361497_PA364_1stClass:361497_PA364_1stClass 3/12/2009 9:08 AM Page 1 No. 634 March 23, 2009 Financial Crisis and Public Policy by Jagadeesh Gokhale Executive Summary This Policy Analysis explains the antecedents its implementation appears panicky—marked by of the current global financial crisis and critical- a knee-jerk trial-and-error process that may have ly examines the reasoning behind the U.S. heightened market uncertainty. Worse, current Treasury and Federal Reserve’s actions to prop interventions in market processes and institu- up the financial sector. It argues that recovery tions could become permanent, to the probable from the financial crisis is likely to be slow with detriment of the nation’s long-term economic or without the government’s bailout actions. prospects. With or without the bailout, the An oil price spike and a wealth shock in hous- ongoing recession is likely to be deep and long. ing initiated the financial crisis. Declines in From a philosophical perspective, any bailout stock values are intensifying that shock, threat- action provides a host of bad incentives. ening to deepen the current recession as U.S. Moreover, we should be mindful that future gen- consumers and investors cut their expenditures. erations already face massive debt burdens from An offsetting wealth injection from additional entitlement programs. Increasing those burdens risk-bearing investors could initiate a quicker by expanding the bailout program or enacting a recovery. Thus, supporters of government inter- massive fiscal stimulus will hasten the long- vention justify the bailout’s debt-financed fund anticipated crisis in entitlement programs. Thus, injections—in essence, they want to compel the ongoing economic crisis could usher in per- future taxpayers to join the group of today’s risk- manently higher taxes, greater government bearing investors. involvement in the private sector, and a pro- However, the bailout is poorly designed and longed period of slower economic growth. _____________________________________________________________________________________________________ Jagadeesh Gokhale is a senior fellow at the Cato Institute and author of Social Security: A Fresh Look at Reform Alternatives (forthcoming). PA Masthead.indd 1 2/9/06 2:08:34 PM 361497_PA364_1stClass:361497_PA364_1stClass 3/12/2009 9:08 AM Page 2 From a This Policy Analysis, however, examines the philosophical Introduction bailout from an economic perspective. Skep- tics of the bailout believe that struggling finan - perspective, any In October 2008, Congress approved a pro - cial firms should be left to fall into bankruptcy. bailout action posal by Bush administration Treasury secre - They believe that the sooner those firms col - provides a host of tary Henry Paulson and Federal Reserve chair - lapse and their assets are purchased by healthi - man Ben Bernanke to spend up to $700 billion er competitors, the sooner the financial sector bad incentives. of government funds to shore up the U.S. can restructure itself to restore normal credit financial system. The plan initially envisioned flows that are vital to maintaining the broader using those funds to buy financial assets— economy’s health over the long term. From this mostly mortgage-backed securities held by perspective, the congressional bailout plan will banks and other financial institutions—that only delay proper asset revaluation and have lost value in the wake of the housing bub - resumption of normal credit flows. Thus, it will ble. Uncertainties about how far home prices prolong the recession triggered by the bursting will continue to decline and about the likeli - of the housing bubble as government interven - hood of future mortgage defaults have made tion slows needed structural adjustments in those securities “toxic.” Financial market par - the financial sector. 1 Unless market forces are ticipants’ unwillingness to lend to or trade with allowed to eliminate insolvent financial com - institutions holding large amounts of such panies through bankruptcy, restructuring, and securities—especially those backed by subprime resale, there can be no lasting economic recov - mortgages with declining ratings—has disrupt - ery, say bailout skeptics. ed credit flows among bank and nonbank Most participants in the bailout policy financial institutions. The convoluted structure debate envision an eventual return to normal - of financial contracts for securitizing and cy—with bank balance sheets restored and insuring mortgage pools makes their valuation credit flows operating at customary levels. The difficult and has contributed to the decline in question is about which policies are appropri - market transactions in these securities. ate to the goal of making the intervening Paulson and Bernanke initially believed recession shorter