Are the Government's Bailouts Hurting the Economy?

Sept. 18, 2008— -- First came Bear Stearns, then Fannie Mae and Freddie Mac and now AIG … but is the third time the charm or the choking point?

Some financial experts worry that the government's moves to bail out ailing companies are keeping the credit crisis from reaching a bottom, ultimately delaying an economic recovery.

"Artificially trying to prop up dead entities is only prolonging the inevitable," said Peter Boockvar, an equity strategist at the trading firm Miller Tabak & Co.

"Anything that slows down the deleveraging process," he said of debt reduction, "prolongs the agony."

With its bailout of AIG -- which consists of an $85 billion loan in exchange for an 80 percent stake in the company -- the government "prevented a short-term calamity," Boockvar said, but "it's not stopping the credit markets from seizing up."

A New York Federal Reserve spokesman did not return a call for comment.

Vincent Reinhart, a resident scholar at the American Enterprise Institute, a conservative think tank, said the government, by opening its coffers, may be discouraging the private sector from lending and investing money.

"Ultimately, the industry needs more capital and, to the extent that there's uncertain government intervention, that may delay the arrival of that private capital," he said.

AIG's ability to attract private capital, in particular, remains in question.

It's unclear whether the insurance company, with more than 116,000 employees and $1 trillion in assets, will be able to sell enough assets to restore its financial health, Boockvar said.

"AIG is now a walking-dead company," he said. "Who is going to want to do business in AIG?"

Not everyone, however, believes the bailouts will delay a resolution to the credit crisis.

Dan Mitchell, a senior fellow at the Cato Institute, a libertarian think tank, is no fan of government bailouts. He believes that "cronyism" allows some companies to receive government aid while less-connected ones lose out.

Still, Mitchell argues that the government's intervention generally will not stop prices on overvalued assets like mortgage-backed securities from falling.

Bursting the Bubble

Mitchell said that the decline of those prices is key to reaching a bottom in the credit crisis and allowing a recovery.

"When you have an economy where people have no idea what the real value of assets is, what are homes really worth, what are investment banks worth because we don't really know what the value of the assets that investment banks hold," Mitchell said, "there's a degree of economic paralysis."

He said that once assets are valued appropriately, banks can begin making loans again.

"If you pop a bubble, prices go down, at least then you're starting from a position of much more certainty," he said.

Experts like Boockvar contend that, under government bailouts, the price declines will occur at a slower pace than they would under bankruptcies. Mitchell acknowledges that criticism but said that bailouts just "slightly hinder the process."

"It won't be a major problem," he said.

Mitchell and others compare the U.S. government's recent interventions into private companies to the banking crisis that rocked Japan a decade ago.

In the 1990s, the country spent tens of billions to nationalize some of its failing banks after the institutions took too long to recognize and write down the bad assets on their books. It took Japan's banking system years to recover and, to this day, some of the banks continue to struggle.

Some say that Japan should have let its weakest banks fail.

"It is a matter of wise pruning," said Meir Statman, a finance professor at the University of Santa Clara in California. "You don't want to cut the trunk and you don't want to cut the main branches, but you do want to cut the weak and dead branches."

Supporters of the federal government's recent actions would argue that it did cut at least one weak branch when it declined to back a deal that would have kept Lehman Brothers, the country's fourth-largest brokerage firm, afloat.

Indeed, standing by and allowing Lehman to file for bankruptcy earned the federal government plaudits from some analysts and scholars, including Reinhart, who are concerned about moral hazard -- the idea that government bailouts will encourage businesses to make irresponsible decisions on the assumption that taxpayer money will serve as a cushion if things go awry.

Reinhart says he's now taking back his praise of the Feds.

"I would reverse myself on that view in the same way the secretary [Treasury Secretary Hank Paulson] reversed himself in his view of bailouts," he said.

Avoiding 'Maximum Pain'?

Statman, meanwhile, argues that if the government's bailouts delay the credit markets' hitting bottom, that might not be such a bad thing. It could, he said, avoid a wider panic.

"It's like administering a treatment that is painful," Statman said. "You can either do maximum pain for a short time or you can do smaller amounts of pain for a longer amount of time. It's not always the case that you want to get it over with with maximum pain."

If you choose the "maximum pain" option, he said, "the patient can go into shock."