The Bailout of 2008

         The libertarian thought about bailouts is to be against them. Investors ought to absorb the losses from their bad decisions. That is what the ideology says, and in most times there is no question about it. It is a good principle.

         Then there are emergencies. They come perhaps once in a lifetime, and they raise the price of principle very high. Here is the view of JMD, a blogger at reason.com:

         “I made NO bad decisions. But my home value and retirement account are being wiped out cuz these a******* destroyed capitalism by figuring out how to pass on their risk to everyone else in the world… I’ll be damned if I’m gonna watch my entire net worth disappear just to save a f****** theory.”

         You can argue that JMD did make bad decisions — he bought the house and retirement investments that now irritate him — but it is a tautological argument, a kind of ontological argument. It has no fuel.

         The emergency broke in September 2008. Fannie Mae and Freddie Mac collapsed, Lehman Brothers collapsed, American International Group collapsed, Washington Mutual collapsed and Wachovia essentially did. Silent runs drained Morgan Stanley, Goldman Sachs and the money market funds, and a Putnam institutional fund briefly fell to 97 cents a share, scaring the Federal Reserve into guaranteeing all money-market funds.

         Across the Atlantic, European governments bailed out the largest bank in Belgium, the second-largest property lender in Germany, the third-largest bank in Iceland and a mortgage company in Britain. Ireland guaranteed all bank deposits.

         Big institutions were being shunned by other institutions afraid to touch them — ostracized, unofficially quarantined. A market system may do that — there is freedom of association among corporations — but in this case if Fan and Fred and AIG and WaMu and all these European lenders fell, then their securities would become infected as well, and bring disease to the healthy.

         This was not an ordinary economic sickness. It was a financial ebola, a plague of fear that could infect and kill a century-old institution within 48 hours. A theoretician might apply the normal rule: “Let the chips fall where they may.” But they were not chips and the people with actual responsibility were not going to do that. The one big place where they did it — with Lehman — convinced them not to do it again. Lehman had helped drag down AIG, as well as the Hypo Bank in Germany.

         The question for libertarians was: if panic could be stopped through government application of public credit, why not do it? To quote JMD, would you watch your entire net worth disappear, just to save a theory?

         JMD’s comments were appended to a Reason feature about the crisis. On Sept. 25, 2008, the magazine asked ten economic thinkers, at George Mason, Harvard, Duke, NYU, libertarian institutes, and in the press and blogosphere, the same set of questions, starting: “How bad is the current market situation?”

         Five said it was bad, very bad, “standing on a knife’s edge.” The others said in various ways that it was not so obviously bad. Two said they didn’t know. Chris Dillow, economic writer at Investor’s Chronicle, said, referring to the late Chicago economist Frank Knight:

         “No one knows! Our problem is one of Knightian uncertainty; we just don’t know (and banks themselves don’t know) what those illiquid mortgage derivatives are worth.”

         Dillow’s answer was about balance sheets — about how much certain mortgage-backed securities will really pay. It was a risk question, about the future, and maybe he was right that no one knew. Reason’s question was different. It was about market conditions, such as whether you can put certain mortgage-backed securities for sale and get any bids on them. It was a sentiment question, about the present. There you could know, and it did seem that things were on a knife-edge. The collapses said so. Henry Paulson’s behavior said so.

         Now, to the “bailout.”

         It is a loaded word. A bailout has come to mean a government act to make good the losses of big institutions. It is, on its face, an unfair thing, because some are bailed out and others pay for the bailout. It is the socialization of loss. 

         Do nothing, then? That was the libertarian consensus. But the supposed do-nothing option is not without government. When Lehman Brothers was allowed to fail, what happened? Lehman filed for protection under the federal bankruptcy law, which puts a judge in charge of it. That is government involvement. It is not the same kind as a taxpayer bailout, and is generally preferable, but it is not the absence of government.

         If putting big financial companies in bankruptcy causes unacceptable losses to third parties, maybe there is something wrong with bankruptcy as applied to big financial companies. The law is a human construct. It can be changed. When Treasury Secretary Paulson talked about a “conservancy” for Fan and Fred, with them growing for a time and then radically shrinking, it sounded like a variant of bankruptcy, not a bailout as such. Fan and Fred were taken over. So was AIG. Selling off the assets of AIG in an orderly manner also sounded like a bankruptcy.

