Europe’s leaders stared into the abyss and finally decided to act. The nearly $1 trillion bailout package, arranged over the weekend, is intended to head off Greece’s default and stop the crisis from dragging under other weak economies — Portugal, Spain, Ireland and Italy are all vulnerable.

The European and American markets celebrated on Monday. The CAC-40 index in Paris rose almost 10 percent. The Dow Jones industrial average rose 3.9 percent. It was certainly the right thing to do. Coupled with the European Central Bank’s promise to buy bonds from stricken European countries, it arrested the financial turmoil — at least for now.

The last sentence is unintentionally prophetic, for whatever “good effects” the bailout supposedly will create, they will be short and will pave the way for future crises. While Greece and other European countries have been facing disaster, it is nothing like the disaster that looms because the economic piper has yet to be paid.

Keep in mind that the European Central Bank (ECB) is buying bonds with printed money, which means inflation. Like the United States, Europe is broke, and will be even more so once this “bailout” goes through.

For all of the talk of “rescuing” Greece, Spain, and Portugal, one wonders how the plan is supposed work. These are countries with bloated public sectors and militant public-employee unions. They also have stringent workplace rules for private firms and other government policies that raise business costs, contribute to high unemployment, and shackle private investment. The “rescue” packages supposedly deal with the public sector — although I am skeptical they will — but don’t address the barriers to economic growth.

Keynesians say all that is needed is a new dose of government spending. People will receive the money, spend it, clear inventories, and then companies will make more goods. The process will continue. In that view, all that matters is spending.

The ECB move smacks of what the Federal Reserve did in the 1920s when, in response to the overvalued British pound, it inflated the dollar, leading to the stock market bubble and collapse. By expanding the currency, the ECB will use inflation to prop up high union wages (and high business costs) in Greece, Spain, and Portugal.

However, the inflation also will produce at least a mini-boom in Germany and other European countries with somewhat stronger economies. While Keynesians see that as a good thing, Austrian economists see this policy as simply extending the errors of the previous boom, and at the end of the new booms another crisis awaits.

The problem is that the fundamentals of these economies are not right. People in those countries cannot maintain a decent standard of living because they are not producing enough in the private economy to keep the public-sector unions afloat. Unfortunately, these unions are so powerful that they can extort pay and work agreements that plunder the taxpayers, and now that the bailouts have arrived, look for the unions to be even more militant and violent.

These countries don’t need more inflation, contra Keynesians. They need to stop feeding the monster of public-employee unions and permit business to operate without being smothered by rules and regulations. But after being bailed out, these governments will go back to doing things as they always have, and the malinvestment will continue.

At some point the further rounds of inflation will no longer paper over the distortions and the resulting economic collapse will be much worse than it should have been. Thus instead of “saving” Greece, Spain, and Portugal, the central bankers only have put off the day of reckoning.

Goldman Sachs is taking a beating in the press because a Senate committee and the SEC are investing whether it engaged in wrongdoing by betting against the shaky mortgages fueling the housing boom and allegedly failing to disclose that fact to buyers of its “synthetic collateralized debt obligations.”

The allegation of wrongdoing is an empirical question, of course, but a few things occur to me at this point:

Financial firms have been roundly criticized for their “herd mentality,” that is, their incentive to run headlong into too-risky mortgage-backed instruments because everyone else was doing it. No firm wanted to be on the sidelines having to explain to its clients why everyone was making tons of money but them. Yet here Goldman went against the herd and it’s coming under fire precisely for that reason. By betting against the sustainability of the boom on the basis of hedge-fund trader John Paulson’s analysis, it injected needed information into the market. More information is always better than less, and there would be no social good from restrictions on short selling. Whether fraud was in the picture, I can’t say, but I am confident that Goldman’s hedge strategy — and its delight over making money when mortgage-backed securities started losing value — would have drawn criticism in any event. It’s a no-win situation.

Second, the absolutely worst place to get to the bottom of things is in Congress. Every member of the committee has an overriding incentive to engage in demagoguery. Goldman Sachs is not exactly a positive household name, so which congressman will resist the temptation to denounce the company in public? If there is evidence of criminal activity, there are agencies for such investigations. This is not to say that those agencies are above demagoguery — politically ambitious U.S. attorneys are notorious for it — but at least we should be spared the spectacle of self-righteous congressmen pontificating on matters for which the Congress itself is heavily responsible. We already must suffer the obscenity of Chris Dodd and Barney Frank rewriting the financial rules to prevent, so they say, a repeat of the debacle that they themselves did so much to bring about. These people are the systemic risk. Enough is enough.

Finally, we must not lose sight of the fact that whatever Goldman did, it was in the context of a corporatist State, a banking cartel, a banking cartel, and loose fiat money, in which Big Finance exercises extra-market power derived from the rules written by Congress and the regulatory agencies. These are hardly free-market enterprises, and it is no coincidence that former Goldman principals have their fingerprints all over the government’s bailout response to the meltdown and that the firm was a major beneficiary.

In an actual free market—without inflationary fiat money, implicit guarantees behind underwriters of dubious mortgages, and regulatory protection against open competition—a financial debacle such as we’ve seen is unlikely to have occurred. Even so, that doesn’t mean that everything that went on constitutes a crime.

Addendum, April 29: Rather than have the SEC or a criminal-justice agency pursue this case, the alleged victims — if that’s how they see themselves — ought to sue Goldman Sachs and John Paulson and at least front the costs of adjudication, saving the taxpayers the money. It is noteworthy that at the Senate hearing, no “victim” testified. Do they not see themselves as victims? Perhaps not. These are sophisticated institutional investors, one of which had a hand in creating the bundle of mortgage-backed securities (MBS) that underlay the synthetic CDO. (It rejected some MBS in favor of others.) The other investor would have been able to examine the contents. Clearly, they knew they had a different outlook on the future of those MBS from those who bet against them. For every buyer, there’s a seller, for every bull, a bear. One does not become a victim simply because one’s outlook proved to be wrong.

Nevertheless, this is worth reading. Other links worth following that case doubt on the SEC case:

Sebastian Mallaby

Richard Epstein

The story takes on a new aspect when we realize that Neil Barofsky, Treasury Special Inspector General of TARP, told both Rep. Thomas Carper of Delaware and Neil Cavuto of Fox Business News that GM repaid the loan with other borrowed money. How’s that again?

“It’s good news in that they’re reducing their debt, but they’re doing it by taking other available TARP money,” Barofsky said, according to Jamie Dupree of Cox Radio.

“It sounds like it’s kind of like taking money out of one pocket and putting in the other,” Carper said.

Barofsky nodded.

“The way that payment is going to be made is by drawing down on an equity facility of other TARP money,” he added.

