Trillion Dollar Bailout Will Lead to Future Bubbles

by Hans Bader on September 19, 2008 · 43 comments

in Economy, Legal, Politics as Usual, Precaution & Risk

Why did the mortgage bubble occur?  One reason was probably that financial institutions engaged in irresponsible lending suspected they were too “big to fail,” and that the government would bail them out if their investments went sour — a perception fueled by the past bailouts of financial institutions like Continental Illinois National Bank and Long Term Capital Management, and companies like Chrysler.

Now, the government is confirming the accuracy of that perception by proposing a massive bailout of the financial sector, at a cost of perhaps a trillion dollars, by buying up banks’ bad loans.  This is a terrible, rotten idea that will encourage financial bubbles for generations into the future by rewarding mismanaged banks and companies.  Congressional leaders have apparently signed off on this deal with the President in exchange for support for a costly multibillion-dollar stimulus package that would give welfare to liberal constituences, the way the previous $160 billion stimulus package did.

If there is no bailout, the economy may go into a recession, but then it will begin expanding again, and the reckless financial institutions that caused the recession will be punished with losses or bankruptcy.  That’s more or less what happened in the sharp recession of 1920-21, which started out as nasty as the Great Depression, but quickly ended, unlike the Depression, and then gave way to an economic boom, because the government didn’t meddle in the economy, and didn’t bail anyone out.

Today, everyone talks about how, in theory, more regulation could have stopped the risky behavior that contributed to the bubble.  But regulation never lives up to neat theories about wise, omniscient regulators.  During the bubble, government officials of all ideological stripes were busy encouraging the risky behavior that caused to the mortgage bubble, not stopping it.  Liberal lawmakers were pushing risky loans to promote “affordable housing,” “racial justice,” and “diversity,” while the Bush Administration was touting them as a way to increase homeownership rates and promote Bush’s slogan of an “ownership society.”

During bubbles, government regulators share the same herd instinct as people in the private sector, the difference being that they know even less than the private sector does about how markets work, as David Brooks notes today in the New York Times.  As Brooks notes, there is no way that a government regulator obsessed with promoting homeownership was going to tell a bank during the real estate boom that it should not make a risky mortgage loan to a poor person, no matter how prudent such advice would have been.  Having worked in the federal bureaucracy, and gained a real-world understanding of how bureaucracies work, I totally agree with Brooks.

As we previously noted, the Clinton Administration stupidly pressured banks to make risky loans to people who couldn’t really afford houses in the name of promoting “affordable housing” and “racial justice.” A liberal commentator notes in response that the Bush Administration likewise stupidly encouraged risky lending, proposing a “Zero Downpayment Initiative” to subsidize mortgage loans for people who were not responsible enough to save enough money for a downpayment.  (Those of us who saved enough money for a downpayment on our own were not eligible for that subsidy, and had to subsidize the irresponsible no-money-down borrowers with our tax dollars).

Many commentators, such as former FDIC Chairman Bill Isaac, believe that federal accounting regulations have aggravated the financial crisis and created a dangerous logjam in America’s financial system.

Far from rewarding the people who warned against the housing and financial bubbles, the Administration is now cracking down on short-sellers, the people who accurately predict that risky assets are overpriced.  “This morning the SEC decided to ban all short selling on 799 financial stocks proving yet again we don’t live in a free market.”

John Berlau explains why short sellers are unsung heroes:

If ever there were a case “killing the messenger,” this would be it. As a commentator on CNBC’s “Fast Money,” pointed out Thursday night, a successful short seller isn’t someone who falsely shouts fire in a theater; it’s instead the person who first notices the theater is on fire.

media kingdom September 19, 2008 at 11:27 am

still, it's hard to object to the government's mass bailouts as similar debt-producing methods were put into action to bring the U.S. out of the Depression… our economy has been supported and driven by debt ever since

Hans Bader September 19, 2008 at 12:54 pm

Thanks. But the whole point of my blog post was that the debt-producing methods in the Depression were part of an overall government policy that was less effective than the government simply doing nothing in the 1920-21 recession.(It's true that World War II, which created debt, did bring the U.S. out of the Depression, but early pump-priming indebtedness during the New Deal didn't produce a lasting, or substantial, recovery, unlike the economic boom in the 1920s, which followed the 1920-21 recession, in which the government did nothing. Great Britain, which cut public employee salaries and spending during the Great Depression, actually fared better during the Depression than the U.S., which increased spending heavily during the New Deal).(Admittedly, the Smoot-Hawley tariff and other factors like Fed policy also contributed to the Great Depression lingering).

dude September 19, 2008 at 4:52 pm

you never really explained how the bailout will lead to future bubbles and I don't know enough about this to read between the lines

dude September 19, 2008 at 4:55 pm

"This is a terrible, rotten idea that will encourage financial bubbles for generations into the future by rewarding mismanaged banks and companies."never mind :)

max September 20, 2008 at 9:14 am

Great article, please send this message to most of the media, etc.

