Irwin Stelzer, writing in the Weekly Standard, discusses the implications of the Bear Stearns bailout and the regulatory reform proposal Treasury Secretary Paulson unveiled last weekend:
The investment banking industry as we knew it is no more. Change has been inevitable ever since the Bush administration and the Federal Reserve Board decided to use taxpayer money to back J.P. Morgan Chase's takeover of Bear Stearns. R.I.P. the deregulatory trend that has dominated policy towards America's financial institutions. Enter the lawyers, regulators, and politicians to reshape the nation's financial markets.
Investment bankers might moan, but when they created a system rife with conflicts of interest and too few incentives to good performance, followed by acceptance of billions of taxpayer money, they sold their deregulated birthright. When Fed chairman Ben Bernanke received permission from the White House and Treasury Secretary Hank Paulson to take almost $30 billion of Bear Stearns' paper onto the Federal Reserve Banks' balance sheet--and to open the discount window to other investment banks, to use the jargon of the trade--it put the taxpayer at risk.
Stelzer's language is not even condemnatory; if anything, it is reflective of a deep resignation, born of the knowledge that the wheel of history has turned, and that, given the actions of the participants, regulation of investment banks is simply a logical development. The bundling of collateralized debt instruments, and the sale of the same to third parties (and beyond) created a dense skein of interrelationships, increasing the likelihood of systemic failures, as opposed to isolated ones, and the fact that the entire architecture operated outside of the reserve requirements under which depository institutions operate, created a system of leverage that looked rather creaky once the black swans caused various asset classes to move in opposite directions, throwing the sophisticated mathematical formulae of the best and brightest into confusion.
In other words, the cowboys of financial innovation, always at least several steps beyond the reach of the regulatory agencies, created a system of financial relationships that was Too Big to Fail. And so the established powers are striving to move heaven and earth in order to ensure that it does not; meanwhile, the jury is still out deliberating over whether their efforts even can succeed.
The question that is always raised in connection with such bailouts is that of moral hazard: will such implicit guarantees - sometimes elevated to explicitness - encourage speculative and risky financial activity that, in other circumstances, and on any rational accounting, would appear imprudent? In the abstract, of course, the answer is obvious and affirmative. In reality, the answers quickly become more complicated; but the logic of the present crisis is that new regulation will be the inevitable price of government-backed salvation:
Wall Street had hoped to take the money and run. But Frank Sinatra had it right: like love and marriage, when it comes to bail-outs and regulation, "You can't have one without the other."
The ostensible logic of regulation is to create a series of mutually-reinforcing interests: the regulatory agencies of the state have an interest in avoiding bailouts, and the regulated entities have an interest in avoiding the risky behaviour that will necessitate bailouts - and penalties. That's the theory, anyway. Given both the pace of innovation in finance, and the mutual interpenetration of the parties, anything could happen.
It is imperative that it be appreciated, however, that moral hazard has not been a merely incidental bug in the system, one that manifests itself every now and again, as in the subprime fiasco. Rather, moral hazard has been intrinsic and systemic, a consequence of the dolorous combination of the Fed's loose, low-interest-rate monetary policy, which propped up two successive bubbles, a lax regulatory environment, a wave of financial innovation justified by a myth of self-regulation and created - in part - in order to evade regulation, a growing current accounts imbalance, both personal and national, and localized regulatory insanities, such as the so-called anti-redlining mandates. All of these factors are mutually-reinforcing, but the bottom line is that a loose monetary policy fueled a bubble of asset prices, which could not be sustained owing to the imprudence of lenders and borrowers (micro-level) and the overall indebtedness of American society, coupled with the inexorable pressures of
globalization international labour arbitrage - the type of economy we now possess could not sustain both those asset valuations and the jobs people require to acquire such assets (macro-level). In other words, bad monetary and fiscal policy undertaken in the context of globalization's pressures was bound to produce both crises and the necessity of bailouts, which are merely another way of saying that gains are privatized, while costs are socialized. The monetary and regulatory policies of the financial establishment, from the Fed downward, were incongruous with the economic realities of the post-national, post-industrial American economy. Ergo, moral hazard was intrinsic to the system.
One issue remains outstanding, namely, the public perception of class-favouritism, of a socialism for the wealthy, who are Too Important to be subject to the same market forces as the rest of us:
...it is difficult for voters to understand why billions in their taxes can be used to enable one investment bank to acquire another, but not one cent can be devoted to preventing a family from being tossed out on the street. Even some conservative congressional Republicans are muttering that sauce for the Wall Street goose is sauce for the Main Street gander. It will be a brave politician indeed who goes through this election cycle chanting "The free market will solve this problem; intervention postpones the solution--and will in the end make the problem worse." Hillary Clinton and Barack Obama both want $30 billion of taxpayer money devoted to the relief of hard-pressed home owners--the same sum devoted to preserving at least some of the value of Bear's shares, worthless without the Fed's intervention, sold for around $10 with Fed backing of the J.P. Morgan takeover.
Any politician who went through the present election season reciting that mantra about the free market would be shellacked, and rightly so; for the entire architecture of the system that failed represented a distortion of the market forces that would have obtained in the absence of bad policies - such a politician would be doing nothing more than granting political cover to a Federal Reserve system that failed, and to a banking system that articulated imprudent degrees of leverage. One cannot coherently present a distortion of a market system as the essence of the market itself, as was done in all of the delirious talk about the Anglo-American financial model, then act as though that entire sector of the market is now non-market, such that only individual mortgage-holders, who ought to have known better, remain in the market. One cannot be so arbitrary with the borders of the market, deeming some interventions permissible and others forbidden, particularly when the latter are but a pittance by comparison to the former. Swallow the one, and you may as well swallow the other, for illusions' sake. If you do opt to act arbitrarily in this fashion, the message communicated infallibly will be that the system will act to protect the interests of the powerful, while the little people can eat cake, or live in tents. A democratic society cannot endure if the elites are permitted, openly, a separate peace, an alternative set of favourable rules accessible only by themselves. Intervention is intervention; and if it is necessary in the case of the financial establishment (which it seems to be, as policy errors create a self-reinforcing logic) in order to prevent collapse, it is necessary in the case of the small homeowners in order to preserve some semblance of legitimacy, or at least the fiction thereof.