Saturday, September 20, 2008
The Wall Street Journal has a useful article about the history of bailouts. Money quote:
[A] short walk through U.S. history demonstrates the point made by Alex J. Pollock of the American Enterprise Institute: "If you would like an empirical law of government behavior, it is that in a panic or threatened financial collapse, governments intervene -- every government, every party, every country, every time."
Moral hazard, it seems, is at the margin.
Anyway, the story of Alexander Hamilton's response to the panic of 1792 is worth reading to the last line:
The nation's first president was in his first term when the U.S. ran into its first financial panic.
In 1791, the federal government assumed obligations that such states as Massachusetts and South Carolina owed from the Revolutionary War, part of a larger deal that included moving the national capital from New York to Philadelphia to Washington. Taking on the states' obligations added about $18 million to a total U.S. domestic debt of $65 million -- debt securities that proved attractive to financial speculators.
Primary among them was William Duer, a well-connected New York businessman who schemed to start a New York bank to drive down the price of Bank of New York stock and win control of BONY on the cheap. He and his colleagues also intended to corner the market on government 6% bonds, so-called Sixes.
Treasury Secretary Alexander Hamilton, the founder of BONY, watched the developments with alarm. "I have learnt with infinite pain the circumstance of a new Bank having started up in your City," Mr. Hamilton wrote to a New York associate, according to research by economic historians Richard Sylla, Robert E. Wright and David J. Cowen. "Its effects cannot but be in every view pernicious," because of the damage they caused to "the whole system of public Credit, by disgusting all sober Citizens and giving a wild air to everything."
The price for Sixes in New York jumped markedly from early December to mid-January. By March, the bubble had burst, with the price of the bonds dropping 25% over two weeks.
Working without a historical blueprint, Hamilton engineered an innovative response. The Treasury borrowed money from the banks and used it to buy government bonds, lifting the market price. He also told banks to accept bonds as collateral for loans to securities brokers, with the government guaranteeing the collateral.
"What Hamilton did in 1792 is just like what Paulson and Bernanke are doing now," said Mr. Sylla, who teaches at the Stern School of Business at New York University.
The financial system stabilized in April, and not a single bank failed until 1809. Mr. Hamilton's improvisation did the trick, or at least so concludes Mr. Wright, also at NYU. He named his son Alexander Hamilton Was Wright.
Either Mrs. Wright shares her husband's enthusiasm for financial panic arcana or she is the world's most accommodating wife. Or both. That said, should young Alex decide to become an economic historian, his name will provide an excellent interview-starter.
I was deeply suspicious of this purported 'rescue' scheme until my wife (who is a banker) sent me some background information on how such things had cropped up and been handled successfully before. At least it's a formula that has worked before.
It'll work out, okay. We bailed out the Masters of the Universe; now, we'll just raise taxes on the Masters of the Universe to pay for it.
In the meantime a lot of houses got built; and a lot of "poor" people got a couple of years "Free Rent."
In an alternative universe, there is no "bail-out", and thus more banks fail and we go into a deeper financial crisis.
The housing market continues to flounder, and house values in many places drop to below their loan value. Cities and towns that rely on property tax to pay for their school systems are strapped for money, now, too.
The stock market flounders around for a couple of years too, with the IRA and 401-K retirement funds of many Americans in jeopardy.
Just like a lot of things, this "bail-out" smells pretty bad to the average tax payer. I'm sure there will be no lack of people harshing Bush and the Republicans for pushing this plan. $700 billion is a LOT of money. But again, in the alternative universe, who is to say that it couldn't get a lot worse? How much wealth is lost if we get into a real bear market and the Dow drops below, say 9,000?