In his exchange with Cavuto, Barofsky said:

“The one thing a lot of people overlook with this is where they got the money to pay the loan. It isn’t from earnings. They didn’t earn and extra 4 1/2 billion dollars. So there’s money in escrow.”

“Wait a minute,” Cavuto said, “They paid off a credit line with another credit line?”

“Exactly.”

Why is this not being widely reported?

Meanwhile, the Obama administration said it would cut by half (on average) the compensation of the highest-paid people at the seven companies still on taxpayer life support: AIG, Bank of America, Citigroup, General Motors, Chrysler, GMAC, and Chrysler Financial.

So here’s the puzzle: Is such government intrusion into the compensation process a good or bad thing?

Before answering, let’s remember that the taxpayers have been compelled to rescue lots of companies, banking and otherwise, over the last two years. The people’s exposure is immense. Neil Barofsky, special inspector general for Treasury’s financial sector rescue, says enormous surprise bailout costs will befall the country in addition to the $159 billion the Congressional Budget Office projects TARP will lose. Barofsky was referring to the cost of government borrowing and the potential cost of rewarding risky behavior.

Besides that, the Fed has been buying up billions of dollars in “toxic” (that is, worthless) mortgage-backed and other paper with money created from thin air. The new money threatens to ignite a monster price inflation when the banks begin to lend it. The impending dissipation of the people’s wealth at the hands of the Fed(eral Bureau of Counterfeiting) is another cost of the bipartisan government bailout of corporate finance. It’ll be a massive tax on the middle and working classes.

Well, then, shouldn’t the government have something to say about what goes on in those companies on the dole, executive pay in particular?

It’s tempting to say yes, but I think the best answer is no. I’m not totally comfortable with that answer, but it seems better than the alternative.

First off, we must reject the propaganda that the Treasury and the Fed are acting as the taxpayers’ agents by taking control of corporate compensation. Nothing can be further from the truth. They are the taxpayers’ adversaries and are only looking out for themselves. After all, they are the ones that exposed the taxpayers to these huge liabilities in the first place.

Moreover, it’s not really the taxpayers’ money the politicians are looking out for. In real terms, it’s now their money by virtue of legal plunder. The Bush administration tried to sell the public on the bailout by suggesting that the toxic assets (or bank shares) acquired by the government might one day be resold at a profit for the taxpayers. But if the assets do sell for more than the government paid, will taxes be cut to reflect the profit? Fat chance. Politicians tend to spend every penny they can get their hands on—and then some. It is they who would profit, not the taxpayers. They ain’t us.

Another reason to oppose government conditions on bailout money is that they are likely to make things worse. I seriously doubt whether anyone at the Fed or Treasury is qualified to design compensation packages that would encourage just the right amount of risk, not too much or too little.

A third reason to reject this government intervention is that it will serve as a justification for further intervention. Pay czar Kenneth Feinberg already says he hopes the pay scheme will become a model for the rest of Wall Street.

My final reason for saying no to the pay czar and bank regulators is that I want to make sure that such bailouts never happen again. Maybe the people will be less likely to acquiesce the next time if they see the current corporate rescue for the plunder it is.

We can’t change the past. The bailouts happened. Now we have to deal with the consequences. We should concentrate on stripping government of the power to bail out companies in the future. We should also begin to fully separate State and banking. A good start would be to abolish government deposit insurance, which only lulls depositors into a false sense of security and creates the very systemic risk the regulators say they want to avoid.

* * *

“Green jobs” are the magic words promising to bestow prosperity and environmental bliss through costless government manipulation. Do you need more reason to be skeptical? Andrew Morriss performs the debunking. Richard Fulmer adds an insight on the shortcomings of alternative energy sources.

In the mixed economy, is freedom’s glass half full or half empty? George Leef shows that this is more than a philosophical question.

Walmart inspires hisses and hosannas. Which are more deserved? Art Carden sorts it all out.

These days it’s especially popular to scapegoat anyone engaged in complex financial transactions not readily understood by laymen. Example: short sellers. They’re accused of manipulating the stock market for personal profit, so the government has its eye on them. Warren Gibson comes to the defense of this valuable yet unappreciated group.

The government’s money managers are willing to risk inflation to avoid deflation. Good idea? Steven Horwitz distinguishes good deflation from bad.

One of the great pieces of American folklore is that businessmen don’t like regulation. Bruce Yandle sets the record straight.

Here’s what our columnists have come up with this time around. Lawrence Reed declares himself a Locofoco. Donald Boudreaux won’t let Chinese currency manipulation keep him up at night. Stephen Davies demonstrates the power of historical myth. John Stossel looks at the tax system and doesn’t like what he sees. David Henderson says don’t fear the trade deficit. And Theodore Levy, encountering the claim that markets for medical care cannot work, remonstrates, “It Just Ain’t So!”

Volumes about the alleged failure of the market, a crusty old individualist, the law, and American public policy undergo scrutiny by our reviewers.

As we see in Moore’s new movie, Capitalism: A Love Story, Moore is offended by some truly offensive things: banks engaging in wild speculation without concern for the risk, taxpayer bailouts for banks and other businesses, cozy relations between Wall Street and Washington, politicians getting favors from companies that want benefits from government, and big institutions pushing less powerful individuals around. True, he’s offended by some inoffensive things as well, such as the cut in the 90 percent top income-tax rate years ago. But by and large, what he rails against should be railed against.

Had he called his movie State Capitalism: A Love Story, I might be applauding (with some reservations). But he’s targeting the more ambiguous “capitalism,” which he uses interchangeably with “the free market.” He can be forgiven for this, however. Most people would say that the current U.S. economic system is capitalist. Moore has probably heard that all his life. He’d hear it if he watched a Fox financial program. Would Ben Stein or Lawrence Kudlow disagree? Moore has also heard Republican politicians—George W. Bush, for example—praise the existing system, with all its deep government interventions, as capitalist. Bush did this even as he and Treasury Secretary Henry Paulson, former chief of Wall Street behemoth Goldman Sachs, stampeded Congress into passing the $700 billion TARP bailout last year. Moore takes such people at their word: The free market is capitalism, and capitalism is what we have today.

Vulgar Libertarianism

Can we blame him for thinking this way?

Yes, it’s sloppy thinking, and had he been more curious and read beyond the confines of “Progressive” literature, he could have gotten the straight story. But many knowledgeable advocates of the free market contribute to the confusion by exhibiting what Kevin Carson calls “vulgar libertarianism,” or what Roderick Long describes as “the tendency to treat the case for the free market as though it justified various unlovely features of actually existing corporatist society.” How often have you heard a free-market advocate condemn pro-business intervention in one breath, then defend existing dominant corporations in the next—as though they did not arise in the interventionist environment just condemned? Pro-market is not the same as pro-business. If some market advocates don’t understand that, why should Moore?

