Ill-conceived policies to encourage homeownership channeled cheap credit into housing markets. Land-use and zoning policies restricted the supply of housing in key desirable markets. In The Housing Boom and Bust, Thomas Sowell of the Hoover Institution has shown how these policies brought about a crisis in housing and finance.

Others have told the story from a number of perspectives and with varying emphasis on different factors. My purpose here is to focus on the policy responses to the crisis and ask whether they have been helpful or harmful.

TARP

On October 3, 2008, Congress enacted the law creating TARP (the Troubled Asset Relief Program), which was authorized to spend up to $700 billion to purchase troubled assets from financial institutions. A little more than a month later, then-Treasury Secretary Henry Paulson announced that rather than buying troubled assets, the Treasury would use the money for capital injections into banks in return for preferred shares.

Regardless of one’s attitude toward bailouts generally, Paulson’s original plan was a recipe for disaster. To help the banks he would have needed to overpay for the assets to the detriment of the taxpayers. If he had paid then-current prices, accounting rules would have forced all firms holding such assets to write them down (not just those selling the assets). Financial institutions holding dubious mortgage-backed assets were desperately trying not to write them down because that might have threatened their depleted capital base. It is fair to say that Paulson failed to grasp the underlying problems at these institutions when he first proposed the program.

TARP became a capital-relief plan. It harkened back to the Reconstruction Finance Corporation (RFC) of the Great Depression. Under Jesse Jones and in conjunction with Franklin Roosevelt’s Bank Holiday, all the nation’s banks were examined and divided into the good, the bad, and the ugly. Call it his version of a “stress test.” Those deemed beyond hope were never reopened. Those troubled but salvageable were eligible for RFC capital injections. Jones also extracted resignation letters from senior management of institutions being bailed out. If he deemed existing management best suited to run the bank, it could stay. If not, it was replaced.

In comparison, Paulson’s strategy was “ready, shoot, aim.” Banks received government injections of money to replace depleted capital, with nothing explicit extracted in return. There were vague promises that banks would resume lending but there was nothing enforceable. The banks were stress-tested only after having received government funds. There were second and even third rounds of bailouts for some banks, indicating they had been weaker than thought. We know that at least one—CIT, a financial institution that received $2.3 billion in TARP money—should have been allowed to close. Instead it eventually filed for bankruptcy, and the taxpayer funds were lost.

Moreover, in what has become a national disgrace, existing management at bailed-out banks remained in place. The Bush administration failed to impose even the level of control exercised under FDR.

On the one-year anniversary of the announcement of Paulson’s reversal on TARP, I was asked by Newsweek for my assessment. “It hasn’t done what [Paulson] said it would,” I said. “Yes, it saved some banks from going under, but did it restore the health of the banking system? Absolutely not.” I stand by that assessment today.

What Does Government Stimulate?

The fiscal response to the crisis of the Bush/Obama administrations has been to spend their way out of the recession. In the process the nation’s debt has skyrocketed. There are deficits and debt as far as the eye can see, and our children’s future has been mortgaged. The 2009 fiscal deficit was double that of 2008. It is running at 10 percent of GDP, and former Fed governor and Bush adviser Larry Lindsey estimates deficits will run at 7 percent of GDP for a decade.

Because of the work of Milton Friedman and his monetarist followers, countercyclical fiscal policy fell under a cloud. First, they argued that recessions are difficult to forecast and we only typically know we have entered one after the fact. The monetarists also argued that fiscal policy was subject to the cumbersome legislative process and thus could not be quickly implemented. Once spending began, its effects were only felt slowly. All this wisdom was forgotten in the panic of the Bush administration and then more so in the Obama administration.

The Economic Stimulus Act of 2008, passed in February of that year, mainly sent $100 billion in checks to households in early summer to stimulate consumption and jump-start the economy. As Stanford economist John Taylor, author of Getting Off Track, has shown, the money did nothing and the economy slid into recession later that year. Any economist worth his salt knows that temporary government cash infusions will likely be saved and at best have transitory effects on spending.

Undaunted by that failure, the Obama administration decided to up the ante on the theory that there had just not been enough fiscal stimulus. It replaced billions in spending with trillions in spending: the stimulus package added on to TARP. In the next section I also discuss Fed spending masquerading as monetary policy.

What is the record? It appears that the recession may have ended in the third quarter of 2009. That would make it less than one year in duration–not atypical in that sense. Most of the Obama stimulus money has yet to be spent. (Recall Friedman’s arguments on fiscal policy.) It may be good electoral politics to claim credit for a still-nascent recovery. But it is poor economics. More likely, the self-adjusting forces of the market have been at work.

Clearly, nothing the government has done has been able to lower the unemployment rate. GDP is an abstraction; being out of work is a reality. In October the unemployment rate exceeded 10 percent. (It fell back to 10 later.) A broader measure of unemployment exceeded 17 percent. These numbers put the flesh on the skeleton of policy debates. More ominously, we now are seeing indications that wage rates are falling. As the Wall Street Journal reported, Professor Kenneth Couch of the University of Connecticut estimates that displaced workers returning to work will on average take a 40 percent pay cut.

Double-digit unemployment rates and double-digit wage cuts are depression statistics. In what way is government spending “stimulating”? In an editorial the Wall Street Journal concluded that “no matter how hard or imaginatively the Administration spins, the reality is that the stimulus has been the economic bust that critics predicted it would be.”

Indeed, the labor story helps us to see the dark side of stimulus spending. A good chunk of it has gone to state governments to support bloated budgets in the face of collapsing revenues. Those fiscal transfers are being done, at least in part, to placate public-sector unions, which want to protect the incomes and pensions of their members.

Fiscal stimulus has failed. What about the monetary variant?

Monetary Stimulus

The Fed’s response to the crisis has drawn mixed reviews among free-market economists. Some approve of the Fed’s easing in 2008–09 as a response to an increased demand for money (falling velocity). Nearly all market-oriented economists are disquieted by the explosion of the Fed’s balance sheet as it takes on more and more assets of dubious quality. It will be extremely difficult for the central bank to dispose of such assets when it inevitably comes time for it to tighten. The Fed will likely suffer losses, and such losses impact the taxpayer. (The Fed’s surplus is paid to the Treasury.)

Many economists have been critical of the Fed for its targeted-credit policies, which amount to credit allocation. They favor one sector at the expense of others, and constitute fiscal policy rather than monetary policy. The Fed’s leadership is dismayed at its loss of approval by the general public and fears calls for greater political oversight. But the backlash is of the Fed’s own making.

In the end its fortunes are tied to the economy’s. Most Americans do not know the technicalities of monetary policy. But Fed Chairman Ben Bernanke has taken an active and public role in defending the policy response to the crisis (under both Bush and Obama). Under Bernanke the Fed has promised much and delivered little.

Just as Americans fear the spending and budget deficits, many understand that easy money helped get us into the crisis. Now Dr. Bernanke has prescribed the strongest dose of cheap money ever administered. How can the elixir that caused the boom cure the bust?

The Bernanke Fed is engaged in a policy of reflating (re-inflating) the economy: stimulating money demand to restart economic growth. It justifies the policy on the basis of Professor Bernanke’s own research that shows the evils of deflation. But what prices is he trying to prop up? All prices? Even in hyperinflations, some prices fall. Is he trying to prevent downward adjustment in wages? As suggested above, wage rates in hard-hit sectors may be falling at double-digit rates. Is he preparing for double-digit price inflation? If so, gold is underpriced at $1,000 an ounce.

Astute observers increasingly fear that what is being reflated is another asset bubble. At present, the asset bubble is concentrated in commodities (such as gold, copper, and oil) and Asian real estate. In what is known as a carry trade, global investors are borrowing dollars at low interest rates to invest in property in cities like Hong Kong and Singapore. Instead of bringing prosperity to Americans, the Fed’s policy is fueling speculation. Instead of production in the United States, the Fed’s easy money is creating paper wealth for Asian property owners.

The rise in commodity prices is perhaps most ominous. The U.S. economy remains weak and unemployment elevated. Yet Americans are already paying higher prices for gasoline. They are facing the prospect of renewed inflation and economic weakness: stagflation. That would be an updated version of the economy of the 1970s. The Fed is thereby impoverishing Americans. Is it any wonder many are calling for a reconsideration of its role?

To be sure, financial firms leveraged up—that is, they did a lot of business with borrowed money. That juiced up revenues and bonuses in the boom—and exacerbated losses in the downturn. Selling notes based on questionable mortgages as collateral was one method for tapping into the money sloshing around.

Without abundant credit, it would not have been possible to borrow so much and in so many different ways. Banks create credit but are subject to myriad controls by the Federal Reserve System. Money was plentiful because of Fed policy.

Politicians, pundits, and the Obama administration want to impose new regulation on the financial system, giving wider powers to government agencies. Depending on how and to what extent they implement that agenda, the Federal Reserve—alongside other agencies like the Securities and Exchange Commission—stands to gain greater authority. Hence the Fed’s track record is a timely and pertinent subject.

Although the institution now commands unquestioning acceptance, its inception was controversial. Richard Timberlake, in his history of monetary policy in the United States, quotes a congressman shortly after the 1913 passage of the law that created the Federal Reserve System: “This act establishes the most gigantic trust on earth, such as the Sherman Antitrust Act would dissolve if Congress did not by this Act expressly create what by that Act it prohibited.”

That gigantic trust has correspondingly gigantic effects on the economy, through multiple roles and powers. As overseer of ordinary banks the Fed makes sure they play by the rules. As lender of last resort it can keep banks going through cash-flow problems. Beyond its supervision of individual banks the Fed pursues economy-wide goals.

