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Truths, myths about big downturns

The Arizona Republic

In Congress, apparently two wrongs can make a right. The House rejected the bailout bill standing alone. The House rejected the tax bill standing alone.

But when the Senate combined the two, the combination passed the House with votes to spare.

The notion that giving Treasury Secretary Henry Paulson $750 billion to go on a shopping spree would restore “confidence” in the markets and all would be OK quickly dissipated.

The American economy is undergoing two large corrections, from overinvestment in housing and overborrowing in general. There’s nothing psychological about it.

Correcting for overborrowing necessitates that some people who want credit won’t get it and those who do get it will have to pay more for it.

The inevitable, and necessary, credit reduction has been made more acute and turbulent by accounting rules that require that mortgage-backed securities be booked not on their likely value held to maturity, but for what they could be sold for today.

The bailout is intended to relieve that by having taxpayers buy the excessively discounted MBSs. Equal if not greater relief could have been obtained, at no cost or risk to taxpayers, by simply suspending the accounting rule.

The Securities and Exchange Commission did relax the rule, but in a way that’s only marginally helpful. The SEC said that if there is a market, sales prices have to be used. If there is no market, then hold-to-maturity value can be booked. And if there is sort of a market, then a combination of factors can be considered.

In other words, it’s a “take-your-chances” rule, another element of uncertainty in circumstances where uncertainty is a major part of the problem.

Moreover, the Paulson shopping spree will undermine whatever relief the SEC provided. Using hold-to-maturity values is permitted only to the extent there is not a market setting prices.

But Paulson is going to create a market. And the first sales are likely to be from the most desperate sellers, so the prices are likely to be heavily discounted.

While the bailout is unlikely to fix the American economy, it may mark a turning point in the relationship between government and private business and thus in the character of the American political economy.

Many economic historians now believe that the Great Depression resulted from a conflation of large government errors: a contraction in the money supply of a third, and the adoption of protective tariffs and tax increases under Hoover.

The downturn was prolonged by inconsistent and hostile business regulation by Roosevelt, which kept private capital on the sidelines.

However, the searing public impression, and thus what is politically significant, is that capitalism careened out of control. That led to the belief that an activist government needs to put up guard rails for it.

The current economic problems are also likely to be seen in retrospect as resulting from a series of governmental mistakes:

• Too loose of monetary policy for too long creating a debt bubble

• Government favoritism for Fannie Mae and Freddie Mac stifling the development of a more risk-aware secondary market for mortgages

• An arbitrary and capricious initial reaction to the debt bubble bursting that scared off private capital

• And an overreaction to temporary spikes in short-term interest rates that created yet more uncertainty and unwillingness to deploy private capital.

However, the searing public impression, reinforced by the bailout, is that the American system of regulating finance primarily for disclosure failed, and therefore it has to be replaced.

If taxpayers are going to be on the hook for bad investments if they get large enough, then government, acting as the agent for taxpayers, has to try to make sure that there are no such large, bad investments.

Regulating the financial markets generally for prudence, rather than just institutions whose deposits are federally insured, is almost inevitable.

But that may be just the beginning.

The federal government now owns the two biggest mortgage finance firms in the country, as well as the biggest insurance company. The bailout law requires Paulson to take equity as part of the shopping spree.

Free markets require that competition determine outcomes. Government sets the rules of engagement but doesn’t take sides in the game.

Markets become distorted when private business and government become so entwined, intermingled and interconnected that government becomes more a player in the game than a referee.

In many ways, the United States is moving in that direction. The historical record in other countries suggests that it’s not a very productive way to organize a political economy.

Robert Robb, an Arizona Republic columnist, writes about public policy and politics in Arizona.

E-mail: robert.robb@arizonarepublic.com

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