This may go a long way in explaining Moore’s aversion to profit—at least other people’s. He associates profit with business, which he associates with (state) capitalism. So for him, profit per se is suspect. But he should see a problem here. Does he think he’s exploiting moviegoers when his production company ends up with a profit? Do the co-ops and worker-owned firms he loves exploit their customers when they sell their products for more than their money costs?

Cornered like this, Moore might say he’s only against the excessive profits that capitalist market power permits. But now we’re back where we started. To the extent that intervention hampers competition by erecting barriers to entry—which is the usual effect, intended or not—protected firms are free to charge higher prices and reap more profits than would have been the case in an open market. Corporate power and privilege derive from political power and can’t exist without it. In contrast to existing capitalism, the truly free market would have no legal barriers to competitive entry, assuring that prices and returns are economically justified and not the fruits of privilege. Only the State permits business to make profits by withholding benefits from consumers.

But Moore doesn’t know this. What he “knows” is that the choice is between the current corrupt system—and it is corrupt—and some vaguely defined scheme of control by benevolent politicians, which he calls socialism and democracy.

In his movie Moore expresses affection for socialism, but he’s not clear what he means. He never advocates collectivization of the means of production or the abolition of markets. Instead he suggests that socialism means workers having a say in how the companies they work for are run. But why assume that’s anti-free-market? He praises worker-owned companies and notes that hundreds of them exist in the United States today. He might be surprised to learn that these things are entirely compatible with the free market. In fact, it’s a perfectly libertarian intuition to abhor being subject to the arbitrary whim of anyone—yes, even a private employer. If government regulatory and tax obstacles to new competition and self-employment did not exist, workers would have their maximum bargaining power and widest array of alternatives. I imagine we’d see more departures from the traditional firm. People used to get their “social insurance” from mutual aid societies. Maybe in a true free market, we’d see a bigger role for the employment counterpart to these public, yet not governmental, organizations.

What would Moore think about a system in which no one could collude with politicians to legally plunder the rest of us for his or her own benefit and everyone was free to enter into any cooperative arrangements to produce and offer goods to others in voluntary exchange? Michael, that’s the free market!

The Nirvana Fallacy: A Love Story

Of course, Moore naively looks to government to provide things. His movie laments that FDR died before he could see his Second Bill of Rights enacted. Roosevelt wanted government to guarantee everyone a good education, job, home, health care, and so on. Has Moore ever wondered where government would get the resources for this? He can’t really believe that somewhere there’s a massive pot of collective wealth waiting to be distributed. He must realize that the tax system would provide the money. But how can he not know that if government appears to penalize wealth creation with confiscation, less wealth will be created?

Moore is unaware that he commits the “Nirvana fallacy.” This is the erroneous idea that our choice is between the admittedly imperfect world we’re bound to live in if government leaves us alone and an imagined utopia in which benevolent and all-wise rulers oversee and regulate everything. Of course that is not the choice. Moore’s preferred system, whatever he calls it, would be run by individuals whose insights into the public interest would be no sharper and whose motives no purer than other people’s. However, since they would wield political power—which is the legal authority to compel obedience—they would be far more dangerous than anyone in a free market could ever be. He knows how corrupt politicians are. Why does he think different people would run things in his utopia? Does he really want them in charge of everyone’s job, education, health care, housing, pension, and the rest? It’s hard to understand why he isn’t uncomfortable with the idea of the people being tenants and employees of the State.

Whether he realizes it or not, Moore favors a system in which an elite necessarily would make critical decisions for the rest of us. He’d be incredulous to hear that, but if he ever comes to understand it, libertarians might end up with an unlikely ally.

Those perceptions have changed now that the Chrysler and GM bankruptcies have set a new standard for the fast resolution of some complex if dubious transactions. So troublesome questions arise: Did these transactions comply with the rule of law? Were the property rights of the secured creditors fully protected in the expedited proceedings? Will the process bring confidence to the credit markets? No, no, and no again. Those three “nos” come as no surprise. The basic classical liberal position is right to insist that the government cannot sensibly occupy the roles of market participant and market regulator simultaneously. All else is detail.

The Downward Spiral

The Chrysler and GM bankruptcies have both remote and proximate causes. The backstory starts 50 years ago with two major developments that sealed the long-term fate of the domestic automobile industry. First the strong union contracts negotiated under the National Labor Relations Act of 1935 enabled the unions to parlay strike threats into rich deals during the 1970s that promised a bonanza to their then-present and -retired workers. Similarly, the large dealer network of the former Big Three, which may have made sense in the 1950s, became entrenched by state dealer-franchise statutes. The joyride could not last. Detroit’s foreign competitors have lean dealer networks and no unions. It was only a matter of time before those foreigners flexed their economic muscle, at which point the Detroit companies lost market share, shed employees, and accrued massive retiree obligations.

Businesses this fragile cannot survive any external shock, especially the huge meltdown of September 2008. By March 2009 GM had about 61,000 unionized employees in the United States and over 500,000 retirees and their dependents in their various pension and healthcare plans. The liquidation value of its assets was estimated at about $8 billion against stated debts of $172 billion. Not viable. Chrysler was also under water but less so. Neither the Bush nor the Obama administration, however, was prepared to bite the bullet and let the bankruptcy courts slim down these bloated dinosaurs. Instead both administrations opted for billions in cash infusions in the desperate hope of keeping the bankruptcy wolves from the door. The unions for their part gave back some of their perks, including full pay for workers sitting idly on call in stuffy waiting rooms for jobs that would never return. Alas, the rigid bargaining structures with unions made these concessions both too little and too late. But once the Troubled Asset Relief Program (TARP) kicked in, Treasury doled out about $50 billion to keep GM afloat and about $4 billion to do the same for Chrysler.

The Bankruptcy Maneuvers

By early 2009 it was clear that more desperate measures were needed. Two political bankruptcies were the answer. The Chrysler and GM deals have much in common, but the Chrysler deal was more complex and more high-profile, so let’s start with it. Once it became clear that Chrysler could not operate as a stand-alone company, Treasury wooed the Italian automaker Fiat to take a stock position in the company, not for cold cash but for access to small-car technology and some international markets. For these intangibles it received between 20 and 35 percent of New Chrysler, depending on whether New Chrysler reaches certain milestones.