It operates various levers that reduce or expand the supply of money and credit. In what is generically called monetary policy, the Fed uses the levers to boost a drooping economy—as is happening at present—or cool down an overheated one. In theory those efforts benefit society at large.

In reality—well, let’s take a look at the 1930s and our own time to understand the Fed’s role in the two most dramatic financial crises of living memory.

Stability Found and Lost

Two seminal insights emerged from the path-breaking A Monetary History of the United States, 1867–1960 (1963) by Milton Friedman and Anna Schwartz. They argued that the Federal Reserve worsened the banking collapse of the 1930s and probably killed off a potential recovery by tightening money. In reaction to a drain on U.S. gold reserves, the Fed clamped down on an already shrinking money supply, thereby turning an ordinary recession into what came to be known as the Great Depression.

Current Fed Chairman Ben Bernanke agrees with that conclusion and is certainly not repeating the mistake. He has eased money in every way it can be eased.

But Friedman and Schwartz offered a broader lesson as well. They showed that the stock of money became subject to greater fluctuations after the Fed took over the control of money from the gold standard system. “The blind, un-designed, and quasi-automatic working of the gold standard turned out to produce a greater measure of predictability and regularity—perhaps because its discipline was impersonal and inescapable—than did deliberate and conscious control exercised within institutional arrangements intended to promote monetary stability,” Friedman and Schwartz wrote.

By the late twentieth century it looked as though central bankers had taken this criticism to heart. They had reason to congratulate themselves on what was called the Great Moderation. Since the mid-1980s both prices and output growth had been reassuringly stable. In a 2004 speech Bernanke argued that this was primarily due to improved monetary policy, although economic change and plain old luck also may have played a role, too.

At that time Bernanke was not yet Fed chairman, but he was a member of the board of governors, a position he held from 2002 to 2005. Current Treasury Secretary Tim Geithner was president of the New York Federal Reserve Bank from 2003 until this year. These facts are worth recalling because there is a tendency to concentrate the blame on former chairman Alan Greenspan. But whatever one thinks of Greenspan, the officials who currently make policy were there with him as the Fed sowed the seeds of financial crisis.

In retrospect those seeds were already discernible in the late 1990s. The steep rise in housing prices had started, encouraged by a stock bubble that created the illusion of wealth. In 1998 the Fed eased interest rates several times in response to panic after Russia defaulted on its bonds and the related near-failure of a large hedge fund, Long-Term Capital Management. This policy reassured investors, who subsequently bid up share prices to the stratosphere in 1999 even as the Fed reversed course.

The stock bubble burst in early 2000, and the economy stalled. Interest-rate cuts are prescribed and expected in a recession, so it is no surprise that the Fed took that course. But even after the economy recovered, rates stayed exceptionally low in comparison to what they would have been by the standard of the Great Moderation.

Stanford University economist John Taylor has used a measure known as the Taylor Rule to demonstrate that monetary excess lasted several years, into 2006. The title of Taylor’s new book says it all: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

Not everybody agrees that monetary policy was loose during the Greenspan era. David Henderson and Jeffrey Rogers Hummel argued in the March issue of The Freeman that monetary policy was not expansionist from 2001 to 2006 as measured by the declining growth of monetary aggregates. The Taylor Rule, however, allows the comparison of two periods—and the federal funds rate was lower in the 2000s than in the 1980s.

Another explanation of the monetary excess, endorsed by Bernanke and Greenspan, is that there was a global glut of savings. But Taylor shows that worldwide there was no such glut because the surplus savings in Asia and the Middle East were offset by a savings gap in other countries, in particular the United States.

It is fair to say that most of us partook of the Fed’s generous punch, whether by running up credit-card debt, buying houses beyond our means, trading with borrowed money, or making 30 percent on exotic debt instruments. Monetary excess meant that borrowing was easy; mortgages were to be had for a song. Housing prices rose at amazing rates year after year. With the hazard of price declines out of sight and out of mind, homeowners, developers, and banks overextended themselves.

It was an extraordinary boom; hence the following bust was also extraordinary. In effect, the stability of the 1980s Great Moderation was over by the time Bernanke credited monetary policy for fostering that stability.

What Failed

The bubble-and-collapse sequence is now attributed to a failure of capitalism, to use the title of a new book by Richard Posner, a judge and prolific author. According to a widely held view, the private financial system is intrinsically unstable, with leverage a central element in its penchant for self-destruction. Had the system been properly regulated and restrained, it would not have gone haywire. Hence whatever is not sufficiently regulated should be nailed down to avoid similar disasters in the future. Much of the media reflects that view.

And yet the Fed and the Securities and Exchange Commission (SEC) between them already have massive regulatory powers over banks and broker-dealers, including investment banks. What is more, they and other agencies were part of the President’s Working Group on Financial Markets, set up after the crisis of 1998 to deal with systemic risk—the kind of danger that came up so frequently in 2007–2008.

Despite all the regulatory powers, a crisis broke out. Posner may represent current conventional wisdom when he writes that the government’s myopia, passivity, and blunders played a critical role in allowing the recession to balloon, but there would have been a crisis anyway regardless of those shortcomings.

The alternative view, represented by Taylor (following in the footsteps of Ms. Schwartz and the late Mr. Friedman), is that monetary policy turned what might have been mild cyclical fluctuations into a big bubble, inevitably leading to a big collapse. No easy money, no crisis.

Regarding the central bank’s multiple functions, its stance in the supervision of individual banks appears to have been of a piece with its broader policy. The Fed as overseer of banks could have demanded that they reduce their use of leverage, but the Fed as maker of monetary policy was providing the wherewithal for that leverage.

Hence the let-them-leverage regulatory stance was not accidental or myopic; it was consistent with deliberate monetary policy. If policymakers were concerned about the galloping credit expansion, they should not have let money go loose in 2003–2006. Lacking such concern, the Fed had no reason to get banks to reduce their risk. The whole institution took this track, not just Alan Greenspan.

Controlling or Creating Risk?

There’s no question private action results in economic cycles, largely because human beings have mental biases that keep them focused on the near term. The key point, though, is that even the largest private actor does not have the impact of the gigantic banking trust. Monetary policy is system-wide; policy mistakes have ramifications across the economy.

So the Fed by itself can create systemic risk, even as people call for expanding its powers to control the systemic risk posed by market participants like banks and hedge funds.

The Fed actively implemented measures that destabilized the system in the 1930s and again in the 2000s, albeit in different ways. The mistake was different—back then the Fed tightened in a downturn; this time it kept money too loose in an upturn. But there was the same fundamental consequence of financial and economic instability.

Timberlake thus summarized the Federal Reserve’s track record: “It comes across as a prototypical governmental institution operating under the rule of men rather than the rule of law.” To prevent misguided monetary interventions, the discretion of the people who run the institution should be limited.

Friedman argued for rule-based monetary policy, specifically that the Fed should follow a rule to keep the money supply growing steadily at a fixed rate of 3 to 5 percent a year. This turned out to be difficult to implement, given that the money supply and its relation to the economy are complicated.

This is where the Taylor rule, which describes actual policy during the Great Moderation, comes in. Taking that policy as a template, the Fed can set the short-term interest rate in accordance with a constant formula based on inflation and output.

Compared to Friedman’s fixed rate, the formula is more flexible.  But it keeps interest-rate policy predictable and transparent. If followed consistently, rule-bound monetary policy, combined with proper enforcement of existing regulations for banks and broker-dealers, would prevent the excesses seen in recent years.

Government Intelligence and the Nirvana Fallacy

Instead, what’s being advocated is broader activity by policymakers. Posner, for instance, draws the conclusion that “we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.” It is interesting that he sees a need not just for more-active government but more intelligent government. If government action has not been intelligent in the past, why expect it to be intelligent in the future?

We’re talking about institutions with overarching powers that have caused a variety of harms, from deliberate Fed policies that created instability to the SEC’s inability to detect fraud even after being told about it, misleading investors into believing that all was well with Bernard Madoff. (See my May Freeman article on the Madoff case) If there is more government activity of this sort, there will be even worse disasters.

One way to prevent another round of government-made debacles would be to replace the central bank with market-based money, thereby imposing an impersonal discipline—to use the words of Friedman and Schwartz. But following the Taylor Rule is a more likely solution, since it serves the goal Fed officials themselves say they want to pursue, namely, more predictable and transparent policy.

Those calling for greater interventionism tend not to engage the issue of what the government does in reality. There is a presumption that regulation is the cure-all, even as we live through the effects of a systemic policy failure. Economist Robert Solow, in a review of Posner’s book, writes that Panglossian ideas about “free markets” encouraged lax or no regulation of a potentially unstable financial apparatus.

When you consider the actual role of the Federal Reserve in crises, it is the notion of government activism as the solution to financial uncertainty and fluctuations that comes across as Panglossian.

“Once you lose your freedom to fail, you also lose your freedom to succeed and you cease to be a free society.” —U.S. Rep. Jeb Hensarling of Texas

In March 2008 the investment banking firm Bear Sterns failed and the federal government quickly stepped in. The public was inundated with the phrase “too big to fail” (TBTF) by the financial news media. You had to go back to 1998 for the last time it was used so often. In that year the troubled hedge fund Long-Term Capital Management had $4.6 billion in losses. The Federal Reserve stepped in to orchestrate a restructuring deal to avoid bankruptcy. With this government intervention, the precedent was established for future calls for help. In 1999 Kevin Dowd, writing for the Cato Institute, stated: “[T]he intervention implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking. . . .”

