Rescue or Waste?

Why the bailout isn't working


Thank goodness Congress approved that bailout. Otherwise, the economy might be tanking.

Just a couple of weeks ago, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke asked Congress to approve a $700 billion rescue of the banking industry. Without this sudden, massive infusion of federal cash, we were told, economic disaster loomed. Prompt approval, on the other hand, would assure the solvency of the financial sector, thaw frozen credit flows, and give investors a badly needed dose of confidence.

In the end, Congress approved the package—seeing as how the alternative was rising unemployment, a plunging stock market, and corporations unable to borrow to cover their short-term obligations. Now, with the bailout proceeding according to plan, Americans are confronted with…rising unemployment, a plunging stock market, and corporations unable to borrow to cover their short-term obligations.

That is not how things were supposed to go. On Sept. 25, The Washington Post endorsed the administration's effort, warning that the nation faced a replay of 1929.

"This catastrophe can be avoided," said the editorial, "and it will be if government promptly and effectively addresses the immediate cause of financial distress—the toxic build-up in unmarketable mortgage-backed securities on bank balance sheets." (My emphasis.) The Treasury plan, it said, fit the bill.

But the effort to restore confidence and stabilize markets turned out to be, pardon the expression, a bust. After the bailout was signed into law on Friday, Oct. 3, investors had all weekend to contemplate its tonic properties but found none.

On Monday, the stock market looked like it had been pushed out of an airplane. The Federal Reserve was so alarmed by the credit situation that it decided to take the radical step of lending directly to businesses.

By then the rescue package was a fading memory. Instead of being safely contained, the turmoil intensified and spread far beyond Wall Street—to financial markets in Europe, Asia, and South America. Said a Tuesday news story in The New York Times, "Three days after the plan was approved, it looks like a pebble tossed into a churning sea."

The feds had decided to fill the markets with enough cash to burn a wet mule—only to see it have no apparent impact whatsoever. But we could have had no impact whatsoever for a lot less money.

You may remember that when the House of Representatives voted against the original rescue plan, it was blamed for the subsequent 778-point drop in the Dow Jones Industrial Average. This stomach-turning development was clear proof of the urgent need for the bailout.

But if a stock market's performance is the test of a policy, this one has failed. At best, the passage of the measure did no evident good. At worst, it backfired.

Harvard economist Jeffrey Miron suspects the latter. "The bailout approach will generate uncertainty about what's going to happen," he told me. "It's quite plausible that it has not calmed markets because no one knows what it means."

Instead of stimulating productive activity by removing doubt, it has impeded it by multiplying doubt. It has also encouraged lenders to hold off dealing with their bad debt in hopes of getting a better deal from the Treasury than they can dream of getting from anyone else. But postponing the banks' rendezvous with reality will not speed recovery.

The sheer size and unprecedented nature of the intervention generates a different kind of uncertainty—about how extensively the federal government will immerse itself in the economy from now on. The spectacle of Washington nationalizing private assets is bound to dishearten millions of investors who think that generally, the most helpful economic role for government is staying out of the way.

The rescue surrenders an important principle: that private sector mistakes should be borne by the people who make them. If the bailout means we may all get the bill anytime a company implodes, it will undermine the critical incentives of the market. In the long run, that will not strengthen the economy but weaken it.

Ditto if it means we are resolved to do the impossible—namely, live indefinitely even further and further beyond our means. Which, by the way, it does.

But none of this will deter our policymakers from sticking to their approach. Waist deep in the Big Muddy, and the big fool says to push on.