by Paul Beaudry**
|The War Against Creative Destruction: Why
Government Bailouts Only Make Things Worse* (Print Version)
Le Québécois Libre, December
15, 2009, No 273.
Since the New Deal, a theory accepted by many holding
political power has been that government spending is the best way to rescue a
country from economic hardship. According to so-called Keynesian reasoning,
governments must boost spending to stimulate aggregate demand.
The plethora of government spending initiatives in the United States under the
Obama Administration since the 2008 economic crisis have demonstrated that that
Keynes’ mentality is still firmly ingrained in the minds of today’s political
leaders and top economists. Indeed, governments around the world rushed to
implement a wide range of spending initiatives designed to salvage their failing
economies and to increase output. The American government has led the way with
Wall Street bank bailouts, partial nationalization of General Motors and
“recovery” legislation providing US$787-billion in stimulus money, which has
been used for a wide array of purposes, such as the rehabilitation of airport
runways, the building of sidewalks, and the purchase of dried fruit!
Canada has followed America’s lead and, although on a lesser scale, has
implemented numerous stimulus pending programs. The 2009 Canadian budget
included $12-billion of infrastructure spending over two years, $8-billion for
housing and construction, and many more billions for the forest, manufacturing,
and construction industries. Canada also took part in the partial
nationalization of GM, costing taxpayers $10.6-billion; that amount is likely to
increase in coming years.
American Federal Housing and Monetary Policy Leading Up to the Recession
For many years, the American government has implemented policies to boost home
ownership, especially among its low-income population. During his presidency,
George W. Bush often praised what he referred to as the “ownership society”:
I understand if you own something, you have a vital stake
in the future of our country. The more ownership there is in America, the
more vitality there is in America, and the more people have a vital stake in
the future of this country.(1)
Policies promoting homeownership in the United States go back
to 1977 when the Carter administration adopted the Community Reinvestment Act
to reduce discriminatory lending practices in lower-income neighbourhoods.
This legislation forced banks to provide risky mortgage loans to un-creditworthy
borrowers and gave community groups the right to protest against banks’ non-compliance
with the law, possibly hindering business plans for mergers and expansion. In
1992, the Clinton administration adopted legislation requiring Fanny Mae and
Freddy Mac, the two government enterprises that purchase and securitize
mortgages, to devote a percentage of their lending to support affordable housing.
Serious problems linked to the U.S. government’s housing policies arose when by
2003/04 financial institutions responded to strong federal policy incentives to
extend mortgages to un-creditworthy borrowers by creating huge quantities of
assets based on risky mortgage debt.(2)
Banks knew they could indulge in such risky behaviour because the federal
government had a history of bailing out financial institutions when risk-taking
activities failed. Combined with the Federal Reserve’s artificially low interest
rate policy in the early 2000s (a policy that is to blame for extending the
housing bubble), this situation was bound to be catastrophic when housing prices
stopped rising – as they did in 2006. The steep decline in value of mortgage-backed
assets caused a panic within financial institutions that had previously relied
on those risky assets. This prompted the federal government to intervene in
order to prevent bank failures.
Bailouts and Stimulus Spending: Will They End the Crisis?
Most of the programs implemented by the American and Canadian governments to
address the economic crisis are corporate welfare aimed at redistributing funds
to well-connected corporate interests. By bailing out shaky subprime lenders,
the American government ended up subsidizing big financial institutions’ risky
behaviour and penalizing better managed financial institutions’ good behaviour.
This use of taxpayer money to shield financial institutions from the
consequences of their actions is unfair and unwise.
Clayton Homes, a home construction and lending business owned by Warren Buffett,
is a good example of a company suffering from government “stimulus” spending.
Due to its high lending standards, Clayton Homes has a good balance sheet. The
business has not needed any government assistance to survive. However, Clayton
Homes is now facing a formidable competitor: the government. As Buffett told his
investors, Clayton’s competitors that had engaged in risky loans are now
benefiting from extended loan guarantees from the government:
Though Berkshire’s credit rating is pristine – we are one
of only seven AAA companies in the country – our cost of borrowing is now
far higher than competitors with shaky balance sheets but government backing.(3)
Similar reasoning applies to the bailout of the auto
manufacturers. By subsidizing North American manufacturers, the Canadian and
American governments ended up giving money to companies whose products were not
competitive and provided such companies with an unfair advantage vis-à-vis their
competitors. Additionally, the bailout will likely have the effect of hurting
the “Big Three” in the long run because they will have no incentive to undertake
a much needed restructuring of their assets and business, allowing them to
reemerge as profitable businesses. The American auto industry should have
followed the example set by the steel industry when it allowed unproductive and
inefficient mills to shut down. Unfortunately, due to the extensive government
involvement in the auto industry, such a rationalization of business activities
might never occur.
Aside from moral hazard, government intervention has negative long-term effects
for taxpayers. Despite the fact that stimulus spending may improve the economy
in the short run, it will contribute to ballooning deficits that will have to be
paid for by future generations. As Alan Reynolds, senior fellow at the Cato
Institute, pointed out:
That so-called stimulus bill was, of course, a $787
billion deferred tax increase, plus interest. Although investors could not
be sure when the tax bill would be presented, Obama warned us that the first
installment would come from higher tax rates on dividends, capital gains,
stock options and the profits from foreign affiliates of multinational
Another New Deal Is Not the Solution
In her groundbreaking revisionist book about the New Deal, The Forgotten Man(5),
Amity Shlaes contends that government spending did not contribute to ending the
Great Depression. Instead, it was the lack of faith in the market demonstrated
by Presidents Hoover and Roosevelt that was responsible for extending economic
malaise. Indeed, the “bold, persistent experimentation” favoured by President
Roosevelt led to dramatic destructions of wealth, the cartelization of many
industries, and high unemployment.
Shlaes’ conclusions provide support to those who contend that economies cannot
be fixed by massive government spending programs that rescue inefficient
corporations and create significant deficits to be paid off by future
generations. Rather, the most effective way to fix an economy during an economic
crisis is to cut government spending and cut taxes in order to increase
competitiveness and strengthen the foundations of a prosperous and
Sheet: America's Ownership Society: Expanding Opportunities," The White
House, August 9, 2004.
2. Jeffrey Miron, "In Defense of Doing Nothing," Cato’s Letter, Spring
2009, Vol. 7, No. 2.
3. John Carney, "Warren
Buffett Explains How the Bailout is Crushing Healthy Companies," The
Business Insider, March 2, 2009.
4. Alan Reynolds, "The Government's Influence on the Stock Market," Forbes,
March 25, 2009.
5. Amity Shlaes, The Forgotten Man: A New History of the Great Depression,
2008, New York, Harper Perennial.
Article first published in
C2C (Canada's Journal of Ideas) and
in the National Post. **Paul Beaudry
is a lawyer based in Montreal.