Remarks at a Conference on "The Latest in the Financial Services Crisis: Government Control v. the Free Market"

Ladies and gentlemen, the bubble was huge, and as we all know, we'remired in a terrific bust. All kinds of asset prices are plummeting,famous financial firms failing, credit contracting, and bailoutsbloating the government's balance sheet. In sum, we're in an extendedfinancial panic. As described by David Ricardo two centuries ago, "Onextraordinary occasions, a general panic may seize the country. . .when everyone becomes desirous of possessing himself of the preciousmetals." We don't do that anymore; now it's cash and Treasury bills.Ricardo continued, "Against such panic, banks have no security on anysystem."

We all know that no bank, even the most solvent bank, can survive arun, and a financial system made up of leveraged financial firms canequally not survive a run. This lack of security for leveragedfinancial firms against a generalized panic "on any system," as Ricardosaid, is what triggers government intervention of various kinds,including government deposit guarantees (so-called insurance) andbailouts.

The bubble, while it's on, is characterized by greatly increaseddebt and leverage. A period of success leads to the belief by allparties--financial actors, regulators, politicians, theorists,competitors--that greater leverage and especially the use of short-termdebt is safe. Of course, it turns out in the end that pushed to anextreme, it isn't. When the bust comes, everybody tries to "delever,"as we say these days, which means to reduce debt and reduce the ratioof debt to capital.

If the need of private balance sheets to shrink is to be confirmed,some other balance sheet has to expand. That's the government's balancesheet.

Ask yourself this question: how is it possible for everybody todelever, for all balance sheets to shrink at the same time? Imaginethat the entire financial system is one big balance sheet, and askyourself: how can that aggregate balance sheet shrink? You will come tothe conclusion that it can't, at least, it can't without an asset pricecollapse and widespread debt deflation.

So, if the need of private balance sheets to shrink is to beconfirmed, some other balance sheet has to expand. That's thegovernment's balance sheet. This yin and yang between these two balancesheets, the private balance sheet delevering in a panic and thegovernment balance sheet expanding in a panic, is what we observe. Thisis why the Federal Reserve balance sheets, if we add all the FederalReserve banks together, have increased from about $860 billion to over$2 trillion. That's why we have the Troubled Asset Relief Program(TARP) program and all these other interventions. That's why we have,in particular, one bailout I want to mention, which is the bailout ofFannie Mae and Freddie Mac. This is of course not an intervention inthe private sector but an intervention to save a governmentintervention.

Fannie Mae and Freddie Mac were interventions of 1938 and 1970, respectively, which didn't go away.

We should hope that these other interventions will be temporary andreversed in time because every intervention brings with it expandedgovernment and--in particular--bureaucratic power. My favorite exampleof an intervention which did go away was the Home Owners LoanCorporation of the 1930s (whose authorizing legislation, by the way,took three and one half pages of statutory text--I give that to all ofyou as a good example). The Act required that the directors "shallproceed to liquidate the corporation when its purposes have beenachieved." Unlike Fannie Mae and Freddie Mac, this is indeed whathappened.

A second thing to be hoped for in these interventions is that thetaxpayers, who are being made into involuntary investors in the equityof financial firms and in distressed debt, will be thought of andtreated like investors to the greatest extent possible. I even have thenotion that if the various bailout schemes, like the TARP, succeed inmaking a profit, which in my view they very well may, 100% of thatprofit should be returned to those citizens who actually do pay federalincome taxes, as a dividend.

As the last word, "Men's spirits are lifted when the times areprosperous, rich, and happy so that their pride and arrogance grow. Adversity chastens them and teaches them what should be done, but goodfortune, which leads them to rejoice, usually makes them stray fromright councils and clear thinking." That was true when Cato the Elderwrote it in the second century B.C., and it's true of bubbles and buststoday.

Thank you.

Alex J. Pollock is a resident fellow at AEI.

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