On many points, however, the two deals moved roughly in common. One key action was to keep the United Auto Workers’ (UAW) retiree benefits in play but to cut down on the dealership contracts. Some jujitsu was needed. Recall that the three basic bankruptcy options are liquidation, reorganization, and sale. The Chrysler numbers tell the story. A government expert witness testified that Chrysler was worth only $800 million if liquidated but could be worth as much as $2 billion if sold off intact to another firm. Under the standard bankruptcy rules the proceeds of that sale would be distributed according to a strict priority by claim type. Secured creditors, including the bondholders, come ahead of unsecured creditors, including union health and retirement funds. Without some fancy high-stepping it followed that a simple sale of the assets of the company for the indicated $2 billion would leave the secured creditors a bit under 30 cents on the dollar for their $6.5 billion in aggregate claims but wipe out all future contributions to the union retiree funds. Not good, thought the Obama administration.

To boost the UAW’s fortunes, Chrysler had to be “sold.” But under what rules? By conscious design the bidding was organized in a unique way. The UAW was given a seat at the table to figure out the conditions that would attach to a permissible bid. One of those conditions was to assume the liabilities needed to finance the union health funds at sums in excess of the stated asset values of the corporation.  To keep the union benefits alive, the parties created Chrysler VEBA—its Voluntary Employment Benefit Association—which ended up receiving a 55 percent equity interest in the New Chrysler corporation plus a $4.587 billion unsecured note from that company. New Chrysler was not asked to take over any liabilities for the dealers or indeed for the unsecured tort creditors (persons who were injured by Chrysler products).

When the dust settled, the government noted with some pride that its $2 billion bid was the only one. That sobering fact should not be taken as a sign of its business acumen but as an open confession of its suppression of any sensible auction. The correct process requires the sale of unencumbered assets, which for all we know could have been worth more than $2 billion if extricated from the losing union entanglements.

The GM deal had larger numbers but the same protection scheme for the GM VEBA. Under the previous deals between Old GM and the UAW, the company was liable for about $20 billion in unsecured retirement trust contributions. New GM offered GM VEBA 17.5 percent of its common stock, a new note for $2.5 billion, up to $6.5 billion in preferred stock, and a warrant that allowed New VEBA to purchase an additional 2.5 percent of New GM equity. GM’s other unsecured creditors were owed $27 billion, for which they received far less—somewhere between 10 and 12 percent of New GM, plus warrants. The unsecured creditors who started with more ended up with less. Once again the supposed bankruptcy sale that linked assets and liabilities allowed this financial inversion to go through.

The conscious decisions in both cases to tie the liabilities to the assets, however, totally transformed the proposed sales by cutting out all private bidders. How does an outsider bid for a business known to be underwater? Easy, for a negative value. It offers to take the company off the government’s hands if the government pays it a sum equal to the difference between the stated liabilities and the net asset value. Such negative bids are used whenever the Federal Reserve seeks a new owner for a failed bank whose liabilities exceed its assets’ negative value: The bank that demands the smallest government guarantee wins.

Of course, the Federal Reserve did not run these auctions, each of which had only one bidder. By design the Treasury put forward a bid for Chrysler that had to win. It was willing to pay the $2 billion to buy a business that had a net worth of minus $4.2 billion, computed as follows: Once the government paid off $2 billion to the secured creditors, it then executed its prearranged master plan to invest, in an “unrelated transaction,” an additional $6.2 billion to keep New Chrysler afloat. It now becomes painfully evident that the highly unusual step of tying the sale of Chrysler assets to the assumption of some of Chrysler’s union liabilities drove away all legitimate bidders. No one knows whether the government’s $2 billion valuation of Chrysler is fact or fancy. A government bid of a penny would have won as well, so long as retiree liabilities had to be assumed.
So why on earth should the bankruptcy court allow this novel step? To Bankruptcy Judge Arthur Gonzalez, the answer was easy:

New Chrysler views the skilled workforce as essential to its future operations and, as a natural consequence, has engaged in negotiations with their representative. As part of those negotiations, New Chrysler and the workers have reached agreement on terms for collective bargaining agreements with the UAW. As part of those negotiations, the parties also agreed to modify the funding arrangements for VEBA, the trust which funds benefits for employees and retirees.

Not credible. The onerous union contracts were one key reason for Chrysler’s steady decline before the financial crisis of 2008. No sane bidder affirms losing contracts. Ron Bloom, the administration’s automobile czar, submitted testimony at congressional hearings held in Detroit last July which stressed that the President prudently approved the deal only after the union made deep concessions. But why just ask for concessions? New Chrysler could have gotten a better deal still by starting with a clean slate that only comes from purchasing unencumbered assets. Suppose that thereafter New Chrysler wants to keep some of these workers; the sensible business approach is to hire back only those workers it wants under market-rate contracts in separate transactions. Other positions can be filled by new workers hungry for jobs in a falling economy. Worse still, it is completely inexplicable why New Chrysler wants to pay billions to present retirees in exchange for future work never to be performed. This giveaway corrupted the bidding process. The whole sale should have been set aside and a new sale of assets only should have been ordered.

GM presented somewhat different issues because the only secured creditors were the U.S. and Canadian governments, which ran the transaction. Even the U.S. government cannot shortchange itself, and here it did not look as though anything could ever be left over for unsecured creditors. But even so, there is no explanation as to why this deal favored the UAW unsecured creditors over the unsecured bondholders. The bottom line was another brand of UAW favoritism.

Sale or Reorganization?

The GM case did not provoke any follow-on litigation, so let’s concentrate on Chrysler, which did provoke a legal challenge by the outgunned Indiana Police Pension Fund with its tiny (under 1 percent) interest in Chrysler’s secured debt. How did Treasury deal with these pesky bondholders? Largely by running them out of court without ever letting them expose the soft underbelly of the arbitrary government bid. The key legal maneuver was a determination that the Indiana Pension Fund did not have standing to challenge a transaction in which it had received its fair share of the $2 billion sale value that represented the full asset value. Whatever else happened in the transaction was of no special concern to it, so it could not protest.

Lo and behold, that conclusion is correct if the transaction is a bona fide sale. But the transaction wasn’t bona fide because any bidder could only buy the assets by agreeing to take over the liabilities. It also wasn’t a sale because the UAW pension and health funds kept their interest in New Chrysler. At this point, as my NYU colleague Barry Adler explained in his testimony before a congressional committee, the deal looks more like a “reorganization” that let previous stakeholders in Chrysler retain an interest in the surviving entity. In this case it is easy to “step” the initial sale to the government with the subsequent deal with Fiat and the Chrysler VEBA into one continuous transaction whose result was to realign the interest of existing players. When the dust settled the UAW’s interest as an unsecured creditor of Old Chrysler was converted into an unsecured note from New Chrysler coupled with its new controlling shareholder position. A clean sale leaves no retained interest for any stakeholder in the sold business.

