A Shotgun Wedding — Big Government in the Banking Business

First Published: 2008-11-07

Article reprinted with the kind permission of the author, Dr. Richard Ebeling, Senior Fellow, with the American Institute for Economic Research.

If you thought that that the word “voluntary” means the ability to say yes or no, you obviously haven’t been in Washington, D.C., lately.  When the senior executives of America’s largest banks were invited to a meeting with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke at 3 p.m. Monday, October 13, they found out that the United States government intended to partially nationalize each of their institutions whether they liked it or not.

After listening to an hour-long lecture on the seriousness of the current economic crisis, the executives of nine banks–including Citigroup, Bank of America, JP Morgan Chase, Morgan Stanley, and Wells Fargo–were handed a document they were expected to sign on the spot. By doing so, they agreed to the government plan to buy up to $25 billion of preferred shares in each of their firms.

The government will spend $250 billion of the congressionally approved $700 billion bailout to purchase equity shares in dozens, if not hundreds, of banks across the United States. When some of the executives at the October 13 meeting raised questions and even challenged the government ‘s plan,  they were basically told to shut up.

They discovered that government knows best. According to The Wall Street Journal, Secretary Paulson said: “The system needs more money, and all of you will be better off if there is capital in the system.” End of story. There was no time for debate or refusals. Just sign on the dotted line and leave. The meeting concluded at 4 p.m., By 6:30 p.m., all the documents had been signed and returned to the Treasury.

Future historians will record that date and meeting as possibly the end of financial capitalism in the United States. Make no mistake, when a government controls, or even predominately influences, the flow of investment capital within an economy, that country’s market is no longer free.

Not that America’s financial institutions have been totally free up until now. Since the Great Depression of the 1930s, the federal government has regulated the banking industry with an intrusive and often heavy hand.  Over the decades, it has overseen numerous bank failures, scandals, and corrupt dealings– very often the result of special interest groups with powerful friends in Congress or the executive branch influencing government policy.

In addition, the Federal Reserve, America’s central bank, has been mismanaging the country’s money supply since 1913. The monetary central planners who run the Fed have manipulated interest rates, created trillions of dollars out of thin air, caused waves of price inflation, and stimulated artificial investment booms that have been followed by inescapable recessions and depressions. All in the name, by the way, of keeping the economy on a stable course of prosperity and growth.

But intrusive regulation and monetary manipulation is one thing. The government directly injecting itself into the banking and financial system through compulsory purchase of shares is something totally different.

Financial capital is the life blood of any market economy. Banks serve as the essential intermediaries that pool the savings of the citizens and funnel it out to prospectively profitable investment projects. These investments result in the new, better, and more goods and services that as the years go by, make all our lives better. A competitive, profit-driven financial sector is crucial to any society becoming increasingly wealthy.

Because such private decision-making is guided by the profit motive, what gets financed are ultimately those products the consuming public wants to buy. Any businessman who fails in getting this right will end up suffering losses. If he persists in making mistakes, over time some other entrepreneur with keener insight and better judgment will take his place.

Secretary Paulson and others in the government say that their intention is not to determine or influence how the banks they partially own make their investment decisions.  But that’s highly unlikely.

New York Senator Charles Schumer already has said that the government has to police bank executive pay and to see to it that the banks don’t undertake “excessive” risks with taxpayers’ invested dollars.
Nobel economist and Obama advisor, Joseph Stiglitz, expressed the concern that, “As we pour the money in, they [the banks] can pour the money out. We don’t have a veto.” Most assuredly he is advising Barack Obama that if he becomes president, the government should have a veto over how banks partly owned by the government invest their money – on what and for whom.

Even if not immediately, you can be sure that political motives will start replacing the profit motive in determining the investment decisions of America’s banks, even more than is already the case. What kind of political motives? Well, some congressman just happens to have a constituent in his district who can’t seem to get a loan on the basis of normal business standards. “This project is really worthwhile, you know,” the constituent explains, “and besides it will benefit a lot of people whose votes might really matter in the next election. By the way, Mr. Congressman, did I tell you I really admire your principled stand on so many issues, and I’ve just sent a check into your campaign office?”

In addition, if a bank the government partially owns falls into another financial crisis, what will determine whether it “lives or dies”? In a free market that is decided by potential private investors on the basis of the bank’s longer-term profitablity. These investors can include other financial institutions that might lend to the troubled bank or even buy it out.. If the profitability is not believed to be there, then others in the market are saying that peoples’ scarce and valuable financial resources can be better spent in different ways.

Once the government has a stake in a failing institution, the issue will be loaded with influences having nothing to do with the short- and long-term financial soundness and viability.  Is it “too big to fail”? This means too many politicians will have unhappy constituents if the bank goes under – plus the media will make them look bad for “doing nothing” at a time of “national crisis.” So more government money will be poured into a losing proposition at taxpayers’ expense.

Investing for a profit means that a businessman believes consumers will value his product enough that the sale price will more than cover production costs. The project pays for itself and earns enough to pay off loans, provide income for the company’s owners, and create the means for additional capital investment. This is what makes the economic pie grow bigger over time.

Investing for political reasons means wasting scarce capital in projects that do not meet the market test of profitability. They end up costing more than they earn. The losses have to be made good out of past savings or current income that could have been used to make those other goods and services that improve our lives. Politically motivated investments mean capital consumption. We end up eating the seed corn. None of us is better off when that happens.

Washington’s partial nationalization of the country’s banking system is turning the clock backwards to the last century’s delusions that government planning can work better than the free market system. Some of us thought the socialist delusion ended when the Berlin Wall came tumbling down.  I guess we were wrong, and the hard lesson about why government planning always ends up in a disaster will have to be learned all over again.

—Richard M. Ebeling, Senior Fellow, AIER

The views expressed are those of the author, and not necessarily those of the Nassau Institute (which has no corporate view), or its Advisers or Directors.

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