P September 20, 2008 at 10:29 am

To paraphrase Homer Simpson: Government-the cause of and solution to all of life's problems.

Weasel-be-gone September 20, 2008 at 12:56 pm

This bailout plan just reinforces the moral hazard that has encouraged speculators to take extraordinary risks knowing that the government will come to the rescue when the chips turn against them. Who wouldn't like a game of "Heads I win big, tails I still don't lose"? Fannie Mae and Freddie Mac were tripping over themselves to guarantee loans that essentially amount to no or little money down. Then when the real estate market sours, of course the collateral backing these loans fall far short of the loan balance. These organizations together with banks are responsible for inflating the real estate bubble. Now tax payers are on the hook for these collapsing loans.

killben September 20, 2008 at 5:50 pm

correct … no bailout …. institutions took risks …. made money .. fine … but don't come to taxpayers when the going gets tough.. now it is payback time .. got to rest…home prices are inflated … do you want it to remain inflated ….if the bailout does not go through, institutions will fail, markets will crash …. there will be pain … but house prices will drop … and you and me can buy homes at the right price and not inflated prices…SO NO BAILOUT PLEASE … SO NEXT QUESTION …CAN A TAXPAYER ONLY RANT OR CAN HE DO ANYTHING … LIKE FILING A LAWSUIT … WHICH THE CLEVER TREASURY SECRETARY HAS FORESEE N…. AND ENSURED HE IS ABOVE LAW TO FEATHER FIN INSTITUTIONS NEST

Topcat September 21, 2008 at 1:43 pm

Idiotic analysis. The rationale that these bubbles have been caused, or will be caused by, a mentality that assumes risk takers assumed a 'bailout safety net that would save them from ruin is inane. By the time the AIG bailout was put on the table the stock price was gone by 95%, and they were on their 3rd CEO in 3 years.Likewise for all the others, so I'm not sure where the 'reward' for all this is.And where was the bailout waiting for the bubble-bust? And we are in the middle of our THIRD bubble/bust cycle in less than 10 years, if you look at what has gone on with the price of oil over the last 18 months. Wall Street makes their money off of FEES, not the up-and-down value of the market itself. It's a fee-generating machine, and as long as that machine is intact, we will have an unstable economy.Absentee investors get ruined by the bubble-bust cycle, not Wall Street. Their money is LONG gone by the time the implosion unfolds.Rail on about the need for 'free market solutions.' This is EXACTLY what laissez-faire delivers: Rampant, de-stabilizing speculation. Everything we've seen on Wall Street over the past 25 years is a RESULT of deregulation. The SEC rules to limit this crap were in place and worked fine for 40+ years; they've been unwound bit-by-bit since the Reagan Administration, and now we're re-living history. And last, If short sellers actually dampened irrational investing, why the 3 massive bubble cycles in 10 years? Sure, it works really well at stopping speculation…

jjfoley September 21, 2008 at 5:02 pm

Ha Ha Ha…I came to this site to see what the cowardly MISS Coulter would have to say about her party's spectacular failure and the establishment of American SOcialism brought to you by BushCO…lo and behold, the queen of hate instead focuses her latest rant on yet another meaningless distraction…she would never have the guts or the spine to speak the truth anyway. I knew that, but was just checking…enjoy the meltdown Ann…keep wracking your brain to figure out how all those subprime vendors were really Fannie Mae, Freddy Mac (they were not) and how the liberals caused it all…LOL. is it getting hot in hell dearie?

jjfoley September 21, 2008 at 5:11 pm

I have been in lending (mortgages) for 14 years…the lending that occurred under CLinton and Fannie/Freddie was a completely different animal from the new subprime lenders that came along in 04 and later…but I see that the Republicans are desperately trying to put them all in the same basket so they can spread the blame around…I worked for Bank of America until 2ooo and they pioneered some of the riskier loans to Hispanics with only 3% down and not verifying income…it was nuts…they were not sold to Fannie/Freddie…that was something they were able to do because they kept the loans…after they performed for a while, they were able to sell them to Wall St and it only got worse from there…it had nothing to do with Democrats lobbying…Bank of A was looking to create a profitable niche and it worked…with all the Mexicans coming in and buying housing, it was a free for all money grab. Yet I sit here and watch you people blame the actions of one of the biggest monolithic corporations on the "liberals?" Just take responsibility or lose all credibility once and for all. The Repubs wanted an unfettered market and got it. Now the crooks and incompetents expect Joe Smith to pay while they walked away with tens of millions…I can think of a good use for Guantano…throw these people in there where they belong…with enough time to contemplate the damage they have done to Main St..

