Big Gov

Last week I discussed why this election year may find some success in appealing to a populist sentiment that is brewing among many middle class voters. But even before the election, the regulatory environment has shifted in a significant way to meet the challenge of the housing and credit crises. After three decades of a “hands-off” approach that lauded privatizing and deregulating much of the economy, the 2008 economy has forced the government and the central bank into the free market lock, stock and barrel in an effort to stave off a deep recession and a financial system freeze-up.

The trend is moving beyond the more conventional tools of monetary and fiscal action (Fed rate cuts and $168 billion of tax rebates) into direct intervention into the inner-workings of financial institutions. The JP Morgan takeover of Bear Sterns was engineered by the government and announced a new era where the treasury is now willing to extend credit against shady mortgage-related collateral. The next iteration of government’s new role was seen in last weekend’s plan to rescue Fannie and Freddie, which may cost taxpayers north of $200 billion when all is said and done. (It is estimated that the Fannie/Freddie bailout will not be as expensive as the $124B S&L bailout, which due to the magic of inflation, amounts to approximately $300B today.)

To many, this is a dangerous expansion of the government’s role in the financial system and increases the likelihood of moral hazard as other institutions assume that Uncle Sam’s safety net will be there when the next crisis emerges. The problem is that when pushed to the edge, government officials did not believe that there was a choice. As former Fed Chairman Paul Volcker said in April, “Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – has failed the test of the market place.” In other words, the free market could not save the financial system from near-collapse.

However, Volcker went on to point out this is unchartered territory. “Out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank. As custodian of the nation’s money, the Federal Reserve has the basic responsibility to protect its value and resist chronic pressures toward inflation. Granted a high degree of independence in pursuing that responsibility, the Federal Reserve should be removed from, and be seen to be removed from, decisions that seem biased to favor particular institutions or politically sensitive constituencies.” In the last sentence, Volcker appears to give a nod to the problems of the politically-connected Fannie and Freddie or a major Detroit auto manufacturer.

It does not appear that the Treasury and Fed have acted due to political motivation. Government interventionist is not a role that either Ben Bernanke or Hank Paulson would have ever cast himself. Yet faced with potential catastrophic failures of risk management in the private and public sectors, swift and dramatic action had to occur. Perhaps the failures will be addressed via increased regulation with tougher controls and better enforcement, i.e. “bigger government,” and then of course when the next upturn occurs, the pendulum will swing back towards a looser, more “hands-off” approach.