Building a Better Bailout

How Washington could have helped the market at no cost to taxpayers. And what it should do if it's hell-bent on spending $700 billion.

Many observers are comparing today's financial situation—crisis is the preferred term—with the Great Depression, which included a four-year period when the American economy contracted by over 40 percent. To put that in perspective, second-quarter growth this year (the latest for which full data is available) was 2.8 percent.

Yet the comparison between today's situation and the Great Depression is apt, though not for the reasons many of those making it suppose: Virtually all economists now agree that the massive government intervention into the economy in the 1930s made things worse and significantly delayed financial recovery.

The $700 billion-plus bailout bill—signed into law in response to recent investment bank collapses and a lack of liquidity in the economy—will likely have a similar effect by distorting basic mechanisms that would allow markets to price securities accurately and efficiently. Packed full of tax breaks and "stimulus" treats to multiple special-interest groups, the bailout wishes away the fact that the current turmoil in financial markets is in large part the result of bad government policy.

In particular, the law does nothing to address easy-money policy by the Federal Reserve and unsustainable subsidies to homeowners and mortgage lenders. Instead, it assumes that bailing out the financial industry will do the trick. Tellingly, even the law's proponents acknowledge they have no idea of whether the bailout will work as intended. As Rep. Barney Frank (D-Mass.) said at the start of bailout negotiations, "We don't have a choice now of debating whether this is a good or a bad thing."

To make matters worse, there are several measures that lawmakers could have adopted—at no cost to taxpayers—that would have actually addressed the underlying causes of the crisis.

We know that a critical mistake was made by allowing financial institutions such as Freddie Mac, Fannie Mae, and investment banks to hold significantly smaller capital ratios than commercial banks, while implicitly guaranteeing certain banks' losses. Over the years, a series of rules were created allowing the Securities and Exchange Commission (SEC) to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. The capital ratio rule requires that firms value all of their tradable assets at market prices and maintain a cash balance equal to a percentage of that price weighed for the risk of each asset.

In 2004, the SEC allowed five firms—Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley—to reduce their capital ratio by letting them keep more assets on their balance sheet while subjecting them to less reporting requirements. They now had an incentive to invest in riskier assets since their expected cost was reduced significantly.

Additionally, the only reason why the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac were able to guarantee nearly $5 trillion in home loans with merely $100 billion in net equity is that both their management and other market operators knew that the government would step in if things took a turn for the worse. Acting as lenders of last resort, the Federal Deposit Insurance Corporation (FDIC), the Treasury Department, and the Federal Reserve Bank fueled the crisis by encouraging a decade of careless lending.

Under these circumstances, the capital ratio for GSEs and other investment banks should be raised at least to the level imposed on commercial banks—an average of 8 percent, depending on regulators' assessment of the bank's financial strength and the type of capital in question. Raising the reserve level would allow institutions to weather tight credit markets by having enough capital to face sudden increases in their default rates. The bailout bill does nothing to address this question.

What it does do, however, is bail out banks, raise FDIC limits to $250,000 (from the current $100,000 per account), and otherwise increase explicit and implicit federal guarantees. While these measures might prevent a panic in the short run, they are the seeds of the next financial meltdown.

Virtually all economists agree that one of the reasons for the current situation is that banks assumed too much risk by lending money they should not have. When the federal government guarantees bank loans or assets, banks have less incentive to evaluate loan applicants thoroughly, but they do have an incentive to engage in riskier behavior than they would otherwise undertake. When things are good, they make high profits and, in the case of a downturn, it is the taxpayers, not the banks, who foot the bill. Congress should return to more a disciplined banking regime devoid of guarantees by moving toward market-based deposit insurance.

One bit of good news is that the bailout bill reminds the SEC that it has the authority to suspend the Financial Accounting Standard 157, or "mark-to-market," which requires that companies value the assets on their balance sheets based on the latest market indicators of the price those assets could immediately be sold for. It's a sensible rule in prosperous times, but it puts otherwise solvent banks in a difficult position when they fail and sell their assets at low prices. Under mark-to-market, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities because the housing collateral protecting them becomes worth much less. Congress should have blocked them from going into effect in their stricter form last November and should have removed them formally in the bill.

The federal government could also have fostered savings and investment in the stock market by extending the capital gains and dividend tax cut past 2010 (when it is due to expire under current law). This would raise the rate of return of financial assets at little cost to the Treasury and give a strong incentive to taxpayers to stay in or go back into the market. Congress could also lift all Roth IRA contribution and eligibility limits for the rest of 2008. Because Roth IRA contributions are not tax deductible, this measure has no immediate cost to the Treasury, but it would have likely pumped billions of dollars into a tight market.

Such simple measures—raising the capital ratio requirements of investment banks, eliminating implicit guarantees to government-sponsored enterprises, suspending mark-to-market accounting back in 2006, and extending tax cuts on capital gains and dividends into the future—would have allowed the market to continue to reorganize its financial sector at absolutely no cost to taxpayers.

That being said, if the president and Congress were dead set on addressing the lack of cash in the economy, they still could have done so in a way that would have achieved the goal of injecting liquidity into the banking system while exposing taxpayers to far less uncertainty.

How? By taking the $700 billion they plan to give to Wall Street and sending checks worth $3,600 to the 191 million U.S. taxpayers. Such checks would then have to be deposited into some type of retirement account or be subject to the IRS's premature IRA distribution rules.

The most risk-averse people would invest this windfall into relatively safe money market funds, thereby preventing the credit crunch predicted by the pundits. Some would buy instruments such as mutual funds, which would sustain the market. Savvier investors, or at least those with a high risk threshold, would profit from the low prices on Wall Street to purchase stock in distressed banks.

Less than 30 days from the presidential election, such a measure would have proven popular with an electorate that does not trust the very politicians and technocrats who ignored the warning signs of a crisis and contradicted themselves constantly. And it would have prevented the socializing of a big chunk of Wall Street, a risky and unprecendented intervention into markets whose full effects won't be clear for many years to come.

Philippe Lacoude is the president of the consulting firm Algokian. Contributing Editor Veronique de Rugy is an economist at the Mercatus Center.

Correction: The original version of this piece stated that the bailout bill has suspended rules such as the Financial Accounting Standard 157, or "mark-to-market."