         What is not available under ordinary bankruptcy, of course, is public credit. That is what the FDIC had when it seized Washington Mutual and sold off its branch network and portfolio to JP Morgan Chase. WaMu’s funders (including depositors) were protected, but its shareholders were not. The stock, which had been above $41 two years earlier, plunged to 11 cents. In none of the big failures were the shareholders any more than minimally “bailed out,” though bondholders did better.

         The Treasury’s $700 billion fund for buying “toxic assets” is troublesome. Opponents made it sound very much like free day at the dump — bring in your old mattresses and computer monitors and give ’em to us — but it, too, might be more reasonable than that. The Treasury could pay what these securities would fetch in a normal market. Not cost. Not a puffed-up value, but a kind of objective value, an estimated normal-market value as distinguished from value during a panic. The Treasury would hold the securities until the market calmed down, and then collect on their real value. The net cost to the public would likely be far less than $700 billion. The public liability — and the state power — would be temporary. 

         That’s what the Treasury’s sales pitch sounded like. Whether they’ll do it that way is another matter. And it is not the only possible rescue. Given that the financial problem is an impairment of capital, another rescue would be an injection of new capital, as the European governments had done, perhaps also with a “haircut” for creditors. I don’t know what’s best: there are hazards in not acting and hazards in acting. The hazards identified by libertarian opponents include some very real ones. But if there is a way to use public credit to keep the system from seizing up in a panic and having financial institutions around the world go down in a heap, then I swallow hard and consider supporting it, still not liking it.  As with JMD, I don’t want all my savings wiped out for a theory.

         I note that this was all happening six weeks before a presidential election in which the frontrunner was an admirer of Franklin Roosevelt. That raises another concern. I don’t want capitalism in ruins in the first hundred days of a president who wants to re-do the New Deal. One of those was enough.

         I knew that would fetch some libertarians, and it did. One was an old college roommate who I had talked with on Oct. 25. He had argued then that there was no crisis, citing the fact that his credit and debit cards still worked, and that life was going on around him. He thought the crisis had been cooked up in order to get the bailouts. Ah, I thought, a conspiracy theory.

         He wrote a letter to Liberty that was published in March 2009. What fetched him was the statement I quoted, “I don’t want all my savings wiped out…just to save a theory.” Speaking of theories, my old roommate — an engineer — replied:

         “In the physical sciences and engineering, we commonly use them to design machines and process upon which people depend for their lives. We utilize Bernoulli’s theory, for example, to sustain an airplane in flight. Economics is less scientific, but supposedly the theory of the free market gives us the most realistic and therefore the most accurate understanding of how markets work, and of the consequences of market interference.”

         He said I was embracing a new theory, Keynesianism. I didn’t think so. I just thought I was being realistic.

         The events of 2008 remain a problem for libertarians. Alan Greenspan was challenged on it, and famously admitted that a belief he’d held was wrong. That doesn’t mean libertarians have to junk their whole doctrine, but they have to admit that sometimes the financial industry can cook up a meal that poisons it. And they have to think about how to keep that from happening again.

         In the following piece I contrast the Austro-libertarian explanation of the crash of 2008 with a book by two journalists — and come down mostly on the side of the journalists. My double review was published in the August 2009 Liberty.

Tracing Blame

         Our economic disaster: Last summer I was reading about it in Paul Muolo and Matthew Padilla’s Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis (Wiley, 2008). In February my nose was in Thomas E. Woods’ Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Regnery, 2009). The two tales are very different. Muolo and Padilla’s “chain of blame” runs through Wall Street. Woods blames the government.

         Consider the authors. Woods is a professional libertarian. He works for the Ludwig von Mises Institute and is author of several libertarian or Christian books, including “The Politically Incorrect Guide to American History.” Muolo is from the trade press, having covered Fannie Mae, Freddie Mac, and the subprime lenders for National Mortgage News. Padilla wrote for the Orange County Register. The Register has a libertarian editorial page, but Padilla was on the business page and covered the subprime lenders because they were based in the Register’s circulation area, just south of Los Angeles.

         Chain of Blame is a business story. It’s journalism about people and their business creations: Angelo Mozilo of Countrywide Finance, Roland Arnall of Long Beach Mortgage, and Lewis Ranieri, who at Salomon Brothers invented the mortgage-backed security. The authors know these men and describe them. They trace the genealogy of the collateralized debt obligation and the sub-prime mortgage, the zero-option adjustable-rate mortgage and the “liar loan” — all the stuff that became “toxic assets.”

