Forest fires are extremely unpleasant, especially when viewed from up close. They’re scary and destructive and can be deadly for those caught in their path. But they’re also essential to the long-term health of any forest ecosystem. They clear out deadwood, control pests and disease, and return nutrients to the ground so that a new generation of growth can take hold.
The same is true of market crashes. They’re painful, frightening, and sometimes essential to purge the excesses and distortions created by long periods of growth and prosperity.
But accepting that idea in principle is easy. Embracing it in reality can be terrifying. Last week, the U.S. government and the titans of American finance looked out at the flames enveloping Wall Street and panicked.
Coming hot on the heels of a US$200-billion bailout of giant mortgage guarantors Fannie Mae and Freddie Mac, and a US$29-billion lifeline for distressed brokerage Bear Stearns, Treasury Secretary Henry Paulson launched a US$85-billion de facto nationalization of insurance giant AIG, followed by a temporary ban on short selling financial stocks (a method used by sophisticated investors to profit on market declines), and a US$180-billion credit line to shore up money market mutual funds. But Paulson’s audacious tax-payer-funded intervention wasn’t finished there. He also put together a plan to have the government clear bad debts from the balance sheets of America’s major financial institutions just as it did during the savings and loan crisis of the late 1980s. No exact price tag yet, but Paulson acknowledged the cost would run into the hundreds of billions of dollars. Taken all together this represents a sweeping redefinition of the relationship between private enterprise and public finance.
Paulson’s rescue of AIG was particularly shocking because it came just 48 hours after he refused a similar lifeline to the venerable brokerage Lehman Bros. In fact, Paulson said he never even considered bailing out Lehman, because it was not the role of government to backstop private companies that get into trouble all on their own. He reversed himself in AIG’s case because to fail to do so, experts said, would have triggered a massive global market panic, and almost certainly a stock market crash. Paulson’s actions, in other words, are based entirely on the cold calculus of pragmatism, rather than principle. Lehman was allowed to fail because it was too small to matter. AIG was saved because it was too big to abandon.
You might think that people would have a problem with this—that some might think principles and guiding philosophies are important, because they allow the world to anticipate and evaluate the ways that public officials will use public funds. But, by and large, the reaction to Paulson’s moves has ranged from laudatory to resigned acceptance. There are a few outraged voices—über-investor Jim Rogers decried the Fannie/Freddie bailouts as madness, insanity and “socialism for the rich,” pointing out that they have massively increased the American national debt to help “a bunch of crooks and incompetents.” But generally, even hard-core conservatives have fallen back on the “desperate times call for desperate measures” rationale.
Still, even in pragmatic terms, Paulson’s strategy is problematic and worrisome. For one thing, it implicitly encourages financial firms to be even more reckless and aggressive. After all, Lehman was allowed to fail because it didn’t have enough exposure to toxic mortgages and other distressed debt. AIG was saved because it had too much. The lesson: load up on junk, and one day you too could be an arm of the federal government.
More importantly, the so-called “Paulson Doctrine” offers even more uncertainty to a system that thrives on stability. Until this week, private companies operated on the assumption of “moral hazard”—that companies and executives can expect to bear the full consequences of their bad decisions. Paulson has replaced that concept with what some academics call “constructive ambiguity.” In other words, you just never know when, or how or why the federal government might intervene. They will make all decisions on a case-by-case basis, focusing on expediency rather than fuzzy principles.
There’s no denying the immediate benefits of the Paulson Doctrine. Pumping half a trillion dollars into the financial system in a week certainly managed to brighten the outlook on trading floors around the world and spared consumers the trauma of plunging stock prices, even more housing carnage and quite possibly widespread job losses. The Dow Jones Industrial Average jumped 1,000 points between noon Thursday and the end of the day Friday. But the celebrations on Wall Street only confirm that the short-term thinking that created this mess remains unchanged.
The central, misguided conceit of Paulson’s bailout effort is that market crashes can be prevented with sufficient will and abundant capital. They can not. They can only be delayed, dispersed and slowed.
Bad debts have not disappeared, they have simply been moved from a place where they are highly visible to a place where they are more or less hidden. Risks have not been defused, they have been shifted from huge private institutions onto the backs of ordinary taxpayers. In a best-case scenario, the costs will linger for decades through higher payments on the national debt and a weaker U.S. dollar—a slow drain of wealth that might otherwise have paid for roads and schools and hospitals and national defence, and will make it even more difficult to support the future strength of the U.S. economy.
The worst-case scenario? The real estate market continues to tank. Then you get all the same consequences except a lot bigger, a lot sooner, and a lot harder to conceal.
“I am convinced that this hold-the-fort approach will cost American families far less than the alternative,” Paulson said on Friday. Let’s hope he’s right. But let’s be honest too: he’s not “holding the fort,” he’s selling it.