An institution is deemed “too big to fail” if its collapse would be expected to create a devastating ripple effect throughout the economy, creating a “systemic risk.” When this occurs the government is expected to provide some form of assistance. This can vary from a guaranteed loan, where management and stockholders get off scot-free (as with Chrysler in 1979), to guaranteeing the assets of a failing bank, to facilitating an outside takeover (Bear Stearns). In the event of an outside takeover thousands of employees could be shown the door and stockholders left with pennies on the dollar. Since the public only notices that it is paying the bill, it has a hard time discerning these subtle differences. As a result, the term “bailout” is used broadly to describe any form of government financial intervention to assist a crashing TBTF company or its creditors.

Too Big to be Free-Market

There are no clear guidelines on who is (or what constitutes) TBTF. As a result the “systemic risk” scare is ad hoc and apparently meant to be taken on faith. Any large company can claim it is vital to the health of the economy because its failure would have a domino effect on suppliers. Other firms can pick up the slack and even acquire the assets of the failed firm, but this is usually ignored.

TBTF is problematic because it indirectly influences how companies are managed. If there is a real, or implied, government safety net should things “head south,” management might be inclined to take on more risk for greater profit. This illustrates the concept of “moral hazard,” an insurance term. If you are insured, you may be less cautious. TBTF is actually a state of mind that afflicts the senior management of our largest corporations. If they think they are TBTF, even if they aren’t, they still behave as if they are. This is the crux of our current financial problem.

In an ideal free-market environment, entrepreneurs would be willing to take on risk based on an expected return. Since returns are never guaranteed, the entrepreneur’s willingness to take on risk is tempered by the potential downside (a loss), if things don’t pan out. While the rewards for extremely risky investments may be great, so too are the penalties. In severe cases the company could go bankrupt. As a result, this risk/reward/loss relationship in the free market would force rational behavior into the business decision-making process.

TBTF companies are no longer on their own to succeed or fail. With TBTF we now have the government in the game—not so much as another player but as a non-neutral referee ready to step in if the game gets too rough. What’s more, TBTF companies operate under a different set of rules from merely mortal ones. In 2004 Gregory Mankiw, then chairman of the President’s Council of Economic Advisers, said, “Expecting a government bailout if things go wrong creates an incentive for a company to take on risk and enjoy the associated increase in return.”

So if you are (or think that you are) TBTF, there is little or no perceived penalty to counterbalance risky behavior. With a guaranteed—or at least an implied—government safety net, the sky is the limit when it comes to risk-taking. The siren song of big returns (with little or no risk) becomes irresistible—and you no longer operate in a free-market environment. According to Thomas Sowell, “The hybrid public-and-private nature of these activities amounts to ‘privatizing profit and socializing risk’ since taxpayers get stuck with the tab when high-risk finances don’t work out.” In other words, it is a travesty to say or imply that our current crisis stems from market failure.

Mixed Signals

What makes the TBTF phenomenon so difficult to follow (and understand) is that there is no official list of “too big” companies put out by the Treasury Department. The taxpayer only finds out that a company is on the list after the company fails.

The tab to the taxpayer for bailing out Bear Stearns is $29 billion and counting. What remained of Bear Sterns’ assets, along with government guarantees, were transferred to JPMorgan Chase. The next TBTF firm to run into trouble was the investment bank Lehman Brothers Holdings Inc. Although conventional wisdom held that Lehman, with $615 billion in debt, was TBTF, this time the Fed said no.

These mixed signals about what was and what was not TBTF sent the financial markets into a tailspin. Some federal policymakers and many in the financial news media saw this as the beginning of the credit “crunch.” (In fact, while credit standards have tightened, money is still being lent for all kinds of loans.) It was no longer prudent to do business with any “troubled” bank. Since no one knew which banks the government would or would not bail out, inhibition set in.

The next TBTF firm to ask for federal help was the world’s biggest insurance company, American International Group Inc. (AIG). Not wishing to mishandle another TBTF firm, the Fed quickly agreed to lend $85 billion to AIG in September to avert bankruptcy. The following month AIG came back to the Fed asking for an additional $37.8 billion, citing liquidity problems. The Fed’s response: No problem. But are you sure $123 billion will be enough? AIG is intricately involved in America’s money-market funds. In November AIG came back and said: “On second thought, could you make that an even $150 billion?” The government response: Fine, but only on one condition, and you may find this to be exceedingly harsh. We absolutely insist that your top 70 executives not get any bonuses this year. AIG’s response: “You drive a hard bargain, but we have a deal.”

As a result of this action, the government now owns 80 percent of the company’s assets.

In September the federal government took over two more TBTF firms. The quasi-governmental Fannie Mae and Freddie Mac own or guarantee about 40 percent of the nation’s mortgages. This bailout will cost the taxpayer $200 billion. Egged on by influential members of Congress, Freddie and Fannie blatantly abused their government-sponsored-enterprise (GSE) designations, and no two firms better exemplify the “moral hazard” argument. Since they were chartered by Congress, many believed their mortgage-backed securities were guaranteed by the federal government. Then-Fed chairman Alan Greenspan told Congress in 2004: “The Federal Reserve is concerned that Fannie Mae and Freddie Mac were using this implicit reliance on a government bailout in a crisis to take more risks, in order to multiply the profitability of subsidized debt.” When housing prices started to tank we found out that this was exactly what was going on.

Bad Medicine and a Hail Mary

One would think that with all of the government oversight these TBTF events would not keep popping up. Since the government doctor has utterly failed to prevent this disease, why should we think the same government doctor suddenly knows how to cure the disease now that it has metastasized throughout the economy?

The Treasury, with the help of Congress, has thrown a $700 billion “Hail Mary” called the Troubled Asset Relief Program (TARP). Whether or not this bailout “restore[s] confidence in our financial system” (Treasury Secretary Henry Paulson) remains to be seen. Judging by the stock market, the early results are not good. Ironically, the first step of the plan was to identify publicly the banks that are really TBTF by buying their preferred stock. Nine TBTF banks, which account for 50 percent of all U.S. deposits, will get half the $250 billion earmarked for banks and thrifts. These include JPMorgan Chase, Wells Fargo, Citigroup, Bank of America (plus Merrill Lynch, which is being acquired by BoA), Goldman Sachs, New York Mellon, Morgan Stanley, and State Street. The bailout bill also includes a provision for the FDIC to offer an unlimited guarantee on bank deposits in business accounts that do not bear interest. For individual depositors, the FDIC insurance limits will increase from $100,000 to $250,000. How do these actions reduce the “moral hazard” problem? The last time the individual deposit insurance limit was raised—from $40,000 to $100,000 in 1980—we had the S&L crisis, which ended up costing the taxpayer $150 billion.

Being on the official TBTF list has its pros and cons. On the positive side, you can’t fail. The government guarantee is no longer implied. It’s real. But being on the official TBTF list has a severe downside: additional regulation. The government will be very close at hand to make sure that our biggest banks become and remain stodgy. In other words: We’re from the government and we’re here to make sure that your risk level remains in the “safe zone.” In October New York Senator Charles Schumer, a member of both the finance and banking committees, wrote Paulson demanding that “banks receiving capital eliminate their dividends, restrict executive pay and stick to safe and sustainable, rather than exotic, financial activities.” Given the makeup of the new Congress and administration, expect even more intrusive micromanaging of our financial institutions—but that is only to be expected if the Treasury becomes a stockholder. From now on innovation will be discouraged, downplayed, or slow-rolled by the government. As a result of these rescue actions, our entire financial system has effectively become nationalized.

A Troubling Cultural Shift

The most troubling aspect of the ever-increasing number of government bailouts is the subtle change overtaking the entire country. The mindset of companies and individuals today is shifting away from self-responsibility. We blame everyone else for our mistakes and look to others (the taxpayer) to come to the rescue.

When it comes to handouts and bailouts the government is no longer simply on the slippery slope—it’s in free-fall. Every bailout makes it harder to say no when the next TBTF request comes forward. Aren’t the Big Three automakers too big to fail as well? In many people’s eyes the answer is yes. At the end of September Congress approved a $25 billion low-cost loan package to help the automakers and their suppliers modernize their facilities so as to be “more green.” But this wasn’t enough. General Motors CEO Rick Wagoner, whose company was hemorrhaging cash, sought another $10 billion in federal assistance the next month to help finance the merger of GM and Chrysler. However, this request was denied. Then in November the Big Three found sympathetic ears from the big two in Congress, House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid, for yet another $25 billion “bridge” loan for the Big Three. The Bush administration ultimately dished out $17.4 billion from the $700 billion TARP fund to assist GM and Chrysler. It also handed the problem of deciding the long-term future of the bailouts to the Obama administration, which had already expressed support for a bailout package. (Notably, the several profitable foreign-owned automakers with facilities in the United States weren’t looking for help.)

It shouldn’t need pointing out that the “too big to fail” doctrine fundamentally changes the nature of a market economy, which when free is a profit-and-loss system. Not only does the doctrine reward error, sloth, and inefficiency, it deprives other, more competent entrepreneurs of the scarce resources they need to serve consumers. Who knows what products and opportunities would arise if the free market, not politicians, determined who had access to capital?

How wrong I was. By the time of this writing, the mainstream press had delivered the “consensus” judgment that blind faith in the free market fostered the housing bubble. Jacob Weisberg’s Slate column, “The End of Libertarianism,” sums up this official verdict: “We have narrowly avoided a global depression and are mercifully pointed toward merely the worst recession in a long while. This is thanks to a global economic meltdown made possible by libertarian ideas. . . . [A]ny competent forensic work has to put the libertarian theory of self-regulating financial markets at the scene of the crime.”

