Let the markets find their own recovery

The takeover of mortgage giants Fannie Mae and Freddie Mac, yet another expansion in government intervention from the Bush administration, could end up costing hundreds of billions of dollars and in the long run will only make the U.S. financial crisis worse.

The costs of the takeover are scary. By pledging to inject capital into the troubled giants, the government has just put U.S. taxpayers on the hook for possibly huge sums if the housing market deteriorates further.

The two firms reported combined losses of $11.7 billion in the last three quarters alone, and many analysts expect the bleeding to continue for years. In last Sunday’s announcement, the government already pledged up to $200 billion in government funds if Fannie and Freddie need them to remain solvent. Saddling taxpayers with more liabilities is always dangerous, but the timing of the bailout could hardly be worse.

If Congress defangs the alternative minimum tax, as it did last year to prevent a large increase on the middle class, the latest Congressional Budget Office forecast projects a record deficit of more than $500 billion for the fiscal year starting Oct. 1. Making the federal government ultimately responsible for roughly half of the nation’s mortgages will make it impossible for the next president to take other measures to help a sputtering economy, such as tax relief.

In exchange for these potentially huge costs, the takeover of Fannie and Freddie offers few benefits. On Monday, the stock market rallied, indicating that investors were reassured by the move. Yet these gains were more than erased the next day. Not only has the mortgage move failed to fix the financial markets, but it will arguably make things worse.

Because of the desire to avoid “moral hazard” – encouraging risky investments by large firms because they believe the government will bail them out if things turn sour – the government-engineered rescues of the Bear Stearns Cos. Inc. and now Fannie and Freddie were designed to punish common shareholders. Fed Chairman Ben S. Bernanke and Treasury Secretary Henry M. Paulson Jr. did not want to reward bad bettors on Wall Street with taxpayer money. Yet this insistence on stern terms might have doomed Fannie and Freddie, making the takeover inevitable.

Private investors are now much more reluctant to inject billions into solvent yet illiquid enterprises because they know they might be left holding the bag in the event of another bailout of a firm deemed “too big to fail.” This paradoxically makes it difficult or even impossible for such firms to raise private funds, and then they have no choice but to turn to the government.

In a vicious cycle during the last year, investor behavior has been based less and less on fundamentals and more on government announcements. If Paulson’s secret strategy has been to show that throwing around billions of dollars won’t fix a broken economy, taxpayers can only hope this was the final demonstration of the rule. This is hardly the path to economic recovery.

When it comes to housing, the American public wants ever-rising prices, and yet they want homes to be affordable. They want the government to encourage banks to offer below-market mortgage rates, and yet they don’t want taxpayers to be on the hook if those loans turn sour.

The public needs to remember that the government cannot create wealth, but only redistribute it. Ever larger government bailouts will only weaken investor discipline, and ensure the need for more “rescues” down the road. If the politicians would just leave the markets alone, investors could assess their losses and then get on the road to recovery.
Robert P. Murphy is a senior fellow in Business and Economic Studies at the California-based Pacific Research Institute

E-mail Robert P. Murphy at [email protected].

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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