A Tool, Not a Fetish
In the wake of Sept. 29’s dramatic House vote, the prospects, nature, and chances for success of any revived Paulson plan were, to say the least, uncertain. What remained certain was that some sort of rescue, bailout, pick the euphemism or pejorative of your choice, was still needed, and needed quickly. That this could ever have been a matter of serious debate is remarkable. Even more remarkable is the fact that a good number of those seemingly opposed to the very idea of a plan have come from the GOP. Washington’s Republicans are supposedly the flag bearers, however tatty, torn, and stained their flag, of what little economic literacy there is within the nation’s capital. Witnessing some of their recent pronouncements, not to speak of their votes, has been a depressing exercise.
As a starting point, we need to discard the distinction so often and so misleadingly drawn between Main Street (good) and Wall Street (bad), and its close cousin, the Pollyanna chatter about the “real” economy (healthy) and the financial world (sick). In fact, Wall Street and Main Street are just different points along the same road. Those who operate within the financial markets do so in the pursuit of their own economic interests, and there are occasional, inevitable, and sometimes spectacular speculative excesses; however, those operations generally facilitate the (reasonably) efficient allocation of capital to the rest of America. It shouldn’t be necessary to remind Republican congressmen that capital is the lifeblood of any economy. It’s worth adding that if anyone really thinks the vital principle of moral hazard — the notion that rescuing failing financiers will encourage others to take excessive risks — has been junked, or that the Paulson plan would have meant that Wall Street had “gotten away” with this mess, I can probably find some Lehman stock to sell him.
And that’s why referring to that plan, an initiative designed to defend this system, as (to quote various House and Senate Republicans) “financial socialism,” “un-American,” and an example of the “Leviathan state” at work is absurd. A belief in the effectiveness of free markets is one thing. Market fundamentalism is another.
Free markets are, to steal Winston Churchill’s famous comment about democracy, the worst way of running an economy “except for all those other forms that have been tried from time to time.” Free markets work better than the alternatives because no one person, organization, or government has the smarts to allocate resources more efficiently than can the collective wisdom of the crowd. But the free market should be a tool, not a fetish, and as with all tools, there are instructions for its use. To think that it can operate in Galt’s Gulch isolation is to ignore history and psychology, and to confuse the economics of Hayek with those of Mad Max.
Free markets need a financial, legal, and regulatory structure to provide the element of trust — without which they cannot work very well, as we saw in Boris Yeltsin’s chaotic Russia. And that basic structure, experience shows us, has to come from the state. The only real question is how extensive it should be. As the failures of socialism demonstrate, too much state intervention is counterproductive. But too little can also be disastrous, especially when it comes to preserving the trust that (for example) enables banks to borrow short and lend long, thereby ensuring the free flow of funds on which the economy relies.
A breakdown in trust has been all too evident in recent months, both to those of us in the financial markets (I work in international equities, but should stress that I am writing in a purely personal capacity) and, increasingly, to those working outside them. In the more insular political arena, there seems to have been rather less understanding. When, on Sept. 23, Sen. Richard Shelby (R., Ala.) suggested that the U.S. should make sure it has “exhausted all reasonable alternatives” before proceeding with the Paulson plan, it was impossible to avoid wondering what, at that late stage, he had in mind. And then there was the first House vote.
Whether it’s the slowdown in interbank lending, the drastic contraction in the commercial-paper market, or even the fact that in late September the U.S. Mint ran out of its one-ounce “American Buffalo” gold coins owing to a surge in investor demand, the signs of collapsing trust and mounting panic in the credit markets (gyrations in the stock market matter much less) are unmistakable — and profoundly disturbing.
And when panic takes over, it is indiscriminate. Sound institutions can fail along with those that deserve to. It’s not only exuberance that’s irrational; free markets may rely on the collective wisdom of crowds, but as Charles Mackay (the 19th-century author of Extraordinary Popular Delusions and the Madness of Crowds) reminds us, crowds can go crazy. That’s why on some occasions the Fed has to take away the punchbowl, and on others come to the rescue.
Unfortunately, the problems this time are so great that the Fed’s interventions have not so far done the trick. At this point, government, the only institution with possibly enough resources (financial and otherwise) to halt this particular panic, has to step in with something very drastic indeed. It’s not pretty, or particularly ideologically comfortable for those of us on the right, but, like the free-market system, it’s pragmatic and, as such, thoroughly American. The Japanese delayed doing what they needed to do for years; the consequences are too well-known to need reciting here.
None of this is to claim that the original Paulson plan was perfect. It was very far from that (I’d have preferred a scheme with more direct equity investment in the troubled institutions). Equally, it must be acknowledged that the congressional Republicans’ criticisms improved the package’s terms prior to the first vote, if insufficiently to convince enough of them to vote yes. The problem is that, in the course of a panic on this scale, time is of the essence (this is not some bogus emergency on the usual Washington model). There is limited room for fine-tuning, with the markets waiting for a move.
As Rep. Henry Steagall (yes, that Steagall, and yes, he was a Democrat) wrote in 1932 about a fix proposed for an economic crisis:
Of course, it involves a departure from established policies and ideals, but we cannot stand by when a house is on fire to engage in lengthy debates over the methods to be employed in extinguishing the fire. In such a situation we instinctively seize upon and utilize whatever method is most available and offers assurance of speediest success.
No bailout, however deftly structured, offers any “assurance” of success. The situation is too treacherous for that. A bailout is a gamble, but not a stupid or extravagant one (banking crises never come cheap), and the stakes are too high to avoid it. To do little or nothing, or to rely on the free market alone, would be to display reckless optimism of the type that got us into this trouble in the first place.
The free market simply cannot do its job in a climate of rising and highly infectious financial panic, hysteria, and risk aversion. A bailout offers a chance of restoring the confidence needed for its normal operation, and with this the semblance of a normal economic cycle.
The alternative could well be systemic collapse, and it is that, not Hank Paulson, that will pave the way for Leviathan.