Unlike sales, reorganizations must meet explicit nondiscrimination requirements that require all unsecured creditors to be treated alike. The Indiana Pension Fund was unsecured to the extent that there was a shortfall in Chrysler assets. So it was right to say it should have been treated on a par with the UAW retirement funds, which were also unsecured creditors.

The Fund also had a second line of argument for its position as a secured creditor—that is, to the extent that some assets in Old Chrysler were available to satisfy claims. The Fund insisted that all non-TARP secured lenders should be treated as their own class. This point matters under reorganization rules because a majority of members in each distinct class must give their approval for the reorganization to go through. The Fund argued that its interests diverged from the TARP lenders, who only voted for this disadvantageous plan in response to veiled Treasury threats to go along.

Why did 99 percent of the secured creditors approve a transaction that subordinated their financial interests to unsecured creditors anyhow? Was their consent voluntary—or coerced? In his testimony before the Detroit congressional hearing, Indiana State Treasurer Richard E. Mourdock hinted darkly that undue pressure was placed on the TARP lenders—JP Morgan Chase, Citigroup, Goldman Sachs, and Morgan Stanley—to vote in favor of the sale/reorganization or else. What counts as the “or else” is hard to say because everyone was mum on these communications. No evidence of that sort was presented at trial, even after several other early non-TARP objectors to the reorganization (whoops, sale) mysteriously folded their tents. But how could the 900-pound government gorilla in the closet not have made a difference? Do we really think that investment bankers can’t subtract liabilities from assets to determine net value? Draw your own conclusions of whether TARP banks operate with independent judgment when placed under government oversight.

Taxpayer Standing

There is still one other loose end. The TARP program was intended to aid financial institutions, which does not seem to include Chrysler or GM. But who can challenge this transaction if in fact it did not come within the scope of the TARP program? Clearly, someone should be allowed (in principle) to say that taxpayer money was improperly used to lard New GM and New Chrysler with sufficient dollars to help fund the UAW benefit plans. Why, one might ask, are the retired workers from Chrysler worth special treatment relative to the retired police officers in Indiana, who had to settle for 30 cents on the dollar? But those questions will never be resolved for the simple reason that under modern American constitutional law no taxpayer ever has standing to challenge a transaction that affects all taxpayers. We thus never get to the merits of the deal. This taxpayer-standing rule has been in effect for close to 90 years, and throughout its history it has aided the expansion of State power by shielding dubious transactions from judicial review. The far better rule is to follow the corporate practice whereby any shareholder can challenge the legality of a transaction that affects all.

The Future?

Now that the taxpayer-standing rule removed the last legal obstacles to these two reorganizations, how best to assess the damages from these exceptional procedures? The obvious question is, why allow the Obama administration to pay off its political debts to Big Labor by manipulating bankruptcy forms? And why did the two district courts and the Second Circuit Court of Appeals go along with what seem to be transparent ruses? This does not bode well for those like me who hope that courts will step up to control these political machinations.

What the ultimate damage is, no one can say for sure. My hope is that the collateral damage will be contained on the simple ground that since extraordinary remedies are only sought in extraordinary cases, routine bankruptcy practice will remain unscathed. But it is too early to be so sanguine. At least two major bankruptcies appeared to deviate from the rules; others may follow, but only if the United States government is prepared to put substantial dollars on the table, which it won’t in most bankruptcies. But the specter of indirect effects remains. The entire structure of large credit markets, for example, depends on following the rules of the game to the letter. We have already seen that market melt down. Add in bad bankruptcy rules and the risks get larger. Memories are long in credit markets, and in the worst-case scenario the pricing of every major deal could be impacted if deviant bankruptcies become the norm. Let’s hope that Chrysler and GM prove to be one-off concoctions borne of desperation. But don’t bet on it yet.

The government of the United States spent the year debating major new undertakings, ranging from health care to climate change to energy development to tax reform. Yet a far more fundamental shift, in the form of a rapid and pervasive expansion of government power over the private sector of the economy, has been going on in stealth. Shifting economic power from individual decision-makers to the national government characterizes virtually every policy proposal being debated in Congress.

Take tax policy. A 131-page document issued by the Treasury goes way beyond recommending the extension of some of the expiring Bush administration tax cuts. For example, the fine print contains more than a dozen ways of discouraging American firms from doing business and investing overseas. Supposedly minor technical changes also would have a severe impact.

For example, eliminating LIFO (last in-first out) inventory accounting would raise business taxes over $60 billion in one decade. The Treasury also wants to revive four corporate environmental taxes that were eliminated in 1969. There’s no relation between the tax burden these four taxes would impose on a company and the pollution that company generates. This bears an uneasy resemblance to Willie Sutton, who robbed banks because that was where the money was.

Inevitably a variety of technical tax provisions will increase the paperwork burden on business. The penalties for failing to file information returns (such as Form 1099) promptly and accurately, for example, will rise in a very complicated, three-tiered fashion.

On the expenditure side, the typical stimulus project increases the power of government in private business decision-making. The bailout of the automobile industry is really an inefficient method of financing union pension and health plans. The stockholders got zapped and the bondholders poorly treated. The taxpayers are left holding the bag, especially considering the restrictions on importing the really fuel-efficient cars General Motors produces overseas. Apparently, the new General Motors factory for building compact cars was chosen on the basis of “carbon footprint” and “community impact.”

It is hard to keep a straight face when analyzing the Cash for Clunkers program. For example, owners of the biggest old “clunkers” got a $3,500 credit for trading in an old vehicle for a new one with an improvement of just one mile per gallon. Surely, it would have saved energy if the Treasury had just mailed the $3,500 checks directly to Detroit!

Of course, the Obama administration is making some reductions in federal spending. It is reportedly imposing a 9 percent reduction in the budget for the division in the Labor Department that polices fraud and other illegalities on the part of labor unions. As noted below, a simultaneous expansion of business-oriented antitrust enforcement is taking place.

The Business of America is Government

Turning to regulation, one of Ralph Nader’s biggest disappointments during his heyday as a “consumer advocate” was the failure of his proposal for a new Consumer Protection Agency. He should be a bit happier now: The administration’s financial regulatory plan creates a powerful new Consumer Financial Protection Agency (CFPA).

This new free-wheeling agency would take authority now divided between the Securities and Exchange Commission (SEC) and the Federal Reserve System. In a change guaranteed to cause confusion, the CFPA would share authority with the Federal Trade Commission. The new regulatory agency would also have a mandate to give consumers more economic education. Educators find that especially scary.

Moreover, the agency will have its own money pot, independent of the normal congressional appropriations process. It will be financed directly by fees assessed on “entities and transactions” across the financial sector.

