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Why bailouts don’t work

Patrick Graff | Tuesday, November 4, 2008

The events that have recently taken place in the financial markets give Americans and investors all over the world plenty of reason to worry. The complete annihilation of the investment banking industry, as well as the failure of companies like Fannie Mae, Freddie Mac, AIG and Washington Mutual have destroyed investor confidence in the market. In an attempt to help remedy market conditions, the House and Senate recently passed a $700 billion bailout plan which would use tax-payer dollars to help buy up assets backed by failing mortgages. The hope is to help cash strapped companies by buying up their illiquid assets and to provide even more credit to the market. Federal Reserve Chairman Ben Bernanke and Secretary of the Treasury Henry Paulson seem to think that this will thwart a recession and allow the markets to function normally again. The problem is it will not work, and, in fact, it will make the problem much worse.

Let’s go back to early 2001. Alan Greenspan, the Federal Reserve Chairman at the time, began slashing the federal funds rate (the interest rate at which banks lend to each other) in order to jumpstart the economy out of an impending recession caused by the recently burst internet bubble. Greenspan lowered rates from 6.5 percent at the beginning of January 2001, to a ridiculously low 1 percent by June of 2003. After holding rates steady for a year, the Fed gradually raised them back up to 5.25 percent by June 2006. The abundance of credit through low interest rates gave incentive to many businessmen to begin making deals that would not be economically feasible if the rates were at the real market price. This manifested itself in the creation of a new asset bubble in the housing market. Housing prices began to rise rapidly and all related assets, such as mortgage securities, became very lucrative. In short, people were borrowing when they shouldn’t have and were living beyond their means because artificial market conditions made it possible. When the housing bubble burst, this short lived reverie came crashing down and billions of dollars in value suddenly disappeared from the economy.

The problem is that artificially low interests rates cause malinvestments, which soon cause many unintended consequences. When scarce resources are allocated according to a central planner’s policies instead of real market conditions, inefficiencies will always exist. The market’s tool to cope with this situation on a large scale is recession. Recession allows the market to correct for activities that the economy cannot afford and consumers do not want. This $700 billion bailout plan will provide the credit to sustain these profitable and unprofitable activities for a limited time, but at a large cost. The influx of credit will continue to drive up inflation by dramatically increasing the money supply and thus rob purchasing power from every holder of U.S. dollars. When bubbles are created, recession is an unavoidable consequence; artificial credit will only create inflation and delay the inevitable.

The actions of the Federal Reserve and Department of the Treasury show an unwillingness to come to terms with the reality that the crisis is based on real factors which cannot be rectified through more of the same. When malinvestments and bad decisions are made, you have to allow prices to adjust downward to the real market value. Yes, we are looking at hard times. But if you continue to prop up this system that isn’t viable, you will have depression for the next decade instead of recession for the next year. The bailout aims to continue the fantasy that more artificial credit can fix the problem. Keynesian economists would have you believe that “deficits don’t matter.” Well, they are going to start to matter real soon when GDP growth begins to stagnate or turn negative as a direct result of current monetary policy.

Capitalism works on the back of savings and our debt ridden government cannot afford the temporary relief a bailout will grant. It is time to be honest and realistic about our monetary future. We need to return to principles of sound money, understand that the Federal Reserve System is the problem and not the solution and create wealth through free markets. We must face the consequences and live within our means, for soon it will be too late. 

Patrick Graff is a Philosophy Major and Philosophy, Politics, and Economics Minor. He is a zealous defender of free markets and the Austrian School of Economics, as well as a member of the College Libertarians. He can be reached at pgraff@nd.edu

The views expressed in this column are those of the author and not necessarily those of The Observer.