Why Bailouts Stinkand Why We Need Them

They may seem unfair to prudent taxpayers who ducked the housing frenzy, but lessons from the Depression show why federal rescues are necessary

Congress and the White House moved with surprising speed (measured by Washington legislative time, of course) last month to pass a bill aimed at bailing out the U.S. housing and mortgage markets. Like all legislation these days, the 694-page bill contains a grab bag of initiatives, but the most important elements put the full faith and credit of the federal government behind mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) while creating a program designed to help hundreds of thousands of troubled borrowers avoid foreclosure on their homes.

The legislation, signed by President Bush on July 31, is but the latest in a series of initiatives by the Federal Reserve, Treasury, and Congress to stem the rising tide of foreclosures and shore up the beleaguered banking industry. No one really knows what all this effort will cost taxpayers. But there's no doubt taxpayers are on the hook if the housing market continues to deteriorate.

Is that fair? Why should folks who didn't get caught up in the real estate frenzy of the 2000s pay for the financial mistakes of those that did? Many people didn't stretch their finances to buy as big a house as possible or invest in several "sure-fire" properties. They didn't take out interest-only mortgages, option ARMs, or apply for so-called liar loans. They were prudent with their money, perhaps continuing to rent while their friends bought homes or maybe staying in their smallish abode because the mortgage payments were affordable. Now they're on the hook for bailing out Wall Street, bankers, and irresponsible borrowers. That's not fair, is it?

No, it isn't.

Risk of Frightening Plunge

It isn't fair that the taxpayer is on the hook to rescue Fannie and Freddie while top executives of the mortgage giants keep their multimillion-dollar-a-year jobs. There's something wrong in a world where former chief executives like Stanley O'Neal of Merrill Lynch (MER) and Charles Prince of Citigroup (C) lose billions of dollars of shareholder money and helped create the credit crunch, yet they reaped so much on the way out that they'll never have to worry about paying a health-care bill or stay up late at night fretting about finding work.

That said, none of this means the bailout is a mistake. "My own view is that the world isn't fair," says Zvi Bodie, finance professor at Boston University. "But would it be fair to put the economy into a deep recession or depression? I don't think so."

There's the rub. If the monetary and fiscal authorities are right in their judgment that the risk of an economic plunge of frightening proportions is real, then the Herculean actions they're taking are fair to all of us. What's more, if innovation is the core dynamic in a capitalist economy, the engine of growth and higher living standards, then there will be booms and busts, especially during periods of rapid technological change. It's in the nature of the beast. Like it or not, limiting the downside damage when the boom goes bust is a critical part of the monetary authorities job.

Take the searing experience of the Great Depression. The 1920s was an era of remarkable technological and organizational innovation. Eventually, as happens in a capitalist system, the boom went bust. Yet the downturn morphed into the Great Depression, an economic calamity of momentous proportions. What happened? The Fed didn't do its job, according to Milton Friedman and Anna Schwartz's A Monetary History of the United States, 1867-1960.

Shoring Up the Money Supply

In essence, the authors argued that the Great Depression stemmed from a decline in the money supply. The public lost confidence in banks. Depositors wanted their money back. The money supply contracted. Bank deposits weren't being used to expand credit and economic activity but to meet the public's panicked need for cash. Incomes fell, economic activity plummeted, more banks went out of business, yet the Fed refused to break the cycle of fear by acting as lender of last resort.

"[T]he experience was a tragic testimonial to the importance of monetary forces," write Friedman and Schwartz. "The drastic decline in the quantity of money during those years, and the occurrence of a banking panic of unprecedented severity, were not the inevitable consequences of other economic changes."

They did not reflect the absence of power on the part of the Federal Reserve System to prevent them, according to the authors. "Throughout the contraction, the System had ample powers to cut short the tragic process of monetary deflation and banking collapse. Had it used those powers effectively in late 1930 or even in early to mid-1931… Such action would have eased the severity of the contraction and very likely would have brought it to an end at a much earlier date."

Scholars still debate the cause of the Great Depression, and the monetary explanation is only one of several accounts. The U.S. economy in 2008—with a 5.7% unemployment rate and economy expanding at a 1.9% average annual rate—is far from Depression-era statistics. Later on there will be a sorting out of whether the monetary and fiscal authorities exercised sound judgment or panicked, and what regulatory reforms are needed now that the Fed and Treasury are backing Wall Street and the mortgage market.

Meanwhile, it's safe to say the Fed is still shaped by its mistakes of eight decades ago. History rewards the bold—not the timid —when the financial system is threatened with collapse. And that may not be fair, but it's necessary.

Oh, as for those who were prudent with their money? There will be plenty of opportunities to buy homes at a substantial discount. That's fair play, no?

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