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Trillion Dollar Bailout Will Lead to Future Bubbles

Why did the mortgage bubble occur?  One reason was probably that financial institutions engaged in irresponsible lending suspected they were too "big to fail," and that the government would bail them out if their investments went sour -- a perception fueled by the past bailouts of financial institutions like Continental Illinois National Bank and Long Term Capital Management, and companies like Chrysler.

Now, the government is confirming the accuracy of that perception by proposing a massive bailout of the financial sector, at a cost of perhaps a trillion dollars, by buying up banks' bad loans.  This is a terrible, rotten idea that will encourage financial bubbles for generations into the future by rewarding mismanaged banks and companies.  Congressional leaders have apparently signed off on this deal with the President in exchange for support for a costly multibillion-dollar stimulus package that would give welfare to liberal constituences, the way the previous $160 billion stimulus package did.

If there is no bailout, the economy may go into a recession, but then it will begin expanding again, and the reckless financial institutions that caused the recession will be punished with losses or bankruptcy.  That's more or less what happened in the sharp recession of 1920-21, which started out as nasty as the Great Depression, but quickly ended, unlike the Depression, and then gave way to an economic boom, because the government didn't meddle in the economy, and didn't bail anyone out.

Today, everyone talks about how, in theory, more regulation could have stopped the risky behavior that contributed to the bubble.  But regulation never lives up to neat theories about wise, omniscient regulators.  During the bubble, government officials of all ideological stripes were busy encouraging the risky behavior that caused to the mortgage bubble, not stopping it.  Liberal lawmakers were pushing risky loans to promote "affordable housing," "racial justice," and "diversity," while the Bush Administration was touting them as a way to increase homeownership rates and promote Bush's slogan of an "ownership society."

During bubbles, government regulators share the same herd instinct as people in the private sector, the difference being that they know even less than the private sector does about how markets work, as David Brooks notes today in the New York Times.  As Brooks notes, there is no way that a government regulator obsessed with promoting homeownership was going to tell a bank during the real estate boom that it should not make a risky mortgage loan to a poor person, no matter how prudent such advice would have been.  Having worked in the federal bureaucracy, and gained a real-world understanding of how bureaucracies work, I totally agree with Brooks.

As we previously noted, the Clinton Administration stupidly pressured banks to make risky loans to people who couldn't really afford houses in the name of promoting "affordable housing" and "racial justice." A liberal commentator notes in response that the Bush Administration likewise stupidly encouraged risky lending, proposing a "Zero Downpayment Initiative" to subsidize mortgage loans for people who were not responsible enough to save enough money for a downpayment.  (Those of us who saved enough money for a downpayment on our own were not eligible for that subsidy, and had to subsidize the irresponsible no-money-down borrowers with our tax dollars).

Many commentators, such as former FDIC Chairman Bill Isaac, believe that federal accounting regulations have aggravated the financial crisis and created a dangerous logjam in America's financial system.

Far from rewarding the people who warned against the housing and financial bubbles, the Administration is now cracking down on short-sellers, the people who accurately predict that risky assets are overpriced.  "This morning the SEC decided to ban all short selling on 799 financial stocks proving yet again we don't live in a free market."

John Berlau explains why short sellers are unsung heroes:

If ever there were a case “killing the messenger,” this would be it. As a commentator on CNBC's “Fast Money,” pointed out Thursday night, a successful short seller isn't someone who falsely shouts fire in a theater; it's instead the person who first notices the theater is on fire.