Just to make sure that the free market got the blame for the financial meltdown, Alan Greenspan himself testified to Congress that he had been “shocked” that self-interest (in the absence of paternalistic regulation) did not compel financial institutions to adopt adequate risk controls. Greenspan—viewed by the average pundit as a staunch libertarian—went so far as to say that he “found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”

I will argue that government interventions, not laissez faire, caused the housing bubble and the ensuing financial crisis. In addition to describing some of the general factors involved, we will focus specifically on the blame attributed to the “unregulated” market for credit default swaps.

Despite their confident judgments of guilt, critics such as Jacob Weisberg point to very few specific regulatory changes that (allegedly) fostered the housing boom and the related vulnerability of so many financial institutions to the ensuing crash in home prices. The only two concrete examples I have seen are the gradual repeal of Glass-Steagall throughout the 1990s and the Commodity Futures Modernization Act in 2000. To his credit, Weisberg candidly admits that he can’t point to a smoking gun: “[N]eglecting to prevent the crash of ’08 was a sin of omission—less the result of deregulation per se than of disbelief in financial regulation as a legitimate mechanism.”

Generally speaking, Weisberg and others accuse Alan Greenspan, Phil Gramm (former chairman of the Senate Banking Committee), and SEC chairman Christopher Cox of willfully ignoring, for ideological reasons, warnings about the growing market in credit derivatives.

At this point, we note that even if this were the whole story, it wouldn’t necessarily prove that these men (and other policy makers) were mistaken in their actions. Two exaggerated analogies will illustrate the point: Suppose an environmentalist group had lobbied for the government to ban all new house construction starting in 2002, or suppose a Marxist organization had lobbied for the nationalization of all real estate in 2002. Either of these moves, in retrospect, probably would have averted the housing bubble and its related consequences. But surely that doesn’t mean government officials back in 2002 would have been wrong to reject these proposals.

By the same token, Greenspan and others had valid reasons for resisting new regulations on the evolving markets in derivatives. As we will explain below, these complex assets can promote efficiency through risk transference. In other words, the world economy grew faster than it otherwise would have because of the proliferation of derivatives. So even if Weisberg and others are right, and the financial crisis is the fault of unregulated derivatives, it is still an empirical question whether avoiding the housing boom and bust would have been worth more than the extra consumption made possible all over the world from the market-driven growth in derivatives.

Government Mistakes: Sins of Commission

In contrast to the vague declaration that “someone should have done something!” offered by the critics of the Invisible Hand, proponents of the free market can point to specific government interventions that fostered the excesses of the housing boom. Most obvious is Greenspan’s handling of the Fed funds target rate and the growth of the monetary base following the dot-com crash. Greenspan’s easy-money policy coincided with the upswing in the housing boom. When the Fed began raising rates, housing prices tapered off and then began plunging. The connection between Fed policy and the housing bubble is so obvious that even mainstream analysts endorse the theory.

Other possible culprits include the Community Reinvestment Act (CRA), a Carter-era measure that was strengthened in 1995 and used to pressure banks and thrifts that enjoyed deposit insurance into lending in all neighborhoods where they accepted deposits, including low-income, weak-credit areas. Many analysts have also placed at least some blame on the Federal Housing Administration as well as the government-sponsored enterprises Fannie Mae and Freddie Mac. Through explicit or implicit federal backing, these agencies were able to bolster the secondary market for mortgages and allow applicants who otherwise would not have qualified to obtain mortgages.

When cataloging government interventions that may have contributed to the housing boom, we should mention the existence of the Working Group on Financial Markets—also known as the “plunge protection team”—that was established in response to the 1987 stock-market crash, as well as belief in the “Greenspan put,” the Fed’s perceived promise to provide bank liquidity when needed. As we will see, the financial crisis of 2008 was largely the result of institutions failing to protect themselves from (what seemed to be) improbable but catastrophic scenarios. Even though writers such as Nassim Nicholas Taleb have been famously warning about “fat tails” or “black swan” events, investors could quite rationally have downplayed these warnings. “After all,” high-level managers could have reasoned in the midst of the housing boom, “in the event of an absolute meltdown, the federal government will swoop in to save us. They couldn’t possibly stand back and let the entire investment banking industry collapse.” The bailouts engineered by Paulson and Bernanke have vindicated this belief. In retrospect it is not obvious that firms such as Lehman Brothers and Bear Stearns behaved foolishly. If politicians tell a man playing roulette that he can keep all of his winnings but will only suffer 20 percent of his losses, is it really irrational for him to borrow large sums of money to wager on the game?

Credit Default Swaps

The poster child for the (alleged) failure of the deregulated financial sector is the market for credit default swaps (CDSs). These contracts are traded over the counter, so no one knows exactly how much exposure they contain, but estimates place the worldwide notional value of all CDSs in the neighborhood of $50 trillion at the end of 2007. It was largely because of its issuance of CDSs that the giant insurer AIG needed a government bailout. The AIG episode showed that the financial panic was not limited to firms that foolishly overinvested in mortgage-backed securities but also could spread to those companies that had issued credit default swaps on the bonds of these now at-risk firms.

Although in practice CDSs can be complex, the idea behind them is simple. The seller of a CDS agrees to compensate the buyer in the event of a “credit event,” such as GM’s defaulting on its bonds. In return, the buyer makes periodic payments to the seller. The obvious analogy is to an insurance contract, but the difference is that people can buy a CDS on GM bonds even if they don’t own GM bonds. It is as if someone bought fire insurance on his neighbor’s house.

One reason these contracts are structured as “swaps,” rather than standard insurance, is to evade the regulations governing traditional insurance products. For example, if AIG wanted to sell life insurance to a man in Florida, it would have to set aside reserves according to Florida law in order to make it more likely that AIG could fulfill the policy if the man died a week later. In contrast, if AIG sold a Florida man protection against a bond default by GM, then the government allowed AIG much more discretion in how it handled this new potential liability on its books.

It is easy to see why critics of pure free markets have such disdain for the credit-default-swap market. This seems to be a clear case where short-term greed led to reckless behavior, which would have been prevented by prudent government oversight.

Yet matters are not so simple. After all, the shareholders and creditors of AIG were presumably not complete idiots. Did they care less about protecting their wealth than politicians in D.C. did? Did they understand derivatives less well than government bureaucrats understood them? Looking at the matter from a different angle, why would the buyers of

CDSs simply assume that the counterparty would make good on the contracts if government regulations did not enforce the same safeguards applied to traditional insurance?

It turns out the Invisible Hand did lead everyone to seek safety. Although all the details are not yet available, as of this writing it appears that AIG’s risk models (primarily developed by academic consultant Gary Gorton) were not to blame for sinking the company. Rather, AIG was driven into the arms of the government because its large clients (such as Goldman Sachs) insisted on larger and larger amounts of collateral as the financial crisis continued.

Plagued by Illiquidity

In other words, Gorton’s models may still prove to be fairly accurate. AIG was not crippled by a string of unexpected credit events (and consequent payouts). What actually happened is that the holders of CDSs issued by AIG became scared about its ability to honor its contracts, and AIG could not continue to operate while satisfying all of the growing calls to put up more collateral against these outstanding time bombs. In short, AIG was plagued by illiquidity, not necessarily by insolvency. It is true that AIG executives failed to prepare adequately for this contingency, but it nonetheless removes some of the mystery behind its failure when we realize that AIG may very well have correctly assessed the risk of its positions—it just failed to predict correctly how its customers would assess this risk, in the midst of a global financial panic and also during a period when there was a “credit crunch” among large institutions.

The case of AIG also reinforces our earlier point about government intervention muting the potency of market incentives. It takes two to tango. The problem of AIG on the eve of its rescue was the fault not just of AIG’s managers and shareholders, but also of the counterparties who had bought billions of dollars worth of CDSs from the insurer. In a completely free market, these counterparties would be subject to the hazards of a potential AIG bankruptcy. In reality, however, huge firms such as Goldman Sachs could rely on the U.S. government to rescue them from their reckless exposure to AIG. In fact, the New York Times reports that Lloyd Blankfein, the current CEO of Goldman Sachs, was the only investment bank executive in the room when federal officials decided to rescue AIG—and this was mere hours after they had decided to let Lehman Brothers fail. (As for Goldman’s demands for more AIG collateral, even “too big to fail” companies exercise some caution—just not enough.)

People Make Mistakes in the Market

In situations such as the present crisis, there is a temptation for libertarian economists to look for specific government interventions that “caused” the problems. This is understandable, and indeed we have listed some of these factors. Yet we should also remember that failure is a normal part of the market process. Investors and entrepreneurs are not omniscient. Bankruptcies do not signal the inefficiency of the market any more than the overthrow of Newtonian physics proved the weakness of the scientific method—let alone that government should take charge of all scientific research.

In addition to the definite contributions of government policies, it is also true—and proponents of the free market should feel no shame in admitting—that many institutions were seduced by fancy mathematical finance models. Part of what happened is that the whiz kids from MIT and other top-flight programs made simplifying assumptions on the underlying probabilities of various events. For example, Moody’s might have rated a particular mortgage-backed security as extremely safe, since it was composed of thousands of small bits of mortgages spread all over the country. Before the housing crash, the conventional wisdom held that “real estate is local.” It was considered virtually impossible that all markets—from San Francisco to Las Vegas to Miami to Chicago—would experience a large spike in mortgage-default rates simultaneously. Nobody had ever seen such a correlated fall, so it seemed like a reasonable assumption. The models, based on this assumption, produced results confirming the safety of mortgage-backed securities.

