Paulson’s Plan Making Things Worse

U.S. financial markets continue to implode, yet government officials assure the American people that the problem is under control. More economists, however, are starting to realize that the government’s constantly evolving rescue plan is contributing to the instability.

When the House of Representatives failed to pass the original request for $700 billion from Treasury Secretary Henry Paulson on Sept. 29, the Standard & Poors 500 (S&P) fell about 8.8 percent. This supposedly proved how vital the rescue plan was for the health and stability of the economy. And yet on Oct. 15—after the porked up $850-billion bill was passed—the S&P fell more than nine percent, its biggest drop since the 1987 crash. It’s not just single-day plunges that have gotten worse.

In the year prior to the collapse of Lehman Brothers in mid-September, the average daily move (up or down) in the S&P was 0.8 percent. And yet since then, the average daily move has increased to 3.1 percent. If the government’s measures were supposed to restore calm to the markets, they have been a huge failure thus far. Many free-market economists have been warning that this would happen.

The least excusable decision was the SEC’s temporary ban on short-selling of financial stocks. Now that the ban has been lifted and the data in, analysts have shown that the stocks in the “protected” sector were more volatile than their peers in the “unprotected” sectors. Bid-ask spreads increased too, meaning that there was less liquidity in these shares. This was perfectly predictable.

Short-sellers provide a valuable service by signaling dangers to other, less-informed investors. By banning short sales, the SEC effectively took away a key source of information about financial stocks, and so investors put their money elsewhere.

When Paulson decided to let Lehman Brothers fail in mid-September, he announced, “Moral hazard is something I don’t take lightly.” Many investors thought he was finally drawing a line in the sand, and that the bailouts were over. Yet just a day after Lehman filed for bankruptcy, it was announced that insurance giant AIG would receive $85 billion from the Fed.

For another example, Paulson originally wanted the $700-billion rescue package to buy up mortgage-backed securities, in order to unclog the market for these “toxic” assets. Then the plan changed to injecting capital directly into troubled banks in exchange for government equity in the companies. And then it was announced that $125 billion would be injected into the nine largest (and healthy) banks, some of which didn’t even want the money.

Both theory and history show that markets can only thrive when there are stable and secure property rights. The “panic mode” mentality of Secretary Paulson and Fed Chairman Ben Bernanke are contributing to the legitimate fears of investors.

The ultimate justification for all of these interventions is that they are necessary to prevent another Great Depression. But we must remember that prior to the 1930s, most U.S. downturns ended within two years. It was not until FDR’s New Deal policies – which prevented wage rates from falling in light of the new realities – that the United States experienced massive unemployment for an entire decade.

Too many resources flowed into the U.S. housing sector during the boom. The damage is done, and the economy needs a period of cleansing and recovery from those misguided investments. The government’s panicked attempts to deny reality, and operate from the New Deal playbook, will only postpone the adjustment and, in fact, make things worse.

Robert P. Murphy is a senior fellow in business and economic studies at the Pacific Research Institute.

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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