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By Nicole Gelinas

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

Eye on the News

Nicole Gelinas
Can TARP R.I.P.?
The public is right to hope that the bailout law stays dead.
15 October 2010

In October 2008, as investors deserted American banks and markets, the Bush administration wrung approval for the Troubled Asset Relief Program (TARP) from the Democratic Congress. The law gave the Treasury secretary the authority to replace vanishing private money in the financial system with public funds. Over TARP’s two-year life, the Bush and Obama administrations deployed $388 billion under its $700 billion authority, including $256 billion for hundreds of banks, $80 billion for Chrysler and General Motors, and $48 billion for the insurer AIG. In return, the government secured claims on the companies, including majority ownership stakes in GM and AIG.

Two years later—that is, last week—TARP expired, with the Treasury losing its power under the law to make new commitments. The department asserted that the program had done the job that Congress intended: it was “remarkably effective,” said Timothy Massad, the acting assistant secretary for financial stability. Best-in-their-field econ professors—Simon Johnson of MIT, Ken Rogoff of Harvard, Anil Kashyap of the University of Chicago, and Alan Blinder of Princeton—agree. After all, the economy has grown, if slowly. States, homebuyers, and corporations can borrow at record-low rates after being closed off from credit markets two years ago. Moreover, defying early projections that it would blow a huge hole in the federal budget, TARP may accomplish something almost unheard-of in government: turn a profit. Beneficiaries have repaid 53 percent of taxpayers’ money. Washington is working with the stragglers, chiefly AIG and GM, so that the government can sell its majority stakes in the firms on stock markets “much faster than anyone predicted,” says Massad. Larry Summers, outgoing economic advisor to President Obama, took this message on the road last Thursday, saying that TARP’s AIG sale could generate a “substantial” profit.

Yet TARP remains public poison. An NBC News/Wall Street Journal poll found that voters disapproved of TARP’s bank-rescue portion by a nearly two-to-one margin, 60 percent to 32. The auto-bailout part fared even worse, with 65 percent of voters against it. TARP is less popular than the stimulus, which enjoys the support of just 49 percent of voters. The law has claimed political victims, too. Republican senator Robert Bennett—known as “Bailout Bob” for his TARP vote—lost a primary challenge this year.

Pols and wonks, wondering why voters can’t appreciate what’s good for them, have decided that the public simply doesn’t get it. As Steve Rattner, Obama’s auto-bailout czar, put it, we would be “eulogizing” TARP today—praising it for its success—if not for “bitter politics and financial illiteracy.” Douglas Elliott of the Brookings Institution was only slightly more empathetic: “It really cuts against the grain for a public that is so angry at banks to think that something that so plainly helped the banks could also be good for the public,” he told the New York Times.

The voters are on to something, though. Start with TARP’s latest selling point: that the program’s profitability proves its success. This is a non sequitur. We could sell the White House for a profit, but few would call that a smart move. More relevant is how TARP is making a profit—and that’s cause for concern. Recall that over the past 22 months, the Federal Reserve has kept its benchmark interest rate at zero percent. Low rates allow large financial firms—including TARP’s wards—to earn what seem like risk-free profits by borrowing at negligible rates and investing the proceeds in instruments (including government bonds) that earn just a little bit more. The Fed’s zero-rate policy has thus been a big factor in the bailed-out firms’ ability to make profits, repay the Treasury, and vindicate TARP.

TARP and other extraordinary government investments in the financial sector, then, give the Fed an extra reason to support the financial industry at all costs. An artificially booming financial industry, boosted by the Fed’s policies, makes the government look especially smart in its TARP investments. But this policy isn’t free. Because large financial firms can borrow so cheaply from the Fed, they—and the Fed itself, through its own asset purchases—have pushed the prices of financial assets, from bonds to stocks, higher than they otherwise would be. Those zero-percent rates can’t last forever. In the meantime, it’s hard for anyone to know what anything is worth, as the prices reflect the government’s policy of supporting the financial markets at all costs rather than the “real” values of companies and investments. Investors can’t make decisions based on companies’ business prospects, then, but must wonder instead how long Washington will sustain its overwhelming support of financial firms and housing prices—and what will happen when that support ceases.

In its desperate effort to show that TARP wasn’t a failure, the White House, too, may take actions that hurt free markets. Consider Washington’s exit plan for AIG. As part of a stock sale of an important AIG unit, Treasury has corralled “cornerstone” investors who will purchase blocks of stock from the government and sell them later. One of those investors is the Kuwait Investment Authority (KIA), a state-owned fund. A look back at America’s recent history of encouraging investors similar to the KIA should make observers queasy. In the fall of 2008, Treasury secretary Hank Paulson, in encouraging a Chinese state-owned company to put money into Morgan Stanley, made it clear that the Chinese wouldn’t lose their money, as he recounted in his memoir. In its frenzy to dress up AIG as a success story, is our government making promises—even implicit ones—to the KIA?

TARP’s role in Washington’s near-total guarantee of large financial firms and debt markets protected the economy from the full force of the financial meltdown, which would have caused hundreds of thousands, if not millions, more jobs to vaporize for lack of financing. But just as 23 percent of potential voters told pollsters, it’s “too soon to tell” whether TARP, in the end, made things better or not. If the public allows the political and financial classes to view TARP as a success, the program will levy a steep long-term price. When future crises arrive, pols will think that the right fix is to shore up Wall Street via more TARPs, thus ensuring that creditors and counterparties to financial firms don’t suffer consequences for their risk-taking. As this lesson congeals, investors will again become comfortable with lending too much money, too freely, to banks, insurers, and investment firms. Eventually, they will help create a crisis so big that the American government can’t save the nation from its full economic effects, just as has happened in Iceland and is now happening in Ireland.

The best hope we currently have against that outcome is the American populace’s still-incandescent rage. The unwashed masses aren’t demonstrating their financial illiteracy; they’re serving as an inchoate substitute for what their government should be providing: the prospect of market discipline through rules that allow any firm to fail without laying waste to the economy at the same time. Unless government lays down those rules, the 45 percent of Americans who think that Washington’s rescues of Wall Street “made things worse” instead of better may be proven right.

Nicole Gelinas, Searle Freedom Trust Fellow at the Manhattan Institute and City Journal contributing editor, is author of After The Fall.

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