enemies of the American state. But when American leaders nationalize finance, the people are told it's for the good of all concerned. Before long South American Marxists including Hugo Chavez were taking great delight in calling Comrade Bush a fellow traveler.

The early costs of the frenzy of rescues were astonishing. A week into October, Bernanke claimed the Fed had already committed $800 billion in loans to banks and other activities, and that was before $200 billion for Freddie and Fannie and before the $700 billion bailout. The bailout gave news life to the expression Legislate in haste, repent at leisure. It only took a couple of months to notice that the bailout produced none of the promised results in mortgage values. The Treasury handed out the first tranche of the TARP money, $350 billion with virtually no accountability for how the money would be spent. Early in 2009 the Congressional Oversight Panel was able to conclude that the Treasury had paid $78 billion more than market value for the first $254 billion it spent.

While all eyes were on the bailout debate, September 30, like some eerie fiscal planetary conjunction, went unnoticed, a silent harbinger of America's economic future. While fiscal year 2008 ended that day, rolling up an all-time-high deficit of $455 billion, the explicit national debt actually increased by more than a trillion dollars for the year, breaking through an astronomical $10 trillion. Meanwhile, all but eclipsed by the debate over the bailout bill, President Bush signed another stopgap spending bill that day. This one was for $634 billion, including $5 billion in earmarks, $25 billion in low-interest loans to automakers (yes, even foreign ones!), and a 6 percent bump in Pentagon spending. By the time he signed the bailout bill three days later, it had been a $1.34 trillion week. As part of the bailout, commanding the sun and the moon of economic reckoning to stand still, Congress raised the national debt ceiling to $11.315 trillion. (Four months later it would raise the debt limit again, this time to $12.1 trillion.)

The Paulson plan was presented as an attempt to undo the harm of mortgage market excesses by again inflating mortgage assets on the balance sheets of Wall Street players. It was a strange, homeopathic remedy, a hair of the dog approach for a problem that was caused by excess credit engineered the Federal Reserve to begin with. Rather than letting housing prices that had inflated beyond sustainability deflate, instead of letting a market of buyers and sellers arrive at some equilibrium, at values that reflected the actual conditions of supply and demand, the plan called for more of the asset inflation that led to the pumping of more air into the tire that had already had a blowout was ridiculous on its face, and the populists were right in suspecting that it was Wall Street welfare, a case of the politically connected of American finance passing the Old Maid of loss to the people.

Informed observers, the Cassandras who had seen the bubble forming and tried to raise the alarm when it would still do some good, were, of course, not consulted about the plan. Five years to the month before the Fannie and Freddie bubble popped, Congressman Ron Paul introduced a measure that would have avoided the calamity. His September 2003 remarks in the House Financial Services Committee on the dangers of government-sponsored enterprises (GSEs) like Fannie and Freddie are nothing less than a shockingly precise preview of exactly what came to pass:

This explicit promise by the Treasury to bail out GSEs in times of economic difficulty helps the GSEs attract investors who are willing to settle for lower yields than they would demand in the absence of the subsidy. Thus, the line of credit distorts the allocation of capital. More importantly, the line of credit is a promise on behalf of the government to engage in a huge unconstitutional and immoral income transfer from working Americans to holders of GSE debt...

Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market...

Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever.

When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary, but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.

In viewing the Paulson plan, the Cassandras must have wondered how often the same discredited economic nostrums need to be refuted. But the administration didn't turn to Ron Paul for advice. Nor did it consult the scholars at the Ludwig von Mises Institute, who had warned about the government-sponsored expansion of bank credit and money and its inevitable cycle of bubbles and busts. Instead Bush turned to Henry Paulson and his team from Goldman Sachs, despite the fact that under Paulson's leadership as CEO, Goldman Sachs had been among the industry's leaders in the issuance of subprime and other mortgage-backed securities, rotten paper that was downgraded scores of times by Standard & Poor's and Moody's Investors Service. And Bush followed the counsel of Fed chairman Ben Bernanke, who was on board and at the helm as the Fed frothed up the real estate and mortgage bubbles to begin with.

Sincerely,
David Goyette