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Don’t Even Try To Blame This Mess On The “Free Market”
Written By : McQ
September 22, 2008

Of the bailout now being considered, the Heritage Foundation says the following:

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As a general principle, conservatives believe government should not intervene to protect those who have made poor business decisions — even if those decisions have been influenced by excessive government regulation. But there can be rare situations where the cumulative effect of many bad decisions in one sector of the economy can threaten everyone. In these rare cases, government has a critical role in keeping the market’s infrastructure functional. We are in such a situation today.

What is the situation? James Pethokoukas has a couple of scenarios based in the reality of the situation:

1) Scenario 1: Great Depression “Lite.” This is supposed to be the worst financial crisis since the 1930s. So let’s assume that the total freezing up of American and global credit markets caused something half as bad as the Great Depression. From 1930 through 1933, the U.S. economy shrank by about 25 percent. Now let’s say that by doing nothing and letting Mr. Market do his worst, the $12 trillion U.S. economy shrinks by half that amount (12.5 percent), or around $1.5 trillion over four years. (Also, figure a near doubling in unemployment.) But there’s also the opportunity cost of not returning to growth, even at a so-so 2.0 percent a year. Doing nothing costs $1.1 trillion more in lost growth. So now we are down $2.6 trillion.

But wait: There’s more. Let’s assume the stock market drops an additional 25 percent or so. That’s $3 trillion more in lost market capitalization. Plus, we are forgoing the opportunity to gain back what we have lost in the market, about $3 trillion. So, add the $6 million (sic) in lost market capitalization to the lost economic output, and we are at $8.6 trillion.

Then there is housing, already down $5 trillion, or roughly 20 percent. Let’s conservatively say that we lose another $5 trillion by doing nothing. Plus, we forgo a partial rebound, say, $2.5 trillion. Adding together further housing losses (plus the lost opportunity to recoup some losses), and we are talking about a total cost of doing nothing of $15 trillion in four years for the whole megillah. But it could be worse.

2) Scenario 2: Great Depression 2.0. The economy shrinks by 25 percent over four years, or $3.2 trillion, plus $1.1 trillion in lost opportunity growth. Economic cost: $4.3 trillion. The market falls two thirds from its peak, losing $7 trillion in value from its current level, plus $3 trillion from not getting a rebound. Stock market cost: $10 trillion. Housing falls an additional $10 trillion from current levels, plus the lost opportunity of $2.5 trillion from a rebound. Housing cost: $12.5 trillion. Total four-year financial and economic cost of doing nothing: $26.8 trillion.

Now this is all a very rough guesstimate and doesn’t include the costs of all sorts of other ramifications. Here is a fun one: the dissolution of China. Its economy is built for hypergrowth. A dramatically rising standard of living is both keeping the Communist Party in power and keeping the country together. Neither might survive a global economic meltdown. What is the economic impact of that? I don’t know. My guesstimator just blew up.

So granted, we’re in a very tough financial situation which has a horrible downside if nothing is done immediately. But as Lance mentioned last night on our podcast, essentially what is being proposed is stretching out the pain, because like it or not, what has been done must be paid for eventually.

Essentially Hank Paulson is hanging his hat on this statement:

“I am convinced that this bold approach will cost American families far less than the alternative: a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.”

The question, obviously, is “will it indeed cost us less?”

The answer is “not if we’re simply shoring them up to do business as usual”. And that “business as usual” isn’t something done in the absence of regulation. As Lance pointed out in his piece yesterday, this was aided and abetted by regulatory exception, poor management, regulatory laxness and poor – very poor – oversight. Not to mention the fact that during the time this was building to this sorry climax, part of the reason it was going wrong is because government had made an economic issue (home ownership) a cultural one.

The solution, unfortunately, isn’t going to punish those who made bad decisions, either among the financial institutions or the regulatory agencies or the institution with oversight responsibility – Congress.

Instead, the US taxpayer is going to bail out all of them – shore up the financial institutions, ignore the regulatory breakdowns and continue to allow Congress to “oversee” that which it hasn’t done a good job at all of overseeing to this point (makes you just want to go out and throw health care right in their lap doesn’t it?).

All of that in the name of saving taxpayers “pain” for having trusted government to properly regulate and oversee a sector into which it has intruded up too its neck over the years.

So yeah, maybe this is what has to happen in terms of lessening the impact of the collective poor decisions by all parties over the years. But don’t try to then convince me that this is a problem of capitalism or free markets.

In a free market the institutions in question would never have gone there or if they had, failed miserably years ago. Of course, in a free market, an economic issue (housing and mortgage financing) would never have become a cultural issue with government intrusion paving the way for this debacle either.

[Crossposted at QandO]

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