March 18, 2008
Dean Baker
The Guardian Unlimited, March 18, 2008
See article on original website
The American economy will be better off if the Federal Reserve stops squandering taxpayers’ money on bailing out failed investment banks.
The collapse of the housing bubble in the US continues to wreak havoc on the financial geniuses who fostered its growth. All over Wall Street, the mantra “Who could have known?” is being heard with every more frequency and greater expressions of pain.
Things got really serious last week, when Bear Stearns was placed on life support, and was then disposed of in a fire sale last weekend. One of the longstanding giants of Wall Street investment banking now has less value than a street corner lemonade stand, if not for the generosity of the Fed. The Fed lent money to Bear Stearns and its purchaser, JP Morgan Chase, under terms that no private lender would have agreed to. The risk that the Fed will end up with a substantial loss on its advances to Bear Stearns is quite large, with no prospect for any real return on its investment.
This raises the obvious question: why did the Fed, an agency of the US government, use our tax dollars to keep Bear Stearns and its rich managers and shareholders above water? After all, the government supposedly doesn’t have enough money to provide kids with healthcare and child care, to guarantee families decent housing or to meet a long list of other needs. Why do we have the money to lend tens of billions of dollars to prop up Bear Stearns at discounted interest rates?
There are two points about this bailout that should be clear. First, this is a bailout – we are handing money to Wall Street. Second, we don’t have to hand tens of billions of dollars to the country’s richest people to save the financial system.
The politicians will try to do their best to obscure the first point. They say “we aren’t giving them money – we’re lending money and we’re getting interest, so the government can make a profit.”
This is what politicians tell people who they think are stupid. No private bank would have lent money to JP Morgan Chase or Bear Stearns at the same interest rate and under the same terms as the Fed. (We know this for certain; otherwise Bears Stearn would not have run to the Fed.) When the government makes a loan at below market interest rates, it is giving away money. People on Wall Street know this very well, that is how they got to be fabulously rich: they borrow money at a lower interest rate than they lend it out.
If they can’t get away with the “no bailout” nonsense, the Wall Street welfare boys will then try the route of claiming that we have to bail them out in order to prevent the whole financial system from collapsing. Such a collapse could turn the recession into a depression, leaving millions unemployed for years.
This is also nonsense. We know how to keep banks operating even as they go into bankruptcy. The UK just did this with Northern Rock, a major bank that managed to get itself into huge trouble because of its holding of bad mortgage debt. After it was clear that the bank was insolvent, the Bank of England stepped in and essentially took over the bank. It replaced the incompetent managers who had ruined the bank and brought in a new team to straighten out the books. The plan is to resell the bank to the private sector once the books are in order.
In the mean time, the bank keeps operating. The depositors can continue to make deposits and withdrawals just as before. This prevents any chain reaction from bringing down the financial system.
The difference between the Northern Rock route and what happened with Bears Stearns last week is that in the Northern Rock, the highly paid managers that ruined the bank are sent packing. What will happen to those at Bear Stearns is not clear – its new owners are planning a wave of staff cuts, but many will be keeping their jobs. Similarly, the shareholders will get little or nothing. They own a bankrupt company, why should the government give them money?
As the financial crisis deepens, it is important that the public realize the distinction between what the Bank of England did with Northern Rock and the handouts from the Fed to Bear Stearns and JP Morgan Chase. There are other banks in serious trouble who are also looking to the Fed for help.
The best thing that the Fed can do is to go the Northern Rock route. Instead of giving more money to troubled banks, it should give less. It should end the Term Auction Facility and its other special mechanisms for injecting money into banks. The economy will recover quickest if we let the banks and the bankers get the full benefit of their own bad judgment. When they have written down their bad debts and are taken over by new management, the banks will again be able to play a productive role in financing growth.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, “Beat the Press,” where he discusses the media’s coverage of economic issues. You can find it at the American Prospect’s web site.
