After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

As the nearly $800 billion economic stimulus plan gets closer to President Obama’s desk, conservatives worry that an overly large government will cripple private-sector recovery. But at least overweight government is an obvious problem. The president’s other big project, the “Financial Stability Plan”—a new $2 trillion–plus scheme to get credit flowing again—contains a far stealthier risk. In planning a new “public-private investment fund” of up to $1 trillion, the president is further blurring the line between the public and private sectors. This development is dangerous, because we need a genuine private sector—not a synthetic, government-supported one—to pull us out of the mess that financiers and policymakers have made.

The Financial Stability Plan contains some of the same problems that plagued the Bush administration’s rescue efforts. Treasury Secretary Tim Geithner is expanding his predecessor’s idea, for example, to use government funds to re-create the failed securitization model, making it that much harder for the private sector to create a new (likely simpler) debt-financing model for the future. In general, the administration still seems to think that the main problem is a lack of financial capital, when the problem is really a lack of confidence in human and institutional capital. Many investors are balking at the financial industry because they don’t want to put their dollars into companies whose failed institutional thinking could persist indefinitely. Giving failed institutions more government money could ensure that their failed ideas survive, even if they lie dormant for a while.

But the worst new idea of all is the public-private investment fund. The government envisions a “public-private financing” model, through which taxpayer money would “leverage” private capital to buy mortgage-related and other debt securities from big financial institutions. Though details are scant, the government will probably offer some kind of guarantee against losses, as well as super-cheap financing, to private-asset managers, including hedge funds and the like, to entice them to buy these securities. With guarantees and cheap financing, these investors could stop worrying that they’ll lose money if they buy such assets at prices high enough for surviving banks to sell them without bankrupting themselves. And once the banks get the assets off their books, they’ll start lending again—or so the thinking goes.

According to the Treasury, one of the program’s benefits is that “private-sector buyers [will] determine the price for current troubled and previously illiquid assets.” Well, no, not really. The program will allow private-sector buyers to determine the price for these assets in an environment of cheap debt financing, free of concern about eventual losses—credit-bubble conditions that the government will probably try to recreate for participating investors. But we already know what the assets are worth in a credit-bubble environment: a lot. Investors don’t know what these assets are worth today, in an environment where credit is scarce and potential losses are real. That’s what we’ve been trying to figure out for the past two years. This plan just delays that slow process of market discovery. This process, though fatal to some institutions that invested heavily in bad loans that were badly structured, is necessary, and it’s been working just fine in distressed markets in which the government hasn’t severely interfered, including in the junk-bond market.

More pernicious is the certainty that once private hedge funds and other asset managers get this close to the government under the new “partnership,” they won’t really be private anymore. Sure, they may be profit-making, but that’s not the same thing. Still, the administration is likely to use the rhetoric of a “private sector” partnership to continue to score points with moderates and conservatives worried that the government is taking over everything. If anyone complains too loudly about the nationalization of the financial sector, Obama and Geithner can point to their armies of private-sector fund managers and say, “See? The private sector likes this! We are good, responsible-government types who know that our job is to support the private sector, not take it over.” Meanwhile, the entrepreneurial risk-takers in the real private sector will be suffocating under the weight of “public-private” cooperation between new crony-capitalism financiers and their government friends.

What does the real private sector need so that it can recover strongly from this disaster? The government should be spending our finite “stimulus” and “stability” money on two things. First, government’s job is to create a reliable environment for people and capital. That means continuing to protect savings that ordinary people consider, well, safe, including bank accounts and money-market funds. Relatedly, the government should spend money to wind down big, failed financial institutions as quickly and efficiently as practicable, rather than continuing to prop them up. Such efforts, along with safety-net costs like unemployment benefits, could become much more expensive in the next few years, as the financial sector keeps foundering and as the economy suffers. So the government should conserve its money—that is, our money—to pay for them as deficits balloon.

Second, the government must build the physical infrastructure that people and capital need to thrive—levees in California, mass transit in New York—but that individuals can’t practically construct on their own. There’s an important difference between government spending to prop up failed private-sector credit infrastructure and government spending to fix crumbling physical infrastructure. With the credit markets, private-sector investors need time and less government-created uncertainty to begin rebuilding. Indeed, they’re already doing so. High-quality companies not guaranteed by the government have issued nearly $80 billion in bond financing in the past few weeks, up from $60 billion during the final three months of last year, as investors have voted for easier-to-comprehend financial structures and borrowers have responded. The more money the government pours into an unnecessary and futile effort to preserve the old, failed credit-infrastructure regime, the less money it will have to repair the public-sector physical infrastructure—which the private sector can’t fix.

If the government continues to co-opt new “private sector” partners rather than support the real private sector, we’ll see the dismal results in a few years’ time. Not only will we have weakened our entrepreneurial class by burdening it with more bad financial assets; we’ll all be traveling on increasingly decrepit roads, making America less competitive and hurting our recovery.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.