When confronted with this reality many free-market thinkers want to blame a government policy. In the case of the ratings agencies, we do have some contenders. The most obvious example is that the dominant firms (Moody’s, Standard and Poor’s, Fitch) benefit from government regulations placed on banks and other institutions. If a bank or insurance company wants to invest in bonds the government insists that these bonds meet a certain level of safety. Of course, the bank can’t simply hire Joe the Bond Rater to slap “AAA” on them. The regulations insist that a reputable ratings agency meet certain criteria. In practice these rules ossify the ratings market, and partially protect Moody’s and the others from the repercussions they would have suffered after their disastrous evaluations of mortgage-backed securities during the housing boom.

But even if the critics were right and the present crisis was largely caused by faulty forecasts made in the private sector, it would not prove a crushing defeat for free markets. After all, there are plenty of examples of horrible business decisions made by private individuals. The Edsel and “New Coke” flops, Decca Records’ 1962 rejection of the Beatles because “guitar music is on the way out,” and the rejection by a dozen publishers of the initial Harry Potter manuscript are all examples of stupendous entrepreneurial error. Given the advantage of hindsight, it is easy enough for us to laugh at the businesspeople who made such boneheaded calls, and critics of the marketplace could easily enough infer that the free market can’t be trusted with the task of innovation.

However, the mere existence of entrepreneurial error is not an indictment of free markets. People can only achieve bold successes when they take risks. The virtue of the market is that it allows individuals the freedom to risk their own money—or that of investors whom they can convince to fund them voluntarily—reaping the rewards if they succeed and bearing the losses if they fail. There is no reason to suppose that government bureaucrats would have designed better models of risk assessment. Indeed, two Fed economists wrote a paper in 2005 claiming that there was no housing bubble!

What is truly ironic is that the government’s rescue efforts—supposedly made “necessary” by the “unregulated” market—only ensure that market discipline will be weaker. Not all major institutions were taken in by the derivatives hysteria during the housing boom. Warren Buffett famously warned his own investors in 2002 that derivatives were “financial weapons of mass destruction” that would at some point wreak unexpected havoc. The takeovers of AIG, Fannie, and Freddie, as well as the $700 billion bailout, reduce the relative strength of those firms that behaved more sensibly during the boom. If and when the next crisis occurs, it will be in part because the government has just shown that playing it safe and adopting a long-term perspective doesn’t pay in U.S. financial markets. It’s much more profitable to go for the risky yet lucrative payouts, and then run to the government if things turn sour.

Amidst the efforts to “control the narrative” and assign blame for the financial crisis, fans of the free market should not lose sight of the real benefits of derivatives. Futures contracts on oil, for example, allow producers and major consumers such as airlines to lock in guaranteed prices and confidently engage in long-term projects that would otherwise be too risky. Even the much-maligned credit default swap allows the transfer of risk in mutually beneficial trades. Especially in an uncertain financial environment, CDS contracts allow certain firms to raise cash more easily—because those lending them money can buy CDSs on their bonds—and the price of a particular CDS contract itself communicates information about the market’s view of the firm being insured. These benefits will all be seriously muted if the government stampedes in and imposes top-down regulations.

Despite the claims of their critics—and even of some of their fair-weather friends—unregulated markets are not to blame for the systematic mistakes of the housing boom. Yet even if private errors were the primary cause, it still would not follow that government bureaucrats would make wiser decisions in the future.

Just one day later, September 20, the Bush administration announced a price tag: It would ask Congress for what the Times described as “unfettered authority for the Treasury Department to buy up to $700 billion in distressed mortgage-related assets from the private firms.” News reports noted that $700 billion amounts to more than $2,000 for every man, woman, and child in the United States. Secretary Paulson released a three-page draft of the legislation he wanted. It did not specify how the money would be spent, but did say that no court could review the Treasury’s decisions about spending the money. Paulson warned of dire consequences should Congress not approve the legislation quickly and as proposed.

In asking for huge sums and unrestrained power for government to intervene in financial markets, Bernanke and Paulson discarded any pretense of adhering to free-market principles. The Times reported that an attendee at a strategy meeting quoted Bernanke as justifying the abandonment of principles by declaring that, “There are no atheists in foxholes and no ideologues in financial crises.” The aim of avoiding a deeper crisis, in other words, rationalizes whatever seems expedient. We should flee from the threat of a “financial meltdown” even into the arms of a constitutional meltdown. Surprisingly, many “free-market” commentators and economists echoed this sentiment. Some of them pledged to reaffirm free-market principles in the future even while calling for their abandonment for the duration of the financial turmoil. Their questionable judgment seems to have been that more government intervention was needed to offset—and would offset rather than compound—the previous interventions that had created financial chaos.

Few in Congress questioned the figure of $700 billion. Some House Republicans proposed a nominally less-interventionist plan that would have had the federal government not purchase—“only” guarantee—home-mortgage assets. Instead of putting an explicit price tag on the taxpayers’ burden for the bailout, government guarantees of mortgages and mortgage-backed securities would have obliged taxpayers to pay lenders and bond holders whenever and wherever borrowers or security issuers defaulted, implying off-balance-sheet taxpayer exposure on an unspecified scale. A blank check rather than a $700 billion check—some improvement.

After congressional wrangling for nine days over what to add to the three-page Treasury proposal, a bill of 110 pages emerged. A deal had been struck. The Treasury’s authority to purchase had grown beyond mortgage-related assets to include “any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability.” In other words, whatever the two wanted.

Shock in the House

On Monday, September 29, the House of Representatives shocked political pundits by voting down the bailout bill 228–205. With constituent email and phone messages to Congress running heavily against the bailout (some estimates said 30–1), the majority that day disregarded dire warnings that Congress had “no time” to put any more careful thought into what it was doing.

Two days later, however, the U.S. Senate approved a further-revised bailout bill 74–25. Although they had not taken time to put a lot of additional thought into it, senators had nonetheless added a lot of text: The bill had now grown to 422 pages. The Emergency Economic Stabilization Act of 2008 now not only provided $700 billion for a Troubled Assets Relief Program, but also included sections and subsections on Renewable Energy Incentives, Carbon Mitigation and Coal Provisions, Transportation and Domestic Fuel Security Provisions, a grab-bag of tax-credit extensions, a subtitle for Mental Health Parity and Addiction Equity, another for Heartland and Hurricane Ike Disaster Relief, an increase in federal deposit insurance, and authority for securities regulators to relax accounting rules that financial firms facing mortgage-related losses were finding inconvenient. The height of special-interest absurdity was reached in Section 503 of the Act which, according to the official Library of Congress summary, “Exempts from the excise tax on bows and arrows certain shafts consisting of all natural wood that, after assembly, measure 5/16 of an inch or less in diameter and that are not suitable for use with bows that would otherwise be subject to such tax (having a peak draw weight of 30 pounds or more).”

Two days after the Senate vote, on Friday, October 3, the once-reluctant House approved the bailout bill 263–171. In the second House vote 33 Democrats and 25 Republicans switched from no to yes. One congresswoman unashamedly explained to National Public Radio that she had switched because the new bill included solar-energy tax credits. President Bush immediately signed the bill. Prices on the New York Stock Exchange, which had closed way down the day the first bill had failed to pass, closed down again on the day the revised bill passed and was signed into law.

“Plan” A

The “plan” for how to spend the $700 billion bailout has always been extremely vague, from its inception in the Bernanke-Paulson phone call, through the case Paulson made before Congress, to the passage of the enabling legislation. Improvisation continued up to the date this account was written in late November. The Treasury originally announced an intention to buy troubled mortgage-related assets, and hence the bill refers to a Troubled Asset Relief Program, or TARP. But on what terms would they buy these assets? More than a month after passage, that had yet to be made clear. American Public Media’s Marketplace program reported on November 7 that, “A securities industry trade group just came out with a survey, and it found that financial players are so unclear about how TARP would work, they aren’t sure they want to participate.” The Treasury had to schedule a meeting with banking industry representatives on November 10 to fill them in on the evolving specifics of TARP.

The “troubled” assets to be purchased are mortgage loans, bundles of such loans (“mortgage-backed securities”), and apparently any other financial assets the Treasury wants to include. What makes them “troubled” is basically that financial institutions can’t sell them for what they paid for them. The basic reason is that an unexpectedly huge share of mortgages has gone bad: Mortgage-default rates have skyrocketed. Further, the secondary market for mortgage-backed securities has dried up. A firm trying to sell some of its holdings would fetch only fire-sale prices.

There is a basic problem with having the Treasury buy assets that the market won’t buy except at fire-sale prices. Either the Treasury outbids the market and overpays for the assets—which benefits financial institutions at taxpayer expense—or the government pays the current market price, which would compel banks to mark other assets down accordingly and book the losses they’ve been trying to avoid booking.

In arguing for the bailout, Bernanke proposed that an “auction” of troubled assets for taxpayer-provided dollars would enable accurate “price discovery,” even though the Treasury would be the only bidder, and thereby would restore an active market. How such an auction would work, how it could be designed to arrive at hoped-for prices—above current market prices but not above what the assets would supposedly be worth in a normal market—was never spelled out. In mid-November “Plan A” appeared to have been more or less officially shelved. Never mind that Paulson had told Congress that hundreds of billions for troubled-asset purchases were urgently and immediately needed to avoid financial Armageddon.

On November 25 the idea of troubled-asset purchases made a dramatic comeback under the auspices of the Federal Reserve, which is discussed below.

