Broke? Blame The Government
Brian S. Wesbury and Robert Stein, 01.26.10, 12:01 AM EST
The private financial system didn't cause the recession.
Last week President Obama announced a new set of policies to deal with financial institutions that are "too big to fail." While a debate about too-big-to-fail institutions and policy is important, a more critical set of issues is being ignored.
First the Federal Reserve should have followed a rule for monetary policy, such as using the growth rate of nominal gross domestic product to guide short-term rates, or a gold standard, or the Taylor rule. If they had, the federal funds rate never would have been cut to 1% in 2003 and housing over-investment would have been either nonexistent or much less damaging.
Second, if mark-to-market accounting rules had not been re-instituted in late 2007, loan problems would have never spread as far or as fast as they eventually did in 2008. Mark-to-market accounting rules are pro-cyclical in the extreme--there is a reason FDR got rid of them in 1938. These accounting rules--which require banks to price assets to illiquid market bids, even when cash-flows are unimpeded--turn a problem in the financial system into a catastrophe.
The banking crisis of the early 1980s, also largely created by easy Fed policy, had more loan losses than the beginning of the 2007-08 crisis. Adding the early '80s bad debts in agriculture, oil and Latin America to those of the Savings & Loan Industry created bank losses of roughly 6% of GDP. Subprime and Alt-A loan losses in 2007 were roughly 4% of GDP. But once mark-to-market accounting started to accelerate, even those smaller losses undermined confidence and created a vicious feedback loop which put the system in jeopardy. While some argue that it is too-big-to-fail institutions that create systemic risk, it's really misapplied government action and policy that creates this risk.
Government action and reaction is why a large (but nonlethal) set of banking losses spread so rapidly and turned into the Panic of 2008.
Instead of suspending mark-to-market accounting rules in 2008 the Fed, Treasury, SEC and FDIC arbitrarily saved certain firms while allowing others to fail. The crisis accelerated after Lehman Brothers ( LEHMQ - news - people ) collapsed, which then led to more government bailouts. Instead of allowing banks to value loans using cash-flow, the government forced these loans to be priced to illiquid market prices. When this put institutions in technical violation of arbitrary capital requirements, Treasury Secretary Hank Paulson forced these banks to swallow TARP money and accept government ownership.
Many conservatives, who profess to believe in free markets, supported these government actions. In a de facto sense this support for government bailouts created a vacuum in Washington. People say, "If conservative Republicans supported emergency bank bailouts, then John Maynard Keynes must have been right. The free market system is inherently unstable. We need the government to save us from the animal spirit of greed." There are few left to defend free markets.
But Keynes wasn't right. It was government that caused the Panic of 2008, not the private financial system. If government had run a stable monetary policy and hadn't artificially boosted housing or enforced a dumb accounting rule, the Panic of 2008 would not have happened. Unfortunately, many leading conservatives do not see the world this way. They panicked in 2008 and supported government bailouts. This leaves them with little firm ground to stand on when debating the merits of more government action against banks.
With any luck, creative politicians can figure out how to circumvent this political stumbling block and focus on fixing the real problems of the financial crisis. Following a price rule for monetary policy would minimize the potential for bubbles, while suspending mark-to-market accounting would end the potential of a crisis spinning completely out of control.
Brian S. Wesbury is chief economist and Robert Stein senior economist at First Trust Advisors in Wheaton, Ill. They write a weekly columnfor Forbes. Brian S. Wesbury is the author of It's Not As Bad As You Think: Why Capitalism Trumps Fear and the Economy Will Thrive.