The transmogrification of federal bailout efforts illustrates why the government should not be in this game.
Simply put, government has neither the wisdom nor the self-restraint to manage a bailout or ameliorate necessary market corrections, regardless of how large or painful they may become.
Free markets depend on failure. This is a hard concept for many people to understand or accept. But failure is how markets impose discipline and reallocate resources from less efficient producers to more efficient ones.
Bailouts are an attempt by government to interrupt and prevent market failures.
Initially, this was justified on the basis that government needed to act to prevent systemic risk. This is the fear that the failure of company A will lead to the failure of Companies B, C and D, and then we'll all be standing in bread lines.
So, to prevent feared systemic failure, the federal government forced the fire sale of Bear Stearns and took over the country's two largest mortgage firms and the country's largest insurance company.
Rather than deal with the fear of systemic risk one company at a time, the Bush administration proposed that the federal government get into the business of buying distressed assets from financial institutions, particularly mortgage-backed securities, thought to be the heart of the problem.
Congress allocated $700 billion for the program. Although the language of the bill was written irresponsibly loosely, it was clear to all that the purpose was to buy distressed assets directly. It was even called, legally in the legislation, the Troubled Assets Relief Program.
Now, Treasury Secretary Henry Paulson has announced that none of the money will be used for the purpose for which it was allocated. Not a penny.
Instead, Paulson has been using the money to buy preferred shares in financial institutions. He began by investing in nine large banks he described to the American people as healthy. In other words, they didn't need the money.
This was supposedly to reduce the stigma attached to participating in the program, so that the financial institutions that did need help wouldn't be reluctant to ask for it. Instead, a reverse stigma was created. Healthy smaller banks felt obligated to try to get federal funds as well, fearing being perceived as too weak to qualify.
So, presumably to try to restore "confidence" in the system as a whole, the government has purposely obscured from depositors and investors which banks are healthy and which need help. Remember that the next time you hear some government official pontificating about the need for more transparency in private markets.
It's clear that the Bush administration is no longer trying to do the minimum necessary to avoid systemic risk, the collapse of the entire financial system. In fact, Paulson has declared that that danger has passed.
Instead, the Bush administration is trying to use its pile of money to make more credit available on easier terms in an effort to goose the economy. So, Treasury wants to expand the program to include companies dealing with auto, student and consumer credit, none of which can be remotely described as representing a systemic risk to the financial system as a whole.
Democrats in Congress want to include the auto companies themselves, which is most accurately seen as a jobs program. Auto parts manufacturers want in on the action.
So, rather than a targeted program to avoid systemic risk, there's a $700 billion grab bag for whatever interests can politically muscle their way to the front of the line.
This isn't to say that government has to remain idle during economic downturns. The government is good at writing checks. It can increase income support to those most vulnerable during a slow economy.
However, the government is incapable of managing or ameliorating fundamental market corrections. If the country has overinvested in housing, housing prices have to come down. If the country has overborrowed, credit must become more scarce and costly. If auto companies have developed unsustainable cost structures, they need to pare their expenses through bankruptcy reorganization.
The federal bailout bill allocated an initial $350 billion, with Treasury able to trigger the second $350 billion subject to a vote of disapproval by Congress.
The sensible thing to do at this point would be to shut the program down. Paulson has indicated that he might not trigger the second $350 billion.
But that would leave $350 billion on the table. And that's a temptation I doubt the politicians can resist.