“Plan” B

On October 13 the Treasury announced a new way to spend $250 billion of the $700 billion: It would inject equity capital into banks, buying newly issued preferred shares. It soon thereafter injected $125 billion into nine major banks: Citigroup, Bank of America, Wells Fargo, JPMorgan Chase, Bank of New York Mellon, State Street, Merrill Lynch, Morgan Stanley, and Goldman Sachs. The last-named is the former investment bank, recently converted into a commercial bank, previously headed by Paulson. From the group of nine banks the Treasury took “preferred shares” with fixed 5 percent dividends (increasing to 9 percent if the shares have not been repurchased in five years).

On November 23 the Treasury announced it would inject an additional $20 billion of equity into Citigroup. For this second injection it took preferred shares with an 8 percent dividend. The Treasury together with the FDIC also provided an off-balance-sheet guarantee against losses on about $300 billion of Citibank’s troubled real estate assets, in exchange for which the Treasury and FDIC took additional preferred shares.

The federal government is now part-owner of the nine banks. The banking system has been partially nationalized. The preferred shares are ownership claims of a type falling between debt obligations (bonds) and common stock shares. They are riskier than bonds because preferred shareholders must stand behind bondholders in the line to get paid in the event that the bank can’t pay everyone.

To compensate for its risk the Treasury also took stock warrants—contracts that give it the right to buy shares in the future at a specified price so that it can make a profit should the banks’ stock prices someday rise higher than that price. “Recapitalizing” a firm normally leads to lower share prices, however, because it means more shares dividing ownership of the same asset portfolio. The infusion dilutes existing shares. For this reason two of the nine banks reportedly objected to participating in the Treasury’s capital infusion with attached strings. The Treasury explained that it did not make participation voluntary because it did not want to stigmatize as weak the banks that chose to participate. A financial analyst’s report in late November named Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley, and Wells Fargo as the weakest institutions.

The other half of the Treasury’s $250 billion has been designated for assignment to smaller banks to be named later. Among other things, the Treasury reportedly hopes these capital injections will enable recipient banks to buy up other, weaker banks. An anonymous Treasury official told reporters: “One purpose of this plan is to drive consolidation.” Thus taxpayer money is being allocated to influence the shape of the banking market.

“Plan” C?

What will “Plan” C be? As the Treasury continues to improvise, everything and anything is possible. So says Neel Kashkari, the former Goldman Sachs employee under Paulson who is now the Treasury’s chief bailout administrator under Paulson. Asked whether funds might go to insurance companies, other financial firms, and even nonfinancial firms like automakers, one news story reported, “Kashkari indicated that everything was on the table. ‘We are looking at everything,’ he said. ‘We are trying to figure out what will provide the most benefit to the financial system.’”

House Speaker Nancy Pelosi, Senate majority leader Harry Reid, and other congressmen have urged the Treasury to use some of the $700 billion to inject capital into the leading U.S. automakers. These same lawmakers specified no such authority in the bailout bill. Some $1.5 billion of the $700 billion will go to local governments for reasons unrelated to the financial system.

Insurance executives have reportedly lobbied for the bailout to include troubled insurance company assets. There is now a precedent: The Treasury has given $67.5 billion of the bailout to AIG, the failed insurance giant brought down by its imprudently massive guarantees on mortgage-backed securities, in exchange for troubled assets and preferred shares. AIG was already on an $85 billion life-support loan from the Federal Reserve.

Second Bailout

The Treasury’s $700 billion bailout is actually the second federal bailout program underway. The press has widely reported on the Treasury bailout bill and the post-bill spending improvisations. Columnists and the public have openly debated the dubious wisdom of that program. Congress has held hearings and has voted on the bailout bill, even if it has left it to the Treasury to decide how the $700 billion will be spent. But flying under the radar, attracting much less public attention and almost zero congressional scrutiny, have been the Federal Reserve’s ongoing efforts that in mid-November added up to a $1.7 trillion shadow bailout program for favored financial institutions, more than double the size of the Treasury’s bailout. On November 25 the Fed announced two new lending lines that will add another $800 billion, bringing the total to $2.5 trillion—more than triple the size of the Treasury’s bailout. (This section draws heavily on my paper for the November 2008 Cato Institute monetary conference, “Federal Reserve Policy and the Housing Bubble.”)

The Fed’s bailout efforts began back in March 2008 with the Fed putting up $29 billion to sweeten a deal in which the commercial bank JPMorgan Chase would take over the teetering investment bank Bear Stearns. A new Fed-owned subsidiary (“Maiden Lane LLC”) was set up to cleanse the Bear Stearns balance sheet by acquiring troubled mortgage-backed securities for the $29 billion. The transformation of the Federal Reserve’s balance sheet, which used to hold virtually nothing but safe Treasury securities, had begun. Between March and November, as the Fed improvised new interventions into financial markets, the dollar amounts of the Fed’s commitments grew and grew.

The interventions are visible among the assets on the Fed’s balance sheet for November 5, where many new entries appear that were absent one year ago. The list begins with “Term Auction Credit” at $301 billion, representing 28-day and 84-day loans to banks. Previously loans to commercial banks were limited to overnight loans for meeting reserve requirements. Banks were expected to attract longer-term funds from depositors or private institutional investors in the money market. Next on the list is “Primary Dealer and other Broker-Dealer Credit” of $72 billion—that is, loans to securities dealers. A year ago the Fed did not lend to securities dealers. Third is the “Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”—loans to banks or bank holding companies to allow them to purchase assets from money-market mutual funds. Previously money-market funds that needed to liquidate commercial paper holdings were expected to sell them in the money market. “Other credit extensions,” a catchall fourth new entry, amount to $81 billion.

The fifth new entry is “Net portfolio holdings of Commercial Paper Funding Facility LLC,” $243 billion. A memo to the Fed’s balance-sheet release explains: “On October 27, 2008, the Federal Reserve Bank of New York began extending loans . . . to Commercial Paper Funding Facility LLC. This LLC is a limited liability company that was formed to purchase three-month U.S. dollar-denominated commercial paper from eligible issuers and thereby foster liquidity in short-term funding markets and increase the availability of credit for businesses and households.” That is, the Fed has formed a new subsidiary for directly allocating funds to a particular segment of the financial system, the commercial paper market. Previously the Fed purchased only Treasury securities, and let private banking and financial markets allocate the funds it thus injected to their best uses.

Sixth is “Net portfolio holdings of Maiden Lane LLC,” $27 billion, representing the troubled assets acquired from Bear Stearns. Note that the assets have been marked down from their acquisition price of $29 billion: the Fed has suffered a loss of $2 billion. By holding the assets the Fed is speculating that the market for selling them will be better later on. Previously the Fed did not get involved in financial takeovers by absorbing troubled assets to sweeten the deal. The FDIC sometimes did, but only in mergers between two insured commercial banks. Bear Stearns was an investment bank, not an insured commercial bank.

Last September the Federal Reserve began buying federal agency notes—short-term IOUs of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—from securities dealers. As of November 5 the Fed was holding $13 billion of such notes, where it held zero one year ago, though it has held small amounts of agency debt in the past. The Fed’s “primary” (overnight) loans to commercial banks are currently at $110 billion, up from only $1.4 billion a year ago. In total the Fed’s assets have more than doubled, from $889 billion a year ago to an astounding $2.08 trillion in mid-November. Further increases are on the way.

Two items make the Fed’s bailout loan program even larger than the $1.2 trillion increase in its total assets. First, the Fed has funded $303 billion of its new loans by selling off Treasury securities from its portfolio. Second, off its balance sheet (but recorded as a “memorandum item”), the Fed also runs a “Term Securities Lending Facility” that has lent $197 billion of its Treasury securities to broker-dealers, giving them something liquid to sell in exchange for IOUs collateralized by less liquid securities like mortgage-backed securities. As of November 5 the Fed’s new loans and purchases had extended $1.7 trillion in new credits to financial institutions over the past year.

On November 25 the Federal Reserve announced that in the following week it would begin purchasing up to $600 billion in securities issued or guaranteed by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. It would buy them from its primary securities dealers through “a series of competitive auctions.” It also announced the creation of a $200 billion Term Asset-Backed Securities Lending Facility to make new term loans to financial institutions, loans to be collateralized by nonmortgage pools of consumer and small-business loans. In both cases the Fed is engaged in price-setting, trying to drive interest spreads (the differential yields over Treasury bills required to attract purchasers) on riskier securities back into their historical ranges. Thus the Fed is second-guessing the risk premiums set in competitive financial markets. As of Thanksgiving, the new facilities had not yet appeared on the Fed’s balance shee

Unprecedented Credit Expansion

From $1.2 trillion of added bank reserves, the late-November lending programs (if not somehow offset) will push added bank reserves to $2 trillion. The Fed has no clear exit strategy from its unprecedented credit expansion. It has too few Treasury securities left to sell in order to pull the credits back in, the traditional method for contracting bank reserves. No doubt the Fed hopes that the new loans will be repaid (and not re-extended) as financial market conditions improve. But borrowing firms whose ability to repay depends on the prices of their mortgage-backed securities recovering may be unable to repay any time soon because the effects of overbuilding during the housing bubble will depress the price of real estate and thus of mortgage-backed securities for a long while. Moreover, they may be unwilling to repay. Nonbank financial firms that are now enjoying the Fed’s below-market lending rates will have no incentive to wean themselves and every reason to lobby for keeping the new bargain lending windows open indefinitely. “Temporary emergency” government subsidies have a way of living on and on. Just ask the recipients of federally subsidized farm loans.

