Although I haven't posted anything on the "Bailout", it isn't because I've been sleeping. I have a keen interest in economics, and have studied Austrian economic theory for a few years. For anyone interested in studying economics, check out the Mises Institute. They offer a free newsletter, free daily articles on their website or by email, and a few blogs. The Mises Institute is the leading advocate of Austrian economic theory in the world.
With that said, I have been following the ongoing economic rescue very closely. I was assigned a (home)school current events report on the bailout, and just finished it up this evening. It's rather long, but it explains the current situation in a simple way.
The Great Bailout
On October 3, 2008, the U.S. House of Representatives passed a bill, which had previously been defeated, appropriating $700 Billion to the U.S. Treasury. This money was to be allotted over an extended period of time, for the purpose of rescuing large financial firms in danger of failing. President George W. Bush urged House members that the bill be passed quickly to avoid a crisis.
Such massive government spending in so short a time is unprecedented. The $700 billion plan would raise the federal debt to $11.3 trillion, assuming all of the money was borrowed. The yoke of paying that debt, or at least the interest, may just be passed on to taxpayers later.
Such massive government intervention has not been seen since the Great Depression in 1930. It is evident that such a perceived need for spending and intervention must be caused by huge events in the market. In order to understand the present situation, it is necessary to study its history.
A real estate bubble was the first cause of what has been termed the subprime mortgage crisis. A bubble is created when large amounts of money flow into one sector of the economy. The best explanation that I have seen of the real estate bubble is an article by Mark Thornton,
The Housing Bubble in 4 Easy Steps.
[link]"1: The Federal Reserve cut interest rates to as low as 1% so that after inflation we had negative interest rates.
2: As a result, mortgage rates fell to an all time low.
3: Low rates caused borrowing and lending to explode, particularly in real estate. For example, commercial banks more than doubled the amount of real-estate loans they made.
4: All these low interest loans had to be extended to people with worse credit ratings and this increased the demand for homes and other real-estate assets. It should not be surprising that home prices skyrocketed."
Charts included in the article show that in 2001, the Fed began to cut interest rates, reaching a low of 1% in 2004. Mortgage rates show a similar slope downwards. Also in 2001, loans begin to skyrocket. The greater demand for loans came about because of the lower mortgage rate, and banks began making loans to borrowers who would previously have been considered unqualified. The reason for this was the rapidly rising price and demand for real estate, which made the banks confident that the homes could be sold easily for a profit. The borrowers were encouraged by low interest rates.
Fannie Mae and Freddie Mac, which were Government Sponsored Entities at the time, bought these loans from the lender banks. This also encouraged the banks in making loans, as they could shift the responsibility off of their own shoulders.
Fannie Mae and Freddie Mac were the catalysts for the subprime mortgage crisis. The purpose of Fannie Mae and Freddie Mac is to provide an opportunity for low-income Americans to acquire affordable mortgages. They would buy loans from the banks which made them, pool the loans together, and then sell these mortgage-backed securities to investors.
Mortgage-backed securities are considered a safe investment, because their cashflow (monthly dividend) is backed by the principal and interest payments of those to whom the loans are made. However, Fannie Mae and Freddie Mac guaranteed that their securities would be paid whether or not the mortgagee made their payments.
As the interest rate began rising in 2005, the demand for housing lessened and housing prices began to fall. The combination of these two factors resulted in a large amount of defaults and foreclosures. This began the subprime mortgage crisis.
Not surprisingly, commercial banks and mortgage companies who had been making unwise loans, or who issued mortgage-backed securities, began to show signs of failing. In June and July, 2007, it was found that funds issued by investment bank Bear Stearns and backed by subprime mortgages had nearly become worthless. This was due to the falling demand for subprime mortgages and a high rate of defaults due to rising interest rates. Legal action was taken against Bear Stearns for misrepresentation to investors. These problems eventually led to the government-encouraged weekend purchase of Bear Stearns by J.P. Morgan Chase.
Similar bankruptcies and takeovers occurred among other corporations involved in the subprime mortgage market. Government intervention prevented all involved except for Lehman Brothers from actually going bankrupt. Apparently, Lehman Brothers was allowed to go bankrupt as an "example" to other investment banks.