         Most of the book is descriptive. Muolo and Padilla are saying to the reader, “This is what was going on.” If they had put it on a diagram, the boxes might have been labeled, “mortgage borrower,” “mortgage originator,” “mortgage wholesaler,” “mortgage securitizer,” “security rating service,” and “security buyers.” All of these were in the private sector.

         Muolo and Padilla argue that blame should be placed where the planning was and where intelligence and foresight should have been. That was in the Wall Street investment houses. They invented the new securities and made them inscrutable to analysts. In the same vein, one might condemn the rating agencies, which pretended to evaluate them rationally, and such institutions as the insurance conglomerates AIG and ING, which pretended to understand what they were buying.

           In Muolo and Padilla’s mental diagram of all this, the Federal Reserve’s cheap-money policy of 2003-2004 is there, but it’s off on the edge. It’s a background condition, not an active cause. 

         Now come to Woods’ book. He states his thesis on page 13:

         “Blaming ‘greedy lenders’ or even foolish borrowers for what happened merely begs the question. What institutional factors gave rise to all the foolish lending and borrowing in the first place? Why did the banks have so much money available to lend in the mortgage market—so much that they could throw it even at applicants who lacked jobs, income, down payment money and good credit? These phenomena, as well as the housing bubble and the economic crisis more generally, are consistently traceable to government intervention in the economy.”

         In Woods’ view, the background condition is what’s important. Woods implicitly excuses everyone in Muolo and Padilla’s “chain of blame.” He doesn’t say he excuses them; he just doesn’t focus on them. His implicit view is that if private-sector lenders are throwing money at applicants with no income, it’s Alan Greenspan’s fault because Greenspan has lowered short-term interest rates to 1 percent. 

         This is putting ideology before eyeballing. We have a theory, we find some facts that plug into our theory, and voila! Our theory is good. We are good. And maybe our theory does bring explanatory order to some of the facts. The Fed did lower short rates to 1 percent, setting up a background condition for a mess. Congress did create Fannie and Freddie, pass the Community Reinvestment Act, and press bankers to make more loans to minorities, just as Woods says. He can legitimately trace a line to these things. But when he says that “the housing bubble and the economic crisis more generally, are consistently traceable to government intervention in the economy,” he is saying more.

         Think again of a diagram with lines and boxes.  Woods is putting government at the center of it—and portraying those who put lenders at the center as leftists railing against “greed.” This is a straw man. The mainstream financial press, of which Muolo and Padilla are a part, is not leftist.

         Woods habitually puts the private sector into the kind of phrases in which things just happen or become. Consider this, from page 21:

         “Although the driving force behind abandoning traditional lending standards was the federal government’s political goal of increasing homeownership, particularly among preferred minority groups, lending innovations like 100 percent loans became institutionalized features of the industry, particularly when the Fed had made banks flush with reserves to lend.”

          I am biased: I was a stockholder in one of the largest banks that failed. Unknown to me (because I wasn’t paying attention), my bank made bad loans–tens of billions worth of such grotesqueries as the zero-option ARM, a home loan in which the principal amount increases in the first five years. The CEO of my bank decided to make that kind of loan. The government didn’t order him to do it. Other CEOs didn’t do it. He did. His motivation was not to suck up to ACORN or the Federal Reserve Board. He was trying to make his bank big and successful. He knew he was violating the traditional rules of lending, but he had a theory of why he could do that, and his theory worked for a while. His bank did become big and successful. Then it was ruined — and so was I, in regard to my investment in it.

         All that is the government’s fault? Woods seems to think it is. His very language excuses. Consider the paragraph quoted above. The government was the “driving force” behind the irresponsibility of bankers. The Fed “made banks” have too much money. Hundred-percent mortgages “became institutionalized.”

         Mortgages became?

         I do not excuse the central bankers. One-percent money is high-proof stuff. The Austrian economists (libertarians) are right about that. Now, under President Obama, one-percent money is back again, and if the Fed keeps the bottle on the bar too long, eventually there will be another bacchanal. It probably won’t be in home mortgages, though. It will be in a different thing with different people making different mistakes. These differences will be important — economically important and also morally important, when it comes time to assign blame. Not all mistakes are government mistakes.

         I have another bias. Though my views are generally libertarian and I am writing here for a libertarian magazine, I make my living in mainstream journalism. For almost 20 years I was a business reporter for a daily newspaper — the job Matthew Padilla had when he was working on Chain of Blame. Done right, newspaper reporting is a facts-first job, not an ideology-first job. You have to have some theory, of course, to know what facts to look for, but it’s fairly basic. There are few decisions of high doctrine to make when you’re telling of the rise and fall of a loan company. 