The Fed’s new activities deserve to be called a bailout program because they seek to channel credit selectively at below-market interest rates, or purchase assets at above-market prices, in hopes of rescuing, or enhancing profits for, favored sets of financial institutions. The Fed’s new lending facilities are not parts of a central bank’s traditional “lender of last resort” role. A lender of last resort injects reserves into the commercial banking system to prevent the quantity of money from contracting—and thereby to protect the economy’s payment system—when there is an “internal drain” of reserves (bank runs and the hoarding of cash). There has been only one bank run (on IndyMac) and no contraction in the money stock. Investment banks do not issue checking deposits, are therefore not subject to depositor runs, and are not part of the payment system. Neither are securities dealers. Money-market mutual funds play a limited payment role, but because they do not issue demandable debt, they are not subject to runs. The Fed’s expansions of its own activities therefore had nothing to do with protecting the payment system or stabilizing the money supply.

The “lender” in “lender of last resort” has long been an anachronism. Central banks in sophisticated financial systems discovered decades ago that they can inject bank reserves without lending by purchasing government securities in the open market. By doing so, the central bank supports the money stock while avoiding the danger of favoritism associated with making loans to specific banks (or nonbanks) on noncompetitive terms. It also avoids the potential favoritism in purchasing other securities. The Fed’s new activities, by contrast, extend an array of loans to various financial institutions and purchase securities from nonbank issuers and holders. These activities pose the risk of favoritism—of substituting the Fed’s judgment for the market’s about what kinds of institutions and what particular firms should survive. They have nothing to do with replenishing the reserves of the banking system or preventing contraction in the stock of money. The Fed’s activities seem rather to aim at protecting financial institutions from the consequences of imprudent portfolio decisions.

The Federal Reserve’s new interventions into financial markets over the past year have proceeded at its own initiative and without precedent. They seem to be enjoying the complete freedom from oversight that Secretary Paulson unsuccessfully sought for the Treasury’s bailout program. The Fed’s program has attracted little attention mostly because it has not required a congressional appropriation. The Fed is “self-financing”: It can “print up” any funds it needs to make loans or purchase assets by simply expanding the quantity of unbacked claims on itself. This does not mean that Fed credit expansion provides a free lunch. When the Fed increases the stock of dollars, it levies an implicit tax on holders of existing dollar balances by creating an inflationary depreciation of the dollar.

An Evaluation of the Bailouts

The financial turmoil of 2008 was the result of what may be briefly described as a government-policy-induced cluster of entrepreneurial errors by financial-market participants. Paulson’s and Bernanke’s bailout programs are disabling the key market mechanisms for correcting entrepreneurial errors: price adjustments and bankruptcies. Delays in the correction of mortgage asset prices, and delays in the necessary resolution of insolvent financial institutions, do not promote but rather hinder a sound economic recovery. As ABC News commentator John Stossel has written: “We do need protection from reckless businessmen. But there is only one way to provide that: market discipline. That means no privileges and no bailouts.”

When government does not intervene with taxpayer-financed bailouts, private market participants will recapitalize banks (as Mitsubishi Bank recently did for Morgan Stanley) and buy distressed assets in genuinely price-discovering market transactions, to the extent that those risking their own money think warranted. The resolution (sale or liquidation) of firms that are not worth recapitalizing makes room in the market for better-run institutions to take their place. As the United States discovered in the savings-and-loan fiasco of the 1980s, and as Japan discovered in the 1990s, a government policy of keeping insolvent financial firms open beyond their expiration date makes survival more difficult for healthy firms.

Along these lines, the eminent monetary historian Anna J. Schwartz candidly criticized the bailout programs in an interview with the Wall Street Journal on October 18. To promote recovery the Fed and Treasury “should not be recapitalizing firms that should be shut down,” Schwartz said. Rather, “firms that made wrong decisions should fail. You shouldn’t rescue them. And once that’s established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich.”

Schwartz observed that “Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them.” Removing the uncertainty by enforcing the usual rules requiring insolvent firms to exit the market promptly would provide greater clarity to financial markets. The economist Pedro H. Albuquerque has drawn out the implications of this insight: bailout plans make “the information problem worse by keeping unhealthy banks afloat,” which “endangers the entire economy through planned obfuscation.” A hypothetical used-automobile market in which buyers are reluctant to buy because they fear that sellers are trying to palm off unreliable vehicles is known to economists as a “lemons” market. Albuquerque observes that “The government is artificially creating a lemon market when it does not allow discrimination between healthy and unhealthy banks to occur via bank failures.”

Some editorial and op-ed writers have claimed that many financial institutions have been “unregulated” too long and must now become regulated. But financial institutions have never been unregulated. They have been regulated by profit and loss. The failure of Lehman Brothers and the near-failure of Merrill Lynch raised the interest rate at which profit-seeking lenders were willing to lend to highly leveraged investment banks. The market thereby forced Goldman Sachs and Morgan Stanley to change their business models drastically and to convert to commercial banks. If that isn’t effective regulation, what is? Protecting firms from failure (Bear Stearns, AIG, Fannie Mae, Freddie Mac, Goldman Sachs, Citibank) and mitigating their losses with bailouts renders this most appropriate form of regulation much less effective.

The eagerness of Ben Bernanke and Hank Paulson to substitute their own judgment for the dispersed judgments of a freely competitive financial market may reflect simple intellectual error. Or, less innocently in the case of former Goldman Sachs CEO Paulson, it may be error compounded with partiality. In an open letter to Congress on the eve of the bailout bill’s passage, John A. Allison, CEO of the large and successful regional bank BB&T, pointed out that “There is no panic on Main Street and in sound financial institutions. The problems are in high-risk financial institutions and on Wall Street.” The bailout seemed designed, in his view, to benefit a select group of Wall Street firms: “The primary beneficiaries of the proposed rescue are Goldman Sachs and Morgan Stanley.. . . [T]his is primarily a bailout of poorly run financial institutions.” This design, Allison continued, was not an accident but the result of partiality in the designers’ interests and perspective: “Treasury is totally dominated by Wall Street investment bankers. They do not have knowledge of the commercial banking industry. Therefore they cannot be relied on to objectively assess all the implications of government policy on all financial intermediaries.”

What is especially noteworthy is the process through which the American public has been desensitized to the explicit expansion of state power in eight short years. It is a virtue that humans adapt quickly to new environments, but this strength can be turned into a weakness by clever politicians.

The housing boom and bust was a product of interventionist monetary policy, namely Alan Greenspan’s decision to slash interest rates after the dot-com crash. The crash in real-estate prices has in turn led to large defaults on mortgage payments, inflicting billions in losses for investment banks and other large institutions that had bet heavily on mortgage-backed assets. The heavily regulated financial sector was vulnerable to these unexpected events. What should have been a large hit to real estate and a few institutional investors has now spread and is currently threatening the global financial system itself. (We should keep this episode in mind whenever someone claims that the free market is too unstable and requires wise government oversight to promote stability.)

Villains and Saints

A panicked citizenry looks about for villains and saints, and the government is only too happy to dispense the labels. The villains are predatory lenders, short-selling speculators, and “do nothing” officeholders and regulators allegedly blinded by their laissez-faire faith, while the heroes (naturally) are the populist politicians who promise to clean up the greed and irresponsibility of the nefarious financial industry. If citizens would just suspend their abstract aversion to nationalization of large sectors of the economy, the government could keep them safe from further economic harm.

The Federal National Mortgage Association—FNMA or Fannie Mae—was founded as an agency of the federal government as part of the New Deal in 1938. Its function was to create a secondary market for mortgages, meaning that Fannie Mae, rather than originating loans to homebuyers, would buy mortgages (and their expected payment streams) from community banks and thrifts. In 1968 Fannie Mae was transformed into a private-sector company with shareholders, and its official connection with the government was transferred to the Government National Mortgage Association (GNMA or Ginnie Mae). The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 as another government-sponsored enterprise in the secondary mortgage market; it too is owned by shareholders.

The ostensible purpose of Fannie and Freddie is to promote homeownership. The two GSEs buy mortgages and bundle them into mortgage-backed securities, which are sophisticated derivatives that slice and dice the incoming monthly mortgage payments such that outside investors can (in theory) limit the risk of their real-estate investments. By providing a huge and liquid secondary market for mortgages, Fannie and Freddie make it more lucrative for others to originate mortgages. Make no mistake about it: The official mission of Fannie and Freddie is to cause banks to lend to applicants who would be rejected in the absence of government meddling. This point needs to be stressed as analysts wonder, “Why did banks make so many bad loans?”

All of this raises an obvious question. How exactly do Fannie and Freddie achieve their goal of promoting more mortgage origination than would have occurred in a free market? The answer is that these GSEs enjoyed implicit—and now explicit—government backing. Until quite recently, the official position of the federal government has been that Fannie and Freddie were private companies, earning private profits to be distributed to private shareholders. No taxpayer money stood behind them. However, investors suspected the GSEs were too big and too symbolic to be allowed to fail. Consequently, investors were willing to lend money to Fannie and Freddie—by buying bonds issued by these two GSEs—at lower interest rates than these same investors would have charged a truly private firm that performed Fannie’s and Freddie’s operations. Because their bonds were presumably guaranteed by the “full faith and credit” of the U.S. government—meaning the IRS and printing press—Fannie and Freddie were able to gain a huge share of their market; they directly owned or guaranteed roughly $6 trillion in mortgages. To repeat an earlier observation: The vulnerability of the overall system to a few giant firms is itself a product of intervention in these markets. If the government suddenly promised that it would use tax dollars to make creditors whole if Apple defaulted on its bonds, then we would expect it to become more “profitable,” cut prices, and gain market share from Microsoft.