SporkLift Driver September 22, 2008 at 6:55 am

The housing bubble probably would have occurred without government intervention. But government HAS intervened to keep it going. This has led to the final bursting of the bubble being a market wrecking event.Short sellers don't get involved until the bubble bursts so you can't blame them for the bubble in the first place.

David Harvey September 22, 2008 at 10:06 pm

I disagree; best case scenario, global financial collapse; worst case, the end of the world as we know it.

Mike September 23, 2008 at 6:58 am

This poster says it all<img src="; border="0" alt="Government: If you think the problems we make are bad, wait until you see the solutions">

edward September 23, 2008 at 7:02 am

Topcat – excellent points! This entire issue is about deregulation. For years we heard from the current admin ( and mr. mccain) how necessary deregulation was and how the leaders of big business were sooooo responsible and honorable. All we needed to do was set them free. On top of that, Bush presided over an economy that was holding up simply because of the inflated, quickly rising prices of real estate. The problem came when these artificially inflated prices ran too far ahead of the salaries of the public. Something had to be done or housing prices would stagnate and the house of cards would fall. The solution? Lay off the regulations, allow "liar" or self stated income loans, promote dangerous variable rate loans that counted on prices rising at an incredible rate to keep the owner in their house, etc….Bottom line: there was a clear signal sent from Washington to the banks to circumvent both the regs and also any responsible business ethics. As long as housing prices kept rising everything was ok. The problem was that you even run out of qualified buyers in these ridiculous mortgages as the price of an 800 sq ft., 50 year old house goes to almost $1 million!This bailout will ultimately destroy the dollar as well as keeping house prices artificially inflated, thus keeping demand low. Interest rates will skyrocket in response to the inflation caused. This "cure" is worse than the disease!

Robert Eastman September 28, 2008 at 5:07 pm

Does anyone realize that the Federal Government purposely promoted Real Estate price escalations so that local government revenues (RE Taxes) would skyrocket. Many areas had a 20% per year apprecation for close to a decade resulting in a doubling of value every 3 to 4 years. After 8 years RE prices had risen 4X, thus boosting local tax revenues by 4X. The biggest complaint of local governments was "unfunded Federal mandates" and rising operating costs. Many municipalities were facing bankruptcies. The Fed came to the rescue with EZ – cheap money for housing thus fueling the RE price boom.While everyone was "dancing in the streets" celebrating their new found wealth, they ignored their increasingly painful tax burdens. As long as there was free flowing wine, the party was fine! Now that the party is over and everyone is sobering up, the hangover is going to be a killer!

George Boling October 4, 2008 at 6:51 am

I just watched Ann Coulter on Niel Cavuto's saturday moring show. She said only the democrats were responsible for this current mess. This may be true but the republicans went along with the democrats policies. The question is why? The answer is that they would have been voted out of office if they had not. While Bill Clinton was president the computer industry boomed and while it did the economy boomed along with raising the standard of living of the american people like it had never been before. The government gets no credit for this boom. It came as the result of new ideas and good business. After 8 years the new ideas ran out and the big boom stopped along with the flow of big money. This signaled a big turn down in our economy and if this was allowed to happen the people would have responded by changing the people in goverment. The solution to the problem the government came up with was to start the money flowing by allowing anyone who was interested to borrow money even if they could't pay it back. It worked the money flowed and severe finatial slow down was posponed untill now. They have now decided that the solution to the problem is to make more money available for loans. This may work but I don't see how all I see is that it may again pospone the problem. They are trying to solve the problem the same way as it was created.

ragavendra October 14, 2008 at 7:19 pm

if this bail out saves the economy then there may not be any harm.if not will lead to future bubbles.

Credit Card Debt

WeTheSheeple November 20, 2008 at 4:29 pm

I am an independent. I just want to get to the root of the problem which seems to be fractional reserve banking. The banks need to get bailed out because they do not have enough reserves to cover their outstanding loans. Under a 100% reserve system, the money would have been there and no bailout would have been necessary. Furthermore, under a 100% reserve system, the boom bust cycles in the real world (not necessarily speculative stock markets) would be a thing of the past. Is my analysis accurate?

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