The Fed’s Risky Business

The Fed’s Risky Business

by William F. Shughart II

Before being appointed Federal Reserve Board chairman, Ben Bernanke was known best in academic circles for his work on the Great Depression. Mr. Bernanke concluded from his studies that America’s economic recovery was due largely to the aggressive actions of President Franklin D. Roosevelt:

“Many of his policies did not work as intended but in the end, FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done.”

While more recent scholarship suggests the opposite — that Roosevelt’s New Deal both deepened the downturn that began before the October 1929 stock market crash and prolonged the nation’s economic miseries — Mr. Bernanke’s recent efforts to deal with the looming financial crisis and credit market meltdown are reminiscent of his hero’s. Mr. Bernanke’s first act was to announce a $200 billion line of credit for cash-strapped commercial and investment banks, which would allow them to borrow Treasury securities using risky mortgage-backed securities as collateral.

He then repeated the offer to brokerage houses. Within days, Goldman Sachs, Lehman Brothers, Morgan Stanley and other Wall Street giants had taken out $28.8 billion in new loans.

The Fed’s next move was to arrange JPMorgan Chase’s purchase of Bear Stearns for the bargain-basement price of $236.2 million (later sweetened to $1.2 billion) by guaranteeing $29 billion worth of Stearns’ illiquid assets.

As Mr. Bernanke should know, this is not the first time the federal government has rescued private businesses. And as he also should know, government bailouts are risky business.

During his famous First Hundred Days, Roosevelt signed a law creating the Home Owners’ Loan Corp. to refinance mortgages, relieving pressures on Depression-battered homeowners who could not make their monthly payments and on the banks that lent them the money.

The credit crunch of the early 1930s, a time before deposit insurance, was precipitated by runs on commercial banks by customers worried about the safety of their life savings. The financial crisis of 2008 is starkly different. There is no need to restore public confidence in bad business decisionmaking.

Today’s banks and brokerage houses brought trouble on themselves by energetically financing the purchase of homes by people who did not qualify for conventional loans and then bundling those subprime mortgages into packages of stock securities that were sold to individual and institutional investors. These securities rose in value as long as the housing market remained robust and they served as hedges against risk as long as falling home prices in some areas were offset by rising prices elsewhere.

When the housing bubble began popping everywhere last August, this hedge disappeared, exposing investors to massive risk.

Failing to foresee such risks is the same mistake that claimed Long Term Capital Management, the investment firm that collapsed in 1998 when its portfolio of foreign exchange holdings took a nosedive during the Asian currency crisis.

The record of government bailouts of private financial institutions in the 1930s, of Continental Illinois Bank in 1984 (which cost $8 billion) and of the entire U.S. savings & loan industry in the late 1980s and early 1990s (which cost $125 billion) teaches that emergency loans keep weak institutions alive just long enough for their problems to increase. Bailouts encourage more risk-taking and eliminate the freedom to fail that is just as essential to a free-market economy as the freedom to succeed.

The end result is likely to be further government intrusion into the private economy.

The Fed, in essence, has already become a member of JPMorgan’s board of directors, saying it intends to monitor the brokerage house’s actions to protect its $30 billion “investment.”

Politicians and regulators, from House Financial Services Committee Chairman Barney Frank, Massachusetts Democrat, to Federal Deposit Insurance Corp. (FDIC) head Sheila Bair, are calling for more government regulation to ensure greater transparency in financial markets and to restore investor confidence. Ms. Bair even thinks a new umbrella agency may be needed to coordinate the regulatory oversight responsibilities of the Federal Reserve, FDIC, Comptroller of the Currency and Office of Thrift Supervision.

A Department of Home Security may not be far behind.


William F. Shughart II is a Senior Fellow at The Independent Institute and Frederick A. P. Barnard Distinguished Professor of Economics at the University of Mississippi and editor of the Independent Institute book, Taxing Choice: The Predatory Politics of Fiscal Discrimination.


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