It is worth pointing out that plenty of insiders got rich during the good times. Former Fannie chairman Franklin Raines earned some $90 million in compensation from 1998 to 2003. Even during the “bad times,” things weren’t so tough for the people running the two politically connected firms. As part of its takeover, the government ousted CEOs Daniel Mudd (Fannie) and Richard Syron (Freddie), yet they are entitled to compensation packages that could be worth up to a combined $24 million.

A Culture of Recklessness

Besides the implicit backing of their debt, the GSEs also enjoyed less regulation than their purely private counterparts. This bred a culture of recklessness and short-term thinking. To hit targets and trigger bonus payments to top executives, Fannie Mae manipulated its earnings over the period 1998–2004. Yet even when it was “caught,” Fannie was only fined $400 million in what was an $11 billion accounting scandal. Furthermore, one suspects that the full $400 million penalty did not fall entirely on the executives who defrauded their own investors, meaning the gamble was well worth it from their narrow point of view. Students of political economy know that regardless of the official motivation for a new government agency or program, once it is up and running, politicians, bureaucrats, and corrupt businesspeople will find ways to enrich themselves at taxpayer expense.

What is particularly insidious about government debt guarantees and rescue loans—whether the implicit backing given to Fannie and Freddie for decades or the explicit guarantee given to the Mexican government during its own credit crisis in 1995—is that they can often seem costless. Indeed, the U.S. Treasury actually made money on its “bailout” of Mexico because the Mexican government didn’t default on the bonds it had sold to investors around the world. In similar fashion, it didn’t cost the government anything for its implicit protection of the GSEs when housing prices were booming in the mid-2000s.

All of this changed, however, once house prices began sharply falling. Speculative buyers and those who had planned to refinance out of ARMs were now caught with mortgage payments they couldn’t afford, and so they began walking away. The stream of monthly payments into the bundled securities created by Fannie and Freddie was now drying up, and so the giants began losing money because as part of their normal operations they had guaranteed some of these payments. From the fourth quarter of 2007 through the second quarter of 2008, the two reported combined losses of $11.7 billion. Now the cost of the government’s backing would be evident.

Parsing Paulson

It will be instructive to parse the actual announcement of the Fannie and Freddie seizure. Right out of the chute, Paulson explained:

Note that the Congress didn’t send a bill to President Bush asking to nationalize the two corporations. On the contrary, it merely gave the relevant agencies the legal permission to take such actions if deemed “necessary.” This latter strategy is far harder to contain, because who could possibly object to giving the executive branch options? That seems to be a different issue from the question of which options were good ones. Thus members of Congress can truthfully say that they merely voted in the interest of preparedness for a takeover. The president and his minions can take the blame or praise for the specific exercise of the powers so delegated.

Paulson went on to say:

Since this difficult period for the GSEs began, I have clearly stated three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers—both by minimizing the near-term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure.

The problem here is that the “critical objectives” are incompatible. When Paulson talks of “supporting the availability of mortgage finance,” this means making mortgages more available than they would be in a purely free market. To achieve that objective, then, the government must expose taxpayers, and the skewed incentives will necessarily distort the financial markets. Again, there is no way around this. If the government induces lenders to make loans that they originally thought were too risky, then the government has obviously made the overall system more volatile.

After Paulson’s opening remarks, he turned the podium over to James Lockhart, director of the new regulator, the Federal Housing Finance Agency. Lockhart explained that the GSE structure was inherently flawed because private shareholders pocketed gains while the taxpayers were ultimately on the hook for massive losses. Even so, Lockhart further explained that as part of the takeover, Fannie and Freddie would expand their portfolios of mortgage-backed securities before reducing them steadily starting in 2010. As usual with government, when something isn’t working, the solution is to make the problem grow—call it a “surge” in mortgage portfolios. No doubt future administrations will continually revisit whether conditions “on the ground” warrant a reduction in the monstrous agencies.

Lockhart also revealed that in exchange for its guarantee, the Treasury received senior preferred equity shares and warrants (similar to call options) that entitle the Treasury to purchase up to 79.9 percent of the common stock of the two companies under certain conditions. (To the best of my knowledge, those “certain conditions” were not revealed to the public—it’s not merely that reporters have omitted the precise details out of laziness.)

It is significant to point out that the preferred and arguably even the common shareholders were robbed in this procedure. The Treasury’s “senior preferred equity shares” bump the original preferred shareholders down a peg, forcing them to absorb losses before the Treasury takes a hit. On the other hand, if things turn around and Fannie and Freddie stocks recover, then the Treasury would find it profitable to exercise its warrants and thereby dilute the values of the other shareholders. For these reasons, the term seizure is far more accurate than rescue to describe the government’s actions with respect to Fannie and Freddie.

The government cannot create wealth. Although he is very smart and understands financial markets, Henry Paulson cannot centrally plan the mortgage market to improve on the spontaneous outcome of voluntary interactions among millions of professionals in the private sector. The fundamental causes of our current financial crisis were mortgages granted to unqualified applicants, as well as investors making very risky bets on assets derived from these mortgages. The bailout of those who lent to Freddie and Fannie, and the easing of the GSEs’ regulatory limits, will only sow the seeds for a potentially worse crisis down the road.

The Trend Toward State Socialism

Beyond the harmful effects on the real-estate and mortgage markets, the seizures of Fannie and Freddie—as well as the bailout of AIG the following week—reinforce the trend toward outright state socialism. Investors are looking less at fundamentals and more at government announcements. The idea that these moves are encouraging “stability” is ludicrous, as the once-mighty Lehman Brothers was allowed to fail in between the two massive bailouts.

During normal economic times, if the government began seizing firms and disbursing hundreds of billions of dollars to particular institutions, and furthermore if each action were discretionary and impossible to predict even one week in advance, then everyone would recognize these policies as incredibly destabilizing. Yet this destabilizing effect still exists when laid over a backdrop of massive losses, and in fact hurts even more because of the victim’s initial weakness.

Hard as it is to believe, the best course of action would have been for the government to allow these troubled firms to fail. This would be akin to pulling the Band-Aid off quickly, which is temporarily painful but soon forgotten. But with the possibility of federal bailouts and other novel techniques to revive the housing sector, troubled firms have been postponing the inevitable, hoping for a reversal of misfortune. As the financial crisis has now entered its second year, Bernanke and Paulson are pulling off the Band-Aid very slowly indeed.

As government-sponsored entities, Fannie Mae and Freddie Mac allowed their private executives to profit greatly from implicit taxpayer support over a period of decades. However, now that their excessive risk-taking has finally caught up with them, the GSEs’ shaky balance sheets have been absorbed by the federal government, which at the same time has announced that the two failing giants will take on even more obligations. Besides the further bilking of the taxpayer, the seizure is an ominous sign of just how much power the executive branch has accumulated. The takeover of Fannie and Freddie will do nothing to promote stability in the financial markets in the long run, but it will serve as a precedent for further “necessary” expansions of government control of the economy.

The federal government unveiled $800 billion in new loans and debt purchases on Tuesday, hoping another infusion of cash can help unfreeze troubled credit markets and make borrowing easier for homebuyers, small businesses and students.The Federal Reserve said that it would buy up to $600 billion in mortgage-backed assets from the government-sponsored mortgage finance giants Fannie Mae and Freddie Mac. The agency would also buy up to $100 billion in debt directly from the companies and up to $500 billion in mortgage-backed securities….Separately, the Fed and Treasury Department announced a $200 billion program to ease commercial lending on debts like student loans, car loans or business loans. The Fed would lend up to $200 billion to holders of asset-backed securities supported by car loans, credit card loans, student loans, and business loans guaranteed by the Small Business Administration.

I don’t think that math is right, but Is there anything more dangerous these days than a desperate treasury secretary? Right now I can’t think of anything. What happens when the consequences of all this borrowing, re-lending, and money creation hit? Are we to believe that people in the financial markets are not looking to that day already and taking precautionary action?More from the Times:

The action by the Federal Reserve on buying mortgage-backed securities brings the full force of monetary policy to bear on the credit markets. Having already reduced the benchmark federal funds rate to just 1 percent, the central bank is now effectively using what economists call “quantitative easing” to reduce the costs of money.

Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated. [There's an understatement. -SR]

For the moment, Fed and Treasury officials made it clear that the sky was the limit. [Emphasis added.]

Have these people gone crazy?P.S. I made one of my periodic calls to a local car dealer to see if the car-loan market is frozen or in meltdown. (Oddly, that works out to the same thing.) Unless Honda World in Conway, Arkansas, is somehow exempt from general economic conditions, this market is decidedly unfrozen, unmelted-down, or whatever. “We’re making loans every day,” my friendly salesman Hans Chandler said. And I see that Ditech is still hawking mortgages on televsion for under 6 percent.

[I]ndustry watchers say credit card and auto lending has actually held up quite well despite the credit crunch. According to market research firm Synovate, the average consumer probably has a higher limit and therefore can spend more on their credit card than they could a year ago.”Our data shows that people have still have more access to credit than ever before,” says Andrew Davidson, a VP at Synovate. “Some companies are pulling back credit to riskier borrowers, but for the industry as a whole, access and usage of credit cards is at record levels.”

Whatever you think of government’s encouraging consumers to go into debt, the excuse given for it doesn’t hold up. By the way, I’m still getting credit-card offers, and I notice that Ditech and Lending Tree are still advertising low-interest motgages.

We are carefully evaluating programs which would further leverage the impact of a TARP [Troubled Asset Relief Program] investment by attracting private capital, potentially through matching investments. In developing a potential matching program, we will also consider capital needs of non-bank financial institutions not eligible for the current capital program; broadening access in this way would bring both benefits and challenges. [Emphasis added.]

The government’s tentacles spread further throughout the economy. What will they think of tomorrow?