One again, a supposed “market failure” is actually the result of bad government policy.
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Subprime loan problems, which started out as a $300 billion problem, have morphed into a $1.5 trillion dollar problem affecting many different markets and types of institutions. Even if the wind shifted, and the fire moved the other way, the damage would have already been done. In other words, it would not matter if the house had actually survived because the bankruptcy would have already occurred.
Suspending mark-to-market accounting will not keep institutions that took excessive risk from failing. Bad loans are still bad loans and there is no way to avoid the pain that they cause. It will, however, end the negative feedback loop, which drags everyone down. It allows time to see if the wind shifts and keeps the flames from spreading.
In the 1980s, loan problems took down thousands of banks, but because we did not force fair value accounting, the economy and stock market actually thrived. Every money center bank would have been insolvent in the early 1980s if they were forced to write down Latin American debt to 10 cents on the dollar. Add in bad oil loans, which took down Penn Square and Continental, and bad S&L loans, and it is easy to see that the bank problems in the early 1980s were much more severe than those of the 2000s. But the rules were not as inflexible then as they are today. Problems did not spread, many banks eventually recovered their principal on Latin American debt and the economy grew.
In contrast, today’s problems are expanding, and have now caused the government to put almost $4 trillion of taxpayer funds at risk to support the financial system. This is an amazing sum of money, equaling 28% of GDP, or 42% of total U.S. stock market capitalization, or more than a quarter of all household debt outstanding, or nearly 40% of all private household mortgage debt, or three times the amount of subprime loans outstanding at their peak.
The government has tried multiple strategies. The only thing they all have in common is that they are designed to offset or stop the damage caused by mark-to-market accounting.
For example, banks have increased their excess reserves from virtually zero to over $630 billion because the Fed now pays interest on those reserves. The Fed uses these funds to buy commercial paper and other debt instruments. So banks are pushing off credit risk to the Fed to avoid any chance of further markdowns or losses. As long as there is a threat to the economy, the Fed will not be able to extract itself from this arrangement, and unless the Fed can extract itself there will be a threat to the economy.
In addition, the Fed has decided to buy Fannie Mae and Freddie Mac debt in order to bring mortgage rates down. One of the key reasons that mortgage rates have remained elevated in recent months is that lenders have become more risk averse, not less. And much of that is due to the erosion in asset values and the interplay with fair value accounting rules. Forcing interest rates down may encourage more home buying, but it does not change the underlying threat.
At some point the government will have thrown so much money at this problem that it could overwhelm the negative feedback loop of mark-to-market accounting. But, in the process, the government will grow larger and the free market will suffer. Moreover, every step on this path the government takes makes it harder to reverse course.
After all, when Chairman Volcker finally put the brakes on the money supply, inflation finally came to an end just like Milton Friedman predicted. But by that time, the government had done incredible damage to the economy as a whole and unemployment had climbed to almost 11%.
A man of faith in a godless age is hitting Americans where it hurts.
Mr. and Mrs. American Spectator Reader, let P.J. O’Rourke talk sense to your kids.
In Britain, defending your property can get you life.
It won’t take long for conservatives to scratch this presidential wannabe off their 2008 scorecard.
Was the President done in by the economy, or by the politics of the economy?