Dangers in the Bailout

There are two great dangers in the president’s proposal to bail out the financial industry.  

One is that the government may interfere too much in our market economy, creating long-term problems larger than those that have now destabilized our financial system.  The other is that President Bush will pay too high a price on other issues to get his proposals through Congress this week.

There is only one certainty:  whatever the government does will cost taxpayers vastly more than anyone will now admit.

As the 110th Congress lurches and stumbles to a conclusion, the president is asking for legislation on a $700 billion proposal to restore order to the capital markets.  The problems stem from the sub-prime mortgage market which gobbled up far too much of the available investment capital. When the housing bubble burst, the sub-prime mortgages became nearly valueless because the homes which secured the mortgages were worth less than the face value of the mortgage.

First, Bear Stearns was bailed out.  Then Fannie Mae and Freddie Mac — two comprehensively mismanaged “quasi-government” companies — were taken over, at unknown cost.  

Last week, when Lehman Brothers went under and the insurance firm AIG was ready to sink, President Bush and his economic team stepped in to take over AIG.  AIG was about to go under because it had invested too heavily in mortgage-backed securities and other risky debt.  Now we — you and I and our families — own billions of dollars of sub-prime mortgages and securities based on them.  Which are not quite as valueless as treasury bonds issued by a fallen government but could be if, for example, Democrats succeed in placing a moratorium on foreclosures.  

As the Wall Street Journal described in a Saturday editorial, panic ensued when credit dried up to the point that daily settlements — in which brokerages and banks do the actual money transfers necessary to buy and sell stocks — were held up until cash or securities were actually in hand.  There was, in effect, an investors’ run on the money market funds which are the source of working credit for many businesses.

Because our economy requires credit to be available 24/7, the drying up of available credit (now largely embedded in unmarketable sub-prime mortgages and securities based on them) risked the continuation of too big a part of it.  Something had to be done to let credit flow again.  

Now the president has asked Congress to rush to enact a pile of legislation that would enable the Secretary of the Treasury to contract for, purchase and resell up to $700 billion of “…mortgage-related assets from any financial institution having its headquarters in the United States.”  

This is being done, the proposal said, to stabilize the financial market and protect the taxpayer.  Some Congressional conservatives are cautioning against doing too much too fast.  In a statement issued Saturday, Rep. Mike Pence (R-Ind) said, “Congress should act, but should act in a way that protects the integrity of our free market and protects the American taxpayer from more debt and higher taxes.  To have the freedom to succeed, we must preserve the freedom to fail.  Any solution to our present crisis must preserve our essential economic freedom.”

Pence and like-minded conservatives are right.  Doing too much too fast is how the government creates big problems by solving smaller ones.

A research paper piece published by the Heritage Foundation sets out eight principles the government should follow to avoid putting our economy on a path to bigger disasters.  Heritage advises that the legislation:

•    Not prop up failed or failing institutions;
•    Not try to support prices that should be set by the free market;
•    Not allow the government to become a permanent “owner of last resort” for devalued securities;
•    Strictly limit legislation to the immediate need to stabilize the financial situation;
•    Avoid “moral hazard” (i.e., not reward companies for taking risks they know are unreasonable, taken because they thought they would be bailed out);
•    Carefully define — and thus limit — the role of the Federal Reserve system;
•    Limit taxpayer exposure and keep actions temporary; and
•    Assure liquidity in markets but require full pricing of government insurance.

Those are principles that conservatives should support and which should guide the president and Congress.  Should, but certainly won’t.

As this is being written, the Democrats are tarting up their own proposals, which follow their government interventionist ideology.  Among them will be legislation to put a moratorium on mortgage foreclosures, which will contribute to maintaining the bottleneck that prevents credit from being released back into the markets.

And, bizarrely, Treasury Secretary Hank Paulson wants to extend action to bail out foreign banks as well.  But why should American taxpayers absorb the losses foreign banks may have suffered by making bad loans?

Conservatives have to fight to make the government use only those measures that will free up American capital, not let it be mired in bad investments here or abroad.  One idea is to index taxation of long-term capital gains for inflation.  

Current regulations say that capital gains are computed by subtracting the basis cost — the price paid for the investment — from the sale price.  By not accounting for inflation, the taxed amount includes an imaginary gain: economic inflation of the cost, from which the investor doesn’t profit.

If inflation indexing were done, only real gains would be taxed, and the difference (which could be hundreds of billions of dollars) could be released into the capital markets.  Common sense demands this be done. But Congressional Dems won’t stand for it.   They smell the political blood in the water.

The other big danger is in how much the president is willing to give to get his package passed.  I fear he will trade far too much.

Congress plans to recess for the election as early as this Friday.  If it does, the offshore oil drilling ban could expire unless it is included in the omnibus bill containing the financial bailout package and, probably, a “continuing resolution” to keep the government funded.  Nancy Pelosi and Harry Reid won’t let that happen.  

Will President Bush cave in on the offshore drilling ban and who knows what other parts of the Dems’ unfinished agenda to get the bailout package?  If he does, the Democrats’ failed Congress will be bailed out, and Republican chances this year will sink.

Principles must be adhered to, and that can never be done without cost.  If conservatives stand fast on their principles — even if they have to oppose the president vocally — they can help the nation pass this economic crisis and help themselves substantially in November.