Treasury Secretary Henry Paulson, President George W. Bush, and Congress are getting ready to try an experimental procedure on America and it's going to cost Main Street big time. As the nation's economic doctor, Secretary Paulson gave the United States just a few months to live unless the federal government conducts radical surgery to rid us of the subprime mortgage cancer. Unfortunately, no one seems to want a second opinion. It's bailout or bankruptcy for all.
Conservative estimates put the cost of a meltdown at $14 trillion in losses-the size of the entire U.S. economy. Paulson is offering a fix that would cost $700 billion, a real bargain if the entire economy falls to Depression-era levels.
Paulson says he doesn't want to offer a massive Wall Street bailout, but he sees no alternatives. But there are. Some of them would even produce a faster short-term recovery while also benefiting America in the long-term. Releasing the private sector in response to this crisis would promote innovation instead of being complacently reactionary.
The immediate concern is lack of liquidity in today's markets. Paulson's believes the "illiquid assets" (assets no wants in today's market such as securitized subprime mortgages or homes that can't be sold) of America's financial institutions are the source of our banking woes. His plan is to buy up their bad loans, allowing banks to take these underperforming assets off their books. This would allow them to begin lending again to borrowers with a stronger financial track record and generate profits. Meanwhile, the federal government—U.S. taxpayers—are stuck with managing the old bad loans. That's the bailout.
Secondary concerns from Congress are centered on corporate liability. Democrats want a compensation cap leveled on Wall Street CEOs. Republicans don't want to reward their failed investments with a get-out-of-bankruptcy-free card. The details are still being debated in Congress, but these battles are primarily political, not economic. Limiting pay to punish executives wouldn't solve anything. It would only serve to drive good talent from top-level jobs while firms find loopholes to provide compensation in other ways (such as a company car or stock options). Moreover, the top executives at Lehman and AIG lost millions in their corporate failures. That's market accountability, not political grandstanding.
All this begs the $700 billion question: Is a federal bailout of the financial services industry necessary? The Founding Fathers used the Constitution to purposefully create a slow moving Congress. They didn't want it to make rash decisions. While the legislative branch is supposed to keep taxpayer interests first, they are also supposed to be a check on executive branch authority—not a rubber stamp on an imperial presidency.
Several alternative actions could be taken to meet both immediate and secondary concerns raised by the current financial turmoil:
First, Congress could eliminate or reduce the capital gains tax. Cutting federal taxes on corporations would allow them to use those funds they would have given the government to cover illiquid asset losses. This would protect taxpayers from loses if the Treasury were to buy up the bad illiquid assets and keep firms accountable for their actions.
Beyond allowing financial institutions to retain capital, cutting capital gains taxes would allow for firms not under pressure from subprime-related losses to grow larger, creating a more competitive market. These bigger firms could even become a source of private sector bailouts of failing firms through mergers and acquisitions. The more products and services offered to the economy, the greater consumption and import/export levels rise, increasing federal revenue.
Second, Congress could cut corporate taxes and small business taxes in general. Trimming taxes for "the rich" opens up new capital to be invested in a struggling economy. At a time when investor confidence in the stock market is low, a tax cut for businesses would encourage innovation and entrepreneurial activity. The effects would be similar to that of a stimulus package, only without the government's involvement or a redistribution of wealth.
Third, the SEC should suspend the "mark-to-market" accounting rules for long-term assets that are driving firms into bankruptcy. Essentially, these regulatory rules are forcing firms to value their assets at much lower prices than what they would be worth long-term. The intent of mark-to-market regulation was to keep firms from overvaluing themselves and deceiving investors. Instead the law has artificially devalued financial institutions as a whole, which hurts their investors. As Steve Forbes noted recently, "The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline."
This accounting clause has significantly contributed to the bankruptcies (or near bankruptcies) of Lehman Brothers, Merrill Lynch, AIG, Bear Stearns, Morgan Stanley, Citigroup, Washington Mutual, and many others. In order to keep firms from overvaluing themselves, Newt Gingrich has proposed a three-year rolling average mark-to-market policy.
Fourth, Congress should repeal Sarbanes-Oxley, which is driving away entrepreneurial spirit. This law, passed in the wake of the Enron and WorldCom collapses, was intended to rein in corporate fraud. But the rules it put in place have not protected America from perverse profit motives brought on by the "too big to fail" philosophy. It has instead frightened off new business ideas with bureaucratic nightmares—$3 million per startup annual accounting fees—that are weakening the economy.
Ultimately, the debate over what to do comes down to a threshold of pain and perspective. Capitalist philosophy suggests that short-term financial pain—even a great degree of pain—will prevent long-term financial destruction. The markets, in other words, are going through a cleansing process. But this is not acceptable to many, particularly the politically motivated, who always prefer to solve future problems at a later date.
Here's the issue: Are we willing to consider all treatment options, or will we dive for the quick, easy, and untested procedure and then hope for the best?
Anthony Randazzo is a research associate at the Reason Foundation.