The Treasury’s financial plan contains many other expansions of government power over business. The Federal Reserve System would have new authority to oversee any large financial entity whose failure the Fed thinks could generate “systemic risk.” The Treasury would head a new Financial Services Oversight Council to “resolve” the inevitable jurisdictional disputes among federal agencies. A new Office of National Insurance is to be established in the Treasury to monitor “all aspects of the insurance industry,” a sector of the economy traditionally under the province of state governments.

The SEC will require the registration of all advisers to hedge funds and other private pools of capital with assets over a given threshold. It also will have the power to inspect the books of the advisers and to ensure compliance by their clients. In addition, the power of the SEC will be expanded by legislative proposals to give it a more active role in guiding the compensation committees of all public companies.

Further, the Federal Deposit Insurance Corporation will have new authority to take over and shut down financial institutions (not just banks) whose failure is deemed to pose “systemic risk.”

Viewed in their totality, these technical financial changes would represent a historic expansion of government. Sadly, there is little comfort in the Treasury’s warning in its 88 pages of detailed proposals: “More can and should be done in the future.” Comparisons with the New Deal of the 1930s are too timid. Shades of Alexander Hamilton!

Business-Climate Change

The complicated climate change bill that recently passed the House of Representatives would dramatically expand government power over the economy. Again, the fine print deserves far more attention than it has received. For example, buried in the 1,201 pages of detail is a provision authorizing the Department of Transportation to require automotive manufacturers to produce vehicles that can run on methanol (wood alcohol), a fuel not widely available.

Other provisions, as expected, have little to do with the subject of global warming. For example, contractors on some energy projects must pay employees at least the locally “prevailing wage.” This well-known code means, in practice, paying higher union wage scales, thus letting unions set wages even for non-union firms.

Many federal departments are trying to climb aboard the economic stimulus bandwagon. The Department of Justice wants to help out by showing that antitrust should be a “frontline issue” in the response to the problems facing the economy. Apparently, business is not getting sued often enough. Incredibly, one new assistant attorney general views antitrust enforcers as “key members of the government’s economic recovery team.”

When we step back and try to add up all the tax, spending, and regulatory actions and proposals of the new Obama administration, the result is clear: a cumulative squeeze on private decision-making and a more slowly growing economy in the years ahead.

In the process, private businesses will be discouraged by a host of government policies from making major new investments, especially long-term investments with payoffs far in the future. The likelihood of higher taxes and greater inflation resulting from the huge budget deficits that are likely to arise in the next several decades, abetted by lax monetary policies, are the key negative factors. The American public is likely to have a long wait until the national unemployment rate gets back down to the 7.6 percent that was reported when President Obama took office in January 2009.

One fundamental point deserves to be stressed. For the next several years, in the inevitable tension in public policymaking between economic prosperity and income redistribution, the American people can expect income equalization to get the government’s priority over improvements in people’s living standards. The average American, at best, will receive a more equal slice of an income pie that will be far smaller than the public expects.

If Washington owns it, it just can’t keep its hands off.

—Senator Lamar Alexander

Twenty-five years ago President Reagan told auto workers in Orion, Michigan, “You’ve demonstrated when the chips are down, what people can do working together freely, rather than at the dictates of some central planner or bureaucratic mandate of government. I happen to believe the last thing your industry needs is the federal government bringing in outsiders to tell you how to run a business.”

Fast-forward to 2009: President Obama fires GM chief Rick Wagoner, the company files for bankruptcy, a government-appointed auto task force calls the shots, and the federal government now owns 61 percent of the new GM.

How did we get to this point and what can we expect from Government Motors?

In its heyday in the early 1980s, GM employed nearly 350,000 workers at 150 assembly plants. It also had a 43.8 percent share of the market. Unfortunately, the good times did not last.

Decades of high labor costs, foreign competition, extensive government regulation, and burgeoning legacy costs steadily reduced GM’s market share to today’s 19.1 percent. A shrinking market means that legacy costs will skyrocket and become unsustainable. Mark Perry at the University of Michigan–Flint estimates that the ratio of retired GM auto workers (plus surviving spouses) to active UAW members was 4.61 to 1 in 2007. Given the state of Social Security, in which fewer workers support a growing retiree population, the phrase “As GM goes, so goes the nation” seems about right.

Given the plummeting market share (averaging 0.85 percent every year), one would think at some point one of the GM chiefs would have taken drastic action to turn things around. One would think wrong. There was no financial incentive to do so. Since the GM board continually rewarded failure with mega-million-dollar bonuses (similar to the practice at AIG), why bang heads to reduce labor rates or eliminate duplicate product lines? GM’s management apparently decided to simply stay the (downward) course, collect their golden parachutes, and hope that the inevitable wreck came on the next guy’s watch.

When time finally ran out for GM in 2008, only two equally bad options appeared to be left for management: bankruptcy or government bailout. As it turned out, there was a third, even more horrible option: a government bailout bankruptcy. When you crawl in bed with the government, it’s not a pretty sight. After the Bear Stearns, AIG, Freddie Mac, and Fannie Mae debacles, it became clear that government money brings some unattractive conditions, including micromanagement, the government’s agenda, and political favoritism.

To oversee the restructuring of GM (and the other auto bailout recipient, Chrysler), the government established a 24-member Auto Task Force, including Obama cabinet members and White House officials. None had any experience in the auto industry. Steven Rattner, an investment banker, was appointed task force leader. According to Neil King of the Wall Street Journal, Rattner “ranked among [New York’s] biggest fund-raisers for Democratic candidates.”

One of the biggest hurdles for the task force was to reduce GM’s $172.8 billion in liabilities and reallocate $82.29 billion in assets to produce a leaner, more competitive company. In normal bankruptcy the secured debt is paid off first, followed by unsecured debt. Anything left over goes to the stockholders. Unfortunately, in this case the GM stockholders came up short. In fact, there was not even enough to pay off all the unsecured debt holders. The U.S. government and UAW came out on top. The chart shows how the debt issue was finally settled.

It should come as no surprise that one of the four parties, the (unsecured) bondholders, balked at the proposed settlement terms. While they were second in the debt held, they came in last with only 10 percent of the common stock, no preferred stock, and no cash. For their objections, they were pummeled by the mainstream media and politicians. What sin did the bondholders commit? They were guilty of “greed” and of being “speculators.” This clearly explained their unwillingness to negotiate in good faith.

Who Are the Bondholders?

Ironically, if we look closely at who these bondholders really are, they don’t seem so ominous, threatening, or evil. As an investment, bonds are unexciting, but they are considered much safer than stocks. While bonds don’t pay that much, the returns are steady. For this reason, they are popular among retirees and working families. This was especially true in the case of GM bonds. According to bond analyst Shelly Lombard, “That’s because unlike most companies that issue debt in large denominations, GM sold many bonds with face values of as little as $25. That made them very attractive to average Americans.” According to the Washington Times, mom-and-pop investors directly accounted for 25 percent of the total. Large banks and investment firms had the rest. But even here, small investors were a major player through their mutual funds and 401(k) retirement plans. Financial-restructuring authority Evan Flaschen said: “The story that hasn’t been told is, this isn’t GM’s union retirees versus the bondholders. It’s retirees versus retirees.”

