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To Bail or Not to Bail

The Fed's decision.

12:00 AM, Mar 18, 2008 • By IRWIN M. STELZER
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There are four problems with all of this. The first is that bad news will continue to overwhelm good. If another investment bank hits the rocks, or even if there are less devastating events such as the $3 billion write-off recently announced by the masters of the financial universe at Goldman Sachs, fear will be the prevailing mood in the board rooms of America's banks.

Second, Bernanke is a tiny player in the mortgage market. The $200 billion of mortgages he will be taking on are a barely noticeable in the $11-trillion mortgage market. And even if he wants to convert the entire asset side of his balance sheet to mortgages, he only has another $400 billion to play with.

Third, so long as house prices continue falling, the value of mortgages will continue falling. And we seem to have a long way to go before house prices reach some bottom, excess inventories of unsold houses are absorbed, and the market turns up. You remember "up"--the only direction in which house prices ever go!
Finally, the Fed might be fighting yesterday's war, when the problem seemed to be a liquidity crisis. No one would lend to anyone else except at relatively high interest rates because of uncertainty as to the ability of the borrower to repay. The first round of Fed ammunition was fired from a blunderbuss, aimed at generally lowering interest rates to facilitate borrowing. No luck; long-term rates were immovable. The second round was fired from small arms weapons at the seize-up in credit markets, making some funds available to credit markets for very short periods on attractive terms. No luck, again. So now we have the heavy artillery: $200 billion of high-quality assets to replace those of lesser quality, a bail-out of Bear Stearns, more credit for investment banks. We won't know whether these shells have knocked down the barriers to lending for several weeks now.

Meanwhile, some nervous observers are saying that the enemy is no longer liquidity, but the threat of insolvency. It might just be that trading and lending in these paper assets has stopped because, gulp, the assets are worthless. We already have had billions in write-offs, and hundreds of billions more of such "marking to market" is in our futures. So steep will these write-downs be that the banks will find they are bust--what they owe to depositors and creditors exceeds the value of their shriveled assets. Unless they can get more capital, they will have to shutter their tellers' windows.

So far, sovereign wealth funds have put up that capital, but even they do not have deep enough pockets to shore up the entire U.S. banking system. Others are not exactly eager to sign up for a trip on what might prove to be the financial equivalent of the Titanic's first and last voyage. If things get really bad, the banks might conserve their existing capital by ending dividend payments, as Paulson is urging them to do. So far, they have ever so politely told him to fuggedaboutit, as we say in New York.

Faced with a systemic collapse of the banking system, the government can do one of two things. It can flood the economy with cash, driving up inflation and the nominal value of the assets underlying bank loans. Lenders would get repaid in depreciated dollars, a warning to them to keep their vaults locked next time someone wants to borrow the odd hundred million.

Or it can nationalize the debt. Taxpayers' funds would be conscripted, and pumped into failing financial institutions to prevent their collapse. Sound like Northern Rock in Britain? Or what our government did when Continental Illinois bank hit the rocks in 1984? Or what former treasury secretary and Harvard president Larry Summers, now a hedge fund adviser, says the government should "at least be thinking about"? Or what 32 of 51 economists surveyed by the Wall Street Journal say is now somewhere between likely and certain?

If it looks like a bail-out, and sound like a bail-out, it is a bail-out. But "Capitalism without failure is like religion without sin. It doesn't work," warns Carnegie Mellon professor Allan Meltzer. Guarantee lenders against failure and they will again lend and lend and lend, diverting resources to ill-conceived ventures, driving down productivity and living standards. Only if the shareholders are first wiped out, or if the taxpayers gain a real opportunity to profit in a recovery, can a government rescue package avoid becoming an invitation to a repeat disaster.

It is certainly true that we need failure to make capitalism work. But the cost should fall on those who made serious errors in pursuit of inordinate profits, not on innocent by-standers. It is the prospect of the infliction of pain on the innocent that makes it so difficult to balance the danger of moral hazard against the risk of a protracted downturn.

Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).