NEW YORK—Seat belt laws embolden drivers to drive faster, causing a net loss of life. It's the law of unintended consequences, or the Peltzman effect: The safer you feel, the more risk you take. Sam Peltzman, the economist after whom said effect is named, says that government bailouts like the Bush administration's $700-billion attempt to stave off economic collapse are no more effective than "pouring money down a rat hole." Rewarding reckless companies while allowing responsible ones to fail may avert one economic crisis while planting the seeds of a worse one down the road.
"In the long run," says Peltzman, "you're just laying the groundwork for more because you're giving people an incentive to take too much risk, where a big part of the risk gets laid off on the taxpayer."
I don't think much of the laissez faire, let-'em-eat-flat-screens school of Darwinian economics flogged by the University of Chicago, where Peltzman is a professor emeritus. But I think he has a point here—with a twist. Government intervention is appropriate and necessary during tough economic times. But not if you bail out corporations.
The 1979 Chrysler bailout is a perfect example. Jimmy Carter's $1.2-billion loan sent an unwholesome message to Detroit: Don't change a thing. If you get into trouble, the government will rescue you. The Big Three kept selling gas guzzlers. Nimble foreign automakers that spent the '80s and '90s developing hybrid technology are crushing them now. Similarly, it's hard to see how U.S. taxpayers will benefit by lending my former employer Bear Stearns $29 billion to facilitate its sale to JPMorganChase. Bear Stearns' corporate culture, reeking of the testosterone-drenched arrogance of its seven-figure-salaried executives, led it to fib about the worth of the collateralized debt obligations that supposedly guaranteed the payment of its subprime mortgage hedge funds. When traders learned the truth, confidence in the firm collapsed, sealing its fate.
Or would have, if the feds hadn't come along. Letting Bear Stearns go under might have prompted caution among future wannabe Masters of the Universe. If capitalism survives this debacle, we'll see more like it as a result. Democrats are asking for some laudable amendments to Bush's plan. They want to give bankruptcy court judges the power to reduce monthly mortgage payments, cap executive salaries and increase Congressional oversight of the financial services companies involved. Good ideas, but they'd expire at the end of 2009. Does anyone think the economy will be booming by then?
At least four million people—9 percent of all homeowners—have fallen behind on their payments or are in foreclosure. And 6.5 million more could go down the tubes next year. "People with poor credit have been defaulting on mortgage payment in large numbers for more than a year," says Douglas McIntyre, an editor at 247wallst.com. "Now the problem has moved to homeowners with reasonably good credit."
Each family that loses its house creates a ripple effect. Empty homes lower property values. Some dispossessed workers, unable to find a new place near work, become unemployed. Savings are wiped out. Forced to move, parents pull children from school, disrupting their education. Banks are burdened with the costs of maintaining property they don't want until they can unload, further depressing real estate prices. Society has an interest in preventing foreclosures.
The unpredictable nature of the current real estate price plunge has created another set of problems. Tobin Harshaw of The New York Times sums up a complicated mess: "There are a whole bunch of mortgage-backed securities, the value of which is not known, because nobody knows what the default rates on the underlying mortgages are likely to be." Investors can't set prices, much less invest, without reliable information. So credit markets have seized up.
Americans are peering into the abyss, aka the End of Everything As We Know It. So whom are we counting on to save the day? The same Bushist dead enders and Congressional lay-abouts who let Osama bin Laden live and New Orleans die. So yeah, we're toast, but here's what should be done:
1. Declare a Bank Holiday. As FDR did in 1933, Bush should shut down the financial system—banks, stock and currency exchanges—for a week or so to avoid panic selling, cool down market volatility and give Congress time to craft carefully considered legislation rather than the spend-a-thon slapped together over the last Black Weekend. It bodes ill that liberals and conservatives alike have so little faith in the plan.
2. Reinstate the Glass-Steagall Act. The current mortgage meltdown couldn't have happened without Sen. Phil Gramm, now a key economic adviser to Sen. John McCain. In 1999, Gramm led the repeal of the Depression-era legislation that had separated commercial from investment banks, allowing Citigroup and other companies to sell mortgage-backed securities that blurred the line between Main Street and Wall Street. Let the financiers handle derivatives, structured investment vehicles and other arcane financial instruments. Banking should return to its dull, staid roots as a business that pays interest on deposits and collects interest on loans without imperiling those deposits.
3. Bail out homeowners, not lenders. Stop doling out hundreds of billions of dollars to a few banks and issue the cash to the disaggregated millions of Americans who will spend the money and stimulate the economy.
4. Abolish predatory interest rates. Millions of people in danger of losing their homes would not be in trouble if their banks weren't charging usurious interest rates. Every primary homeowner should be automatically refinanced to a floating 30-year mortgage, with the interest rate set at .25 percent point above the fed funds borrowing rate. Similarly, all consumer credit card debt should be refinanced to prime plus .25. The same goes for student loans. Secondary and vacation homes don't qualify. Unemployed homeowners can apply for hardship deferrals, allowing them to skip mortgage payments until they find a job. Payday loans ought to fall under similar guidelines. In Utah, the average interest rate on payday loans is 521 percent. Reforms will cut deeply into lenders' earnings. Many banks would be at risk of going under, which is why ...
5. Banks that fail should be nationalized. As should investment banks and any other institution that needs federal taxpayer money to avoid failure. If we the people fund 'em, we the people own 'em. If and when the economy recovers, the Treasury collects the spoils and cuts our taxes.
6. Withdraw from Iraq and Afghanistan, and slash defense spending. Christopher Whalen, managing director of Institutional Risk Analytics, tells USA Today the government may have to cover $1.4 trillion in bad mortgage debt. That's a lot of money, but we can get it. In 2007, the Congressional Budget Office estimated the occupations of Afghanistan and Iraq would cost at least $2.4 trillion through the next decade—even more if Obama or McCain keep their pledges to send more troops to Afghanistan next year. Cutting our losses and cutting the $515 billion a year Defense Department appropriations budget would help finance the clean-up of the mortgage meltdown.
Ted Rall was a trader at Bear Stearns & Co. and a loan officer at the Industrial Bank of Japan during the 1980s.