The fall in demand for mortgages and large amount of foreclosures led to huge losses by Fannie Mae and Freddie Mac, and, to avoid collapse, they were placed into conservatorship of the Treasury on September 7, 2008.
As the crisis loomed large on the financial horizon, President George W. Bush and U.S. Secretary of the Treasury Henry Paulson proposed a "bailout" plan. Their proposal was that $700 billion dollars of troubled assets, such as mortgage-backed securities, be acquired by the Treasury.
In practical terms, this meant that the Treasury would issue Treasury bonds to buyers around the world, amounting up to $700 billion. This would, of course, raise the national debt by the same amount. Then, the Treasury would buy the assets which were at the root of the financial crisis, particularly mortgage-backed securities. The Treasury would then sort the assets with value from the assets with little to no value, and would resale any assets with value. The proceeds from this sale would then be used to buy back T-bonds, thus lowering the national debt again.
In theory, this plan sounds feasible and seems like it would be effective, but it has many weak points exposed by its critics. Should the plan work as intended, there would be no cost to the taxpayers.
The most effective arguments against the rescue plan come from economists of the Austrian school of economic theory. Austrian economics takes its name from the fact that most of its founders, or prominent members, come from Austria. Austrian economists believe that government intervention is not necessary for a market to function as it should.
Austrian economists were
predicting the current recession as early as 2004. Now that the crisis has occurred, Austrian economists have argued that the government "bailout" will actually slow recovery. Here are some examples of the market solving its own problems in the current bailout, taken from
The Rescue Package Will Delay Recovery [link] by an Austrian economist, Frank Shostak.
"The market's ability to make swift adjustments without much drama was vividly illustrated only a few weeks ago when the very large investment bank, Lehman Brothers, was allowed to go belly up."
"One could have made the case that when Lehman was on the brink it was too big to fail — assets of $639 billion and employing over 26,000 people. Yet in a few days the market, once allowed to do the job, reallocated the good pieces of Lehman to various buyers and the bad parts have vanished."
"Washington Mutual, the largest US saving and loan bank, was forced into liquidation" due to "heavy losses on its $227 billion book of real-estate loans, of which a large portion was in subprime mortgages."
There are also arguments against the feasibility of the bailout plan. First, the plan assumes that enough of the assets have enough value to pay back the lenders (those that purchase T-bonds) with interest. If these assets do have value, why are the investment banks holding them going bankrupt? Why are no private investors attempting to profit from these mortgage-backed assets?
Assuming that the assets have some value, the government must then manage the buying and selling process very efficiently to prevent over-spending or under-selling. The government doesn't have a very good track record of efficiency.
If the government fails to meet either one of these two contingencies, the consequence will be an increase in the federal debt, and thus a greater burden on taxpayers, or an inflation money supply, which would result in higher prices for the same taxpayers.
Austrian economists also dispute the idea that the principle of the bailout will work at all. Frank Shostak continues in
The Rescue Package Will Delay Recovery:
President Bush urged that the rescue bill be passed quickly. The bill, HR 3997, was first voted on in the House of Representatives on September 29, 2008. The bill was defeated 228-205, a major legislative defeat for President Bush, and described by the Washington Post as "stunning." The fact that the Representatives were voting as their constituents wished was explained away by the fact that many of the representatives were running for re-election in just five weeks, and feared losing the votes of their constituents. Sadly, President Bush disregarded the overwhelming response of the people against the bill. After the bill was defeated, the President stated: "I’m disappointed in the vote by the United States Congress on the economic recovery plan."
HR 3997, The Emergency Economic Stabilization Act of 2008, was desperately amended by the Senate to include several tax benefits, although it also raised the funds appropriated to the Treasury to $810 billion. The bill was passed by the House on October 3rd by 263-171.
The bailout of the financial industry is beginning. If everything goes as the government plans, the economy will pull through this crisis and recession quickly as the credit markets begin functioning freely again. If the Austrian economists are correct, the bailout will have little effect other than postponing the inevitable market adjustments. Are the Austrians right? We will know in a few years; in the meantime, I wouldn't recommend investing in mortgage backed securities.