and shallower. that government purchase of the securities at prices determined through auctions would refuel finance by replacing toxic assets with Recessions: Oil Shocks government cash. However, in the weeks fol - versus Financial Shocks lowing the congressional vote, the bailout evolved into a plan to spend at least $250 bil - Postwar U.S. recessions have usually been lion of the allocated money on purchasing the result of oil shocks combined with restric - preferred stock in banks and other financial tive monetary policies adopted by the Federal companies. That would not eliminate the tox - Reserve to prevent higher energy prices from ic assets from those firms’ books, but it would inducing a broader inflationary spiral. Oil infuse the firms with additional capital in the price spikes require firms and households to hope of reigniting credit transactions and implement structural adjustments: alter pro - restoring the financial sector to normalcy. duction technologies to economize on energy Regardless of the details, government use or shift to cheaper energy sources. Firms efforts to bail out the financial sector have that cannot adapt technologies to conserve met with sharp criticism. There is a strong energy inputs must scale back operations or sentiment among the public that their tax fold. Eventually, new firms emerge in less ener - dollars should not be used to shore up the gy-intensive sectors, especially services. Most health of financial firms that made poor eco - economists agree that in such an environ - nomic decisions. It is difficult to disagree with ment, allowing market price signals to facili - that sentiment. tate needed structural change, rather than 2 361497_PA364_1stClass:361497_PA364_1stClass 3/12/2009 9:08 AM Page 3 Figure 1 World Spot Crude Oil Prices 160 140 120 l e r r a 100 b r e p 80 s r a l l o 60 D 40 20 Now, although 0 oil prices have 2000 2001 2002 2003 2004 2005 2006 2007 2008 pulled back Source: U.S. Energy Information Agency. substantially from peak levels, government-determined resource allocation, substantially from peak levels, the main force the main force is the best approach. propelling economic decline is the continued Although the price of oil has receded in devaluation of the nation’s housing stock. propelling recent months, the trend in oil prices has That decline is sustained by the now-large economic decline been positive so far during this decade inventory of unsold homes and gathering (Figure 1). Oil prices have been creeping momentum in mortgage defaults and home is the continued upward since December 2002 but did not foreclosures. 3 Figure 2 shows the Case-Shiller devaluation of interrupt the post-2003 surge in housing index of home values—a composite index the nation’s prices (Figure 2). The oil price increase was based on home price samples in 20 U.S. continual, however, through 2006—rising major metropolitan areas. It shows that housing stock. from $30 per barrel during late 2003 to home price changes had moderated for a few almost $70 per barrel by mid-2006. That sus - months during the spring of 2002. 4 Had that tained increase in oil prices is associated with moderation been maintained, home prices a declining trend in U.S. non-oil consumer might have remained close to their long-term spending growth and probably caused hous - trend through 2003, as shown in Figure 2. ing price increases to slow during 2006. 2 One reason for the rapid escalation in home After all, most new home construction in prices through 2006, which was far faster than major metropolitan areas was occurring in the long-term trend and happened despite ris - far-flung suburbs, and energy cost increases ing oil prices, was the populist political agenda meant households could no longer commit of promoting home ownership. The genesis of to lifestyles requiring high energy and com - a reinvigorated push for increased homeown - muting costs. The slowdown in home price ership can be dated to President Bill Clinton’s appreciation was tipped into a downturn by support, through the Department of Housing the subsequent, increase in oil prices that and Urban Development, for expanded home - lasted from early 2007 through mid-2008. ownership by first-time, low-income, and Now, although oil prices have pulled back minority homebuyers. Policymakers weakened 3 361497_PA364_1stClass:361497_PA364_1stClass 3/12/2009 9:08 AM Page 4 Figure 2 Composite Case-Shiller Home Price Index 250 Trend through December 2003 Projected Trend 200 CoCmopmopsiotseitCeaCsea-sSeh-Silhleilrler HoomeePPrriicceeIInnddeex x e u l 150 a v x e d n I 100 50 0 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1 9 9 9 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 Source: Federal Reserve Bank of St. Louis. regulations governing mortgage loan eligibili - menced.