Today’s Bailouts Are the Result of Bad Incentives Created by Previous Bailouts

Tyler Cowen explains how the bailout of LTCM in the 1990s helped create the excessive risk that produced today’s financial turmoil. Unfortunately, politicians think injecting more heroin is the best way to wean the economy off drugs:

The financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad. …Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses. …With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed… Bolstered by this sense of security, bad loans mushroomed.

Of course, there were many reasons for the reckless lending and failures of risk management that led to the most recent systemic credit shocks. …The Long-Term Capital episode…was important precisely because the fund was not a major firm. …After the episode, financial markets knew that even relatively obscure institutions — through government intervention — might be able to pay back bad loans. The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good. …In 1998, there was no collapsed housing bubble, the government’s budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months. The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. …this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.

Bailout of Long-Term Capital: A Bad Precedent?

World Government?

If one likes the corruption and anti-market activities of the European Union, Organization for Economic Cooperation and Development, and Union Nations, then the future may be wonderful. Gideon Rachman writes in the Financial Times that a world government is increasingly likely. President-Elect Obama’s naiveté and ideology make him susceptible to these endeavors, and the Europeans would welcome the chance to shackle America:

…for the first time in my life, I think the formation of some sort of world government is plausible. A “world government” would involve much more than co-operation between nations. It would be an entity with state-like characteristics, backed by a body of laws. The European Union has already set up a continental government for 27 countries, which could be a model. The EU has a supreme court, a currency, thousands of pages of law, a large civil service and the ability to deploy military force. …a change in the political atmosphere suggests that “global governance” could come…soon… The financial crisis and climate change are pushing national governments towards global solutions, even in countries such as China and the US that are traditionally fierce guardians of national sovereignty. Barack Obama, America’s president-in-waiting, does not share the Bush administration’s disdain for international agreements and treaties. In his book, The Audacity of Hope, he argued that: “When the world’s sole superpower willingly restrains its power and abides by internationally agreed-upon standards of conduct, it sends a message that these are rules worth following.” The importance that Mr Obama attaches to the UN is shown by the fact that he has appointed Susan Rice, one of his closest aides, as America’s ambassador to the UN, and given her a seat in the cabinet. …Jacques Attali, an adviser to President Nicolas Sarkozy of France, argues that: “Global governance is just a euphemism for global government.” As far as he is concerned, some form of global government cannot come too soon. …International governance tends to be effective, only when it is anti-democratic.

Taxpayers Picking Up the Tab for a Bigger Bailout Thanks to Republican Lobbyists

The Associated Press reports on the various former Republican politicians who got fat contracts and enriched themselves in exchange for lobbying on behalf of Freddie Mac. Unfortunately for taxpayers, these amoral lobbyists were successful and the government-created entity was able to dig itself even deeper into a hole – which taxpayers are now responsible for filling.

When the Washington Nationals played their first-ever baseball game in the nation’s capital in April 2005, two congressmen who oversaw mortgage giant Freddie Mac had choice seats – courtesy of the very company they were supposed to be keeping an eye on. …The Nationals tickets were bargains for Freddie Mac, part of a well-orchestrated, multimillion-dollar campaign to preserve its largely regulatory-free environment, with particular pressure exerted on Republicans who controlled Congress at the time. Internal Freddie Mac budget records show $11.7 million was paid to 52 outside lobbyists and consultants in 2006. Power brokers such as former House Speaker Newt Gingrich were recruited with six-figure contracts. Freddie Mac paid the following amounts to the firms of former Republican lawmakers or ex-GOP staffers in 2006: Sen. Alfonse D’Amato of New York, at Park Strategies, $240,000. Rep. Vin Weber of Minnesota, at Clark & Weinstock, $360,297. Rep. Susan Molinari of New York, at Washington Group, $300,062. Susan Hirschmann at Williams & Jensen, former chief of staff to House Majority Leader Tom DeLay, R-Texas, $240,790. …The tactics worked – for a time. Freddie Mac was able to operate with a relatively free hand until the housing bubble ultimately burst in 2007. http://news.yahoo.com/s/ap/20081207/ap_on_go_co/the_influence_game_fre ddie_mac;_ylt=AnVL2NgotsHh6s.yTrra01lp24cA

Interestingly, at least one of these former politicians is contemplating a return to the political arena. He even portrays himself as a friend of the taxpayer. It is unclear, though, how much of a friend he really is considering that the story reveals that, “Freddie Mac enlisted prominent conservatives, including Gingrich…, paying [him] $300,000 in 2006, according to internal records.”

Politicians Creating Anti-Growth Business Environment.

Investor’s Business Daily notes that companies now have an incentive to escape America because of the punitive tax and regulatory policies imposed by the political class:

Much political hay has been made in Congress about “unpatriotic” corporations that move operations abroad. Weatherford International is the latest, taking its headquarters from Houston to Switzerland. The oil services company said that it wants to be closer to its markets. But what it really meant was that it no longer saw the future in the U.S. In a political atmosphere of blaming corporations, it’s no wonder. Halliburton fled to Dubai in 2007. Tyco International, Foster Wheeler and Transocean International all went to Switzerland. As a pattern emerges, America’s global standing diminishes, in part because it’s based on the willingness of companies to invest. It’s an especially bad sign when domestic companies flee. …What accounts for this vote of no confidence in the U.S.? Start with the demonization of oil companies. Executives have been hauled before Congressional star chambers, held up to abuse and ridicule, and then blamed for high oil prices as if they wanted to kill their markets. Rising global demand, nationalizations and Congress’ failure to open the country to drilling go ignored. …With an expanded Democratic Congress and an incoming Democratic president determined to create “patriot corporations,” it’s no surprise to see companies try to get out while they can. Make no mistake – it’s investment fleeing the country. As this goes, foreign capital could flee next.

Read the whole article here.