The government’s treatment of the GM bondholders was simply disgraceful. Investor’s Business Daily said the sordid affair “underscores why GM should have been allowed to undergo a normal bankruptcy—not the politically rigged one that the government forced down all of our throats. A regular bankruptcy would have given GM bondholders first call on its assets. Instead, they literally had money stolen from them.”

At a time when we are trying to restore faith in our financial system, the government chose to run roughshod over the investor class. This near-term political expedient will have long-term negative consequences. Other corporations will have a much harder time raising capital by selling bonds. If American investors get stiffed by the government, how will potential foreign investors view this shabby treatment? Could they be next?

Let the Micromanaging Begin

While many people might say GM did not really have a business model for the past 25 years, can we expect the new one at Government Motors to be any better? After all, there are now 535 members on the de facto board of directors, each making political rather than economic decisions. The recent bizarre treatment of the GM dealerships illustrates this point.

GM planned to eliminate about 2,400 of its 6,000 dealerships. What should have been a pure business decision has, unfortunately, gotten wrapped up in politics. Those dealers slated for closing have appealed to Congress for help. According to CNN, “The push by the dealers to reverse the cuts has garnered strong bipartisan support, especially from powerful Democratic Leaders Financial Service Committee Chairman Barney Frank and House Majority Leader Steny Hoyer.” So far, the Automobile Dealer Economic Rights Restoration Act of 2009 has 250 House and 26 Senate cosponsors. The bill is designed to “re-open profitable dealerships and restore basic fairness.”

The elite class has known all along that the real problem at GM was that it built too many SUVs and light trucks and not enough of the fuel-efficient cars that consumers really want. It now appears that at the new Government Motors environmental considerations will trump business considerations. Congress and the various regulatory agencies, such as the EPA, have been micromanaging the auto industry in the “green” direction for decades with their ineffective and deadly Corporate Average Fuel Economy (CAFE) program. The new CAFE standard calls for all cars and trucks to get 35.5 mpg by 2016. No GM vehicle currently meets the new standard.

Given that the government is now a majority shareholder in the auto industry, expect even more green micromanaging. It has already started. Energy Secretary Steven Chu, who is on the task force, recently said that the Obama administration is thinking about requiring all new cars to run on E-85 gas (85 percent ethanol). This mandate will cost the auto industry $1 billion a year. It is worth noting that E-85 gas is available at less than 2 percent of the gas stations nationwide.

In deciding where to build the new green compact cars that will save the company, the new GM considered the “community impact” and “carbon footprint” of the production facility. Ironically, it ultimately settled on the Orion, Michigan, plant where Reagan had disavowed central planning a quarter century earlier.

President Obama has said that his decision to take a majority stake in GM was unavoidable and that it would be temporary. This remains to be seen. However, we have been down this road before. In 1971, the federal government became the majority shareholder in Amtrak. This too was unavoidable and was to be temporary. Amtrak has been a ward of the state ever since; costing the taxpayer $2.6 billion a year to operate.

I fear that the new slogan in America will be, “Is this any way to run an auto company?”

Meanwhile, the Obama administration said it would cut by half  (on average) the compensation of the highest-paid people at the seven companies still on taxpayer life-support: AIG, Bank of America, Citigroup, General Motors, Chrysler, GMAC, and Chrysler Financial.

So here’s today’s puzzle: Is such government intrusion into the compensation process a good or bad thing?

Before answering, let’s remember that the taxpayers have been compelled to rescue lots of companies, banking and otherwise, over the last two years. The people’s exposure is immense. Just the other day Neil Barofsky, special inspector general for Treasury’s financial sector rescue, said enormous surprise bailout costs will befall the country in addition to the $159 billion the Congressional Budget Office projects TARP will lose. Barofsky was referring to the cost of government borrowing and the potential cost of rewarding risky behavior: “With the potential of moral hazard and ‘too big to fail,’ the government could be setting itself up for an even more dangerous crisis in the future,” he said.

Besides that, the Fed has been buying up billions of dollars in “toxic” (that is, worthless) mortgage-backed and other paper with money created from thin air. The new money threatens to ignite a monster price inflation when the banks begin to lend it. The impending dissipation of the people’s wealth at the hands of the Fed(eral Office of Counterfeiting) is another cost of the bipartisan government bailout of corporate finance. It’ll be a massive tax on the middle and working classes.

Well, then, shouldn’t the government have something to say about what goes on in those companies on the dole, executive pay in particular?

It’s tempting to say yes, but I think the best answer is no. I’m not totally comfortable with that answer, but it seems better than the alternative.

They Ain’t Us

First off, we must reject the propaganda that the Treasury and the Fed are acting as the taxpayers’ agents by taking control of corporate compensation. Nothing can be further from the truth. They are the taxpayers’ adversaries and are only looking out for themselves. After all, they are the ones that exposed the taxpayers to these huge liabilities in the first place. The companies did not bail themselves out. (Some did not want the money.) They didn’t ask the American people to send in voluntary contributions to help them through hard times. Instead, they relied on the coercive State apparatus to be rescued from the consequences of their own risky strategies. (Yes, in a variety of ways the government created the incentives that led to those strategies. The politicians are ultimately the responsible parties. But some companies avoided the trap and didn’t need help.)

Therefore, it’s not really the taxpayers’ money that the politicians are looking out for. In real terms, it’s their money. Sure, all wealth possessed by the State comes from the taxpayers. But once government operatives seize it, it’s not the taxpayers whom they are concerned about. The Bush administration tried to sell the public on the bailout by suggesting that the toxic assets (or bank shares) acquired by the government might one day be resold at a profit for the taxpayers. But that’s balderdash. Let’s say the assets do sell for more than the government paid. Will taxes be cut to reflect the profit? Will a planned tax increase be canceled? Fat chance. Politicians tend to spend every penny they can get their hands on — and then some. It is they who would profit, not the taxpayers. They ain’t us.

We really have to stop thinking of elected officials as our representatives. That kind of talk is just their way of keeping us from realizing what they are doing to us.

Another reason to oppose government conditions on bailout money is that they are likely to make things worse. When the banks were accused of using the money not to make loans but to buy other banks, I wondered if we really want bureaucrats and politicians prodding banks into lending. Isn’t that what helped create the financial problems in the first place? I seriously doubt whether anyone at the Fed or Treasury is qualified to design compensation packages that encourage just the right amount of risk but not too much or too little. The term “pretense of knowledge” comes to mind here. The Fed and U.S. Treasury are certainly imposing institutions, but so was the Wizard of Oz. Remember who’s behind the curtain.

