The meltdown of AIG, Merill Lynch, and Lehman Brothers in the last few days is remarkable. I’m nearly speechless at the scale of these failures and what they portend for the economy generally. I can’t pretend to fully understand their causes, likely consequences, and the desirability of particular regulations to avoid such failures in the future.
My first thought is that bailouts are a huge mistake. Risk has been made public, while the benefits of the last ten years have been notoriously private. Fed Chairman Bernanke has misdiagnosed these problems as a liquidity crisis rather than the predictable contraction of bad investments following an overheated expansion by the market responding to the combination of perverse incentives, cheap credit, and underregulation.
Speaking of regulation, conservatives should not necessarily oppose all of it. There is a big difference between price controls and regulations that address systems of private behavior with public consequences. For example, banking regulation to encourage transparency and solvency in the form of adequate reserves and sound investments is perfectly sensible, with or without the hook of banking insurance in the form of the FDIC, because banks operate as trustees of large amounts of private wealth deposited by relatively unsophisticated investors ill-equipped to oversee these institutions.
Unfortunately, central banking and deficit spending have made our government to some extent hostage to a handful of private investment banks that trade in government debt. The “liquidity crisis” is also a crisis of the government’s ability to deficit spend. Conservatives should not necessarily renounce some repudiation of that debt, if such a repudiation punished the enablers of mass government spending. Bad credit for the government would be a good thing for the public, making expensive endeavors like the Iraq War, farm subsidies, and prescription drug benefits a thing of the past. Regulation should aim above all at stability, transparency, and buffering of the economy as a whole from the actions of a small circle of risk-preferring speculators.
Government bailouts of entities on Wall Street, as well as large companies like AIG, would further entangle profit-motivated private businesses and the federal government, whose watchword should be fiscal restraint and immunity from the rise and fall of one sector of the economy. The Fed’s multiple bailouts of Bear Sterns, Fannie Mae and Freddie Mac, and now AIG invite the government to get more in bed with economic enterprises in order to control their decisions, in effect picking winners and losers. This would create a pretext for greater regulation of the content of economic activity–as opposed to the result-indifferent rules–in the name of protecting the government’s own interest in raising revenue.
A reckoning is on the way. There are something like $60T in underfunded “credit default swap” obligations out there. This is 6X the United States’ annual economic activity. The combination of parallel government debt, undersecuritized private debt, opaque securitized mortgage instruments, and the inevitable encroachment of these failures on ordinary financial institutions like banks and small business credit portends a sustained series of cascading failures. The market’s rally today is more like a death gasp.
Any conservative approach to economic regulation should first acknowledge what government does well and what it does poorly. Straightforward limits on certain volatile or fraud-laden economic activities–trading on margin, usury, risky bundling of subprime mortgages–should be distinguished from ill-advised price controls and government involvement in aggregate consumer preference for this or that product and service. Conservatives should also prefer the concentration of pain on the risk-takers rather than taxpayers. If Wall Street is bailed out–as it has now been on multiple occasions–it is unseemly and unsustainable to employ the rhetoric of obligation in relation to “upside down” homeowners and other under-water debtors. But this is exactly what recent events, including the giveaway to credit card companies several years ago and the taxpayer bailouts of companies like Fannie Mae and Freddie Mac and now AIG, mean.