         Muolo and Padilla focus their book on the mortgage lenders because that was the story of their daily journalism. One imagines that one of them said to the other, “You know, this would make a good book.” That approach helps Chain of Blame considerably, and also biases it.  When I imagine the best possible book about the Crash of ’08, it has more about the Fed in it, and more about Fannie Mae and Freddie Mac. It also has more about the people who bought the securitized mortgages — what was the matter with the people at AIG, anyway? But my ideal book would be like Muolo and Padilla’s book. It would not be like Woods’s book.

         The story of the Crash of ’08 cannot absolve players in the private sector, as so many defenders of the market do. Consider a final example: the rating agencies. These companies repeatedly stamped investment-grade OKs on products later discovered to be lethal. In my view, the raters should be condemned. Shunned. Tarred, feathered, and rolled in oyster shells, along with the CEO of the bank I had stock in. 

         In his book Woods gives the rating agencies two and a half paragraphs. There he quotes an assistant professor of economics from a college I’d never heard of — a libertarian who wrote his doctoral thesis on lynching and property rights — saying that the bond raters were just trying to please the Securities and Exchange Commission. The idea is that the SEC represents the interests of the liberal, ACORN-infected politicians who want mortgages for all. Then Woods says that the private rating agencies are “an SEC-created cartel,” with the unstated but obvious-to-a-libertarian implication that no defender of the private sector is obliged to defend them. Problem solved! Everything that is bad is once again “consistently traceable to government intervention.”

         It is possible to trace — and think what that means — every economic problem to government, if that is what you set out to do. But if you want an accurate explanation — an honest accounting of which causes are contributory, which are necessary and which, if any, are sufficient, you don’t set out with a predisposition to trace everything to one source. You immerse yourself in the facts, see what the connections are, and let the story itself tell you what the explanation is. This is what Muolo and Padilla try to do, and to a great extent, succeed in doing. It is what many libertarians ought to learn how to do.

         The Mises folks were pretty sore about this review. Thomas DiLorenzo of the Austro-libertarian Ludwig von Mises Institute wrote on the Mises Blog, July 16, 2009, that my criticism of his colleague’s book was “pure nonsense from the perspective of real libertarians,” and that my argument to focus on “facts” (his quotation marks) “is exactly the mode of analysis that statist enemies of economic freedom have employed for more than 150 years.”

Jeff Friedman, editor of Critical Review, sent me a note saying he liked my previous piece — and inviting me to review a special issue of his magazine on the crisis, Volume 21, Nos. 2 and 3, 2009. My review was printed in Liberty, November 2009.

Critical Decisions

The Great Recession has not been a good time for libertarians. The Left crows that the market has failed.  Deregulation failed. The great libertarian Alan Greenspan, who could not see a bubble until it popped in his face, admitted error. Feeling the sting of derision, libertarians have turned to their own theories, aiming for an exit door labeled “Not the Market.”

 Libertarian economists of the Austrian school, who have some wisdom about recessions, reassure us. For the purest Austrians the cause is never the market, because their theory of the market doesn’t have any recessions in it. Their theory is that investors are misled by the central bank, which misprices credit, making it too cheap, and that they rationally overinvest and create a boom. The implication is that if there were no mispricing of credit, there would be no boom, and therefore no bust.

 And yet we have had booms and recessions, and have been having them for 200 years, whether we had a central bank or not.

 That the Austrian theory has its finger on one of the causes is certainly true this time. But the history of markets, and of economic enthusiasms, belies the idea that the causal agent is always the central bank. Enthusiasms begin in the mind of man. They become fads, and they may affect lenders as well as borrowers, whether credit is mispriced or not. Capitalism has its ups and downs because capitalism allows people to make their own decisions, and people are prone to move in herds.

Market analyst and historian James Grant said it well in The Trouble with Prosperity (1996):

“Cycles in markets are inevitable, irrepressible, and indispensable. Even if some all-knowing central bank could create a state of economic perfection — measuring out growth in ideal, non-inflationary doses, neither too much nor too little — human beings would respond by overpaying for stocks and bonds. In this way they would restore imperfection.”       

Grant, who makes his living writing about the credit markets, wrote that book during “the great moderation,” the Volcker-Greenspan period of the 80s and 90s, in which upturns were extraordinarily long and downturns mild and short. His book was a warning that the financial firmament was still subject to earthquake. He was right. Crises are part of capitalism. But their details differ and require specific explanations. Particularly the recent one.