Bad Precedent

A third reason to reject this government intervention is that it will serve as a justification for further intervention. If bureaucrats can set up pay schedules for bailed-out companies and regulated banks, it won’t take much for them to find pretexts for guidelines — or other forms of intervention — in other circumstances where systemic risk is real or imagined. Pay czar Kenneth Feinberg says he hopes the pay scheme will become a model for the rest of Wall Street. What’s to stop him now from giving the firms a little push in that direction.

The Journal is wrong to call this a “watershed moment,” because government has been deeply intertwined with banking for generations. Since 1914 at least, the country has been under the thumb of a formal banking cartel through the Fed. Every aspect of banking is controlled. (Not that the big bankers mind.) So dictating pay guidelines is not quite as radical as it seems. Nevertheless, it is a further step, and any such step will be cited later as a precedent for the next one, and so on.

My final reason for saying no to the pay czar and bank regulators is that I want to make sure that such bailouts never happen again. Maybe the people will be less likely to acquiesce the next time if they see the current corporate rescue for the plunder it is.

The only good reason I can think of for okaying the government’s plan is that it might lead other companies to refuse bailouts in the future. But I’m not too sure about that. Bank executives nurtured by state capitalism might be happy to live with guidelines as long as the taxpayer money keeps flowing. The truly talented personnel will just head to unregulated parts of the economy.

We can’t change the past. The bailouts happened. Now we have to deal with the consequences, and there are no good answers. Corporate executives whose conduct was likely influenced by their belief in a government safety net (which turned out to exist) and who deserve no sympathy from the taxpayers got hold of our money anyway. The only question now is whether we let the government make things worse. We should concentrate on stripping government of the power to bail out companies in the future. We should also begin to fully separate State and banking. A good start would be to abolish government deposit insurance, which only lulls depositors into a false sense of security and creates the very systemic risk the regulators say they want to avoid.

But the view that consumption is “stimulative” while saving is harmful is almost the exact opposite of the truth if the goal is to generate sustainable economic growth. Savings is what makes long-term growth possible. It just ain’t so that more consumption is what is needed in a recession.

An Incomplete View

This particular fallacy is essentially a version of the more general fallacy identified by Frédéric Bastiat in the nineteenth century: an inability or refusal to “see the unseen.” Consumption has easily observable effects on the economy. We see people spending on new cars or televisions, and we understand how that means larger profits for firms and more opportunities for employment. So it comes as no surprise that people would think that an increase in saving, defined as the portion of our income we do not devote to consumption, would be bad for the economy. If we are increasing our saving, we are presumably reducing our consumption, which means lower profits and fewer job opportunities in the places where we used to be spending those consumption dollars.

So far, the analysis is not necessarily wrong, just incomplete. A full analysis would then ask, “What happens to the portion of people’s income no longer being devoted to consumption?” What exactly do we mean by “saving?” If people are “saving” by simply increasing their holdings of currency (say under the storied mattress), then the critics have a point. Those resources are being withdrawn from the larger economy, and to that degree they will reduce conventional measures of economic well-being. Of course, those increased currency holdings will improve the well-being of their owner, as he or she is now holding wealth in the preferred form of currency.

This isn’t how it usually goes, though. Most saving takes the form of financial instruments, including everything from basic checking accounts to the fanciest investment tools. If people are keeping higher checking account balances or putting more in savings accounts or money market mutual funds, then that wealth is not withdrawn from the economy. It is simply channeled elsewhere than into consumer goods. Financial institutions that accept such deposits lend them to customers who invest in their businesses. This is the process of creating the capital that is the sine qua non of sustainable, long-term economic growth.

In Bastiat’s terms, we see the lost expenditures at the retail store, but we mostly don’t see the “backdoor” way the savings are channeled to other businesses. More precisely, an increase in the savings rate represents a change in consumers’ time preferences: They are saying they are less interested in current consumption and more interested in future consumption. The beauty of financial markets is that they translate that change in preferences into a change in the flow of resources. Those investments will take time to become consumption goods, but that’s what consumers want.

Saving Creates Growth

So contrary to Isidore’s arguments, restricting consumption does not hamper economic growth. In the long run, economic growth requires saving and the creation of new capital goods.

For savings to contribute to growth this way, financial intermediaries must function properly. The fallacy that increases in saving will frustrate growth finds its most recent theoretical statement in Keynes, particularly in his assumption that the financial system cannot translate savings into investment. In contrast to the classical and Austrian economists, who believed that interest rates would coordinate the supply of savings and the demand for investible funds, Keynes argued that saving was a function of income, and investment was driven by the “animal spirits”—that is, people’s psychology and expectations. As a result, there was no reason to think that increases in saving would make their way back into the economy as investment. Indeed, savings was a “leakage” from the expenditure stream made up of consumption, investment, and government spending.

But Keynes was wrong about how markets, especially financial markets, work—at least when they are left to themselves. As Isidore’s article points out, if banks are reluctant to lend out the funds that savers are supplying, increases in saving will not get translated into investment spending. He argues that is precisely what is happening right now.

If true, the fault lies not with the saving habits of the public, but with whatever is causing the banks to hesitate. Blaming the public for “saving too much” is wrong, as Isidore himself notes in claiming that “a high savings rate is not a bad thing for the economy.” The problem, he argues, is people doing it now when banks won’t lend. Why then are banks reluctant to lend?

One answer is that at the onset of the crisis the Federal Reserve System decided to pay interest on the reserves banks hold in their accounts at the Fed. Combined with very low rates of return on other assets, this made sitting on both the public’s increased savings and the Fed’s newly injected reserves a better choice than lending.

Moreover, the combination of bailouts, quasi-nationalizations, and policy zig-zagging might be making lenders more uncertain about the future and less likely to lend. What economic historian Robert Higgs has termed “regime uncertainty” was responsible for the length of the Great Depression and might be a key reason why banks might lend less than in the recent past. Isidore and others never consider that, in the words of economist Roger Koppl, “Keynesian policies can create a Keynesian world”—that is, bad policy can break the link between savings and investment. In any case, blaming the savers misses the real problem.

And there might not be a problem anyway: A number of economists have disputed the claim that banks have stopped lending. Even at the height of the crisis in October, economists at the Minnesota Fed found no evidence that banks had stopped lending to individuals or nonbank entities. More recent data from the winter show that while the rate of lending growth had slowed, the total quantity of loans to individuals and firms was steady, if not growing slightly. So theory aside, the empirical reality since September does not support the claim that savings is counterproductive.