Regime Uncertainty and Economic Crisis

An important factor in the recent credit crisis and the ensuing recession is what Robert Higgs of The Independent Institute has called “regime uncertainty.”  It appears to be one of the biggest reasons our economy hasn’t yet recovered more and faster from the current recession.

Higgs makes the very effective case that one of the reasons we endured the massive decline in economic activity and the extremely high rates of employment during the 1930s was the creation of uncertainty in the minds of producers about where the Roosevelt administration was taking the economy.  There was a real fear that we were headed for a revocation of the market system in favor of socialism.  In part these fears were realized, with the massive government intervention in the economy, marginal tax rates that exceeded 90 per cent, and price fixing.  Business was reluctant to hire, expand, innovate, or take any action that expanded its capacity because the threat of government take-over of the economy was very real.  

The federal government was constantly changing the rules of the game and signaling that, while it did not have a clear analysis of the problems at hand, it would try whatever options it managed to come up with.

Both the Bush administration and the Obama administration have once again created regime uncertainty.  As John Taylor of Stanford University pointed out in his book, Getting Off Track, and Luigi Zingales and John Cochrane of the University of Chicago discussed in the Wall Street Journal, the credit problems were in part a result of government action that confused investors and entrepreneurs as to what the rules of the game were going to be.  For example, the government arranged for a rescue of Bear Sterns, let Lehman Brothers go into bankruptcy, then days later took over Fannie Mae and Freddie Mac, and provided massive loans to AIG.  

No one could be sure why some firms were left to go bankrupt, some were merged under government pressure with large firms, some were essentially taken over by the federal government, and some were granted massive loans or given capital from the federal government in return for preferred stock.  A potential investor would not know what might happen to their investment or loan over the weekend as the U.S. government flailed about intervening in the financial industry.

Taylor, Zingales, and Cochrane all noticed that measures of risk in the financial industry, while widening the day after the Lehman bankruptcy, moved substantially from September 23 to September 25, more than a week later.  Their explanation for this is that the testimony of Federal Reserve Chairman Ben Bernanke, and Secretary of the Treasury, Hank Paulson, along with President Bush’s address to the nation on September 24th pushed us over the cliff.  Bernanke and Paulson testified before Congress that they must be given $700 billion to save the nation’s economy by the end of the week, or the world would go into Depression.  They came to the hearing with a two and one-half page bill giving Treasury and the Fed $700 billion with no oversight and no plan.  The following day, the President addressed the nation and said the following:

    Financial assets related to home mortgages have lost value during the house decline, and     the banks holding these assets have restricted credit.  As a result our entire economy is in     danger.

When the head of the Federal Reserve, the Secretary of the Treasury, and the President of the United States all say that we are in for an economic collapse and they don’t really have a good plan as to how they are going to get us out of this mess, it does not inspire confidence in the market.  To add to the uncertainty, the TARP money was at first going to be used to purchase troubled assets from banks, then to inject capital into banks.  When Congress was asked to fund a bailout of GM and Chrysler, the Secretary of the Treasury said he didn’t have authority to use the TARP funds for non-financial institutions.  When Congress failed to provide money for the auto companies, the Secretary discovered that he indeed had the authority to use the TARP money to lend to GM and Chrysler, as well as purchase stock in the companies.

Once of the reasons we have seen the unemployment rate remain frustratingly high as the economy recovers is the regime uncertainty being created by the Obama administration.  Companies contemplating expanding their business have no idea what will happen to their energy costs as the “cap and trade” bill has foundered about in the Senate and the House over the past year.  If you run a dry cleaner you are more concerned with what will happen in Washington than you are with what your current and potential customers may be doing.  

Similarly, the health care bill has probably by itself put a halt to the employment plans of thousands of businesses.  Suppose you run a silk screening business and employ 25 people.  You have a chance to expand, but it will require hiring 5 new people.  You have no idea what the costs of those 5 people will be if the 2000-page health care bill comes into existence.  All you know is that the House has passed a version, the Senate has passed one, and that there will be a conference report determined in secret by Democratic leadership that could contain anything.  It might require you to increase your contribution to your employees health care by thousands of dollars each, it might tax you for having improper (in the eyes of the central planners in DC) health insurance for your employees.  It is far better to wait until you see what the Washington takeover of the nation’s health care system will be. Thus the unemployment rate remains mired at 10 per cent and part-time employment is substituted for full-time employment.

Tax policy adds more to the regime uncertainty.  The Bush tax cuts expire at the end of 2010, and unless the Congress acts, there will be substantial increases in capital gains taxes and taxes on dividends.  This is weighing down the stock market and the value of everyone’s 401K.  A tax credit for first time home buyers pops up, is set to expire, and then is extended.  Cars for clunkers moves vehicle sales forward but expires months before it  is supposed to as the administration vastly underestimates the amount of credits that will be claimed. The most recent idea of the Administration is to impose a tax on the major banks to ensure that the TARP funds are repaid.  Now the fact that the major banks that have paid back their TARP funds already plus $11 billion in interest will be paying the tax, but Freddie Mac, Fannie Mae, GM and Chrysler, who are and will be responsible for the vast  majority of any losses to the taxpayer of the TARP funds, are all exempt from the tax, certainly gives one pause as to what this tax is about.

Unfortunately it is now more important to producers to predict what the federal government is going to do than to innovate in the production of goods that consumers will desire.  Market economies are extremely resilient and magnificently efficient in producing goods and services for the masses and making the best use of resources.  However, markets require that all participants be certain of the rules of the game and that property rights be protected.  The actions of the federal government over the past few years have created a situation where regime uncertainty threatens the well-being of all but the politically connected.