Econ 101: Financial Bailouts and the Rule of Law

     Friedrich Hayek wrote of the importance of what he called the rule of law over the rule of man. His point was that in order to be free to act according to our own plans we must know what the rules of the game are, for what reason they are promulgated, under what conditions they will hold, and that these rules are the same for everyone.

     This is consistent with James Madison’s comments in Federalist #62: “It will be of little avail to the people that the laws are made by men of our own choice, if the laws be so voluminous that the cannot be read, or so incoherent that they cannot be understood; if they be repealed or revised before they are promulgated, or undergo such incessant changes that no man who knows what the law is today can guess what it will be tomorrow.”

     If we are under the rule of man, such as a lord in the Middle Ages, the rule changes with the whim of the man who makes it. This allows for a coercive government and it severely constrains innovation and investment, since these require some certainty of the rules in order of estimate the payoff from undertaking risk. 

     One of the major difficulties with the recent actions of the Federal Reserve and the U.S. Treasury is that they appear much more to be the rule of men rather than the rule of law. Bear Stearns ran into financial problems when it relied upon risky and volatile short term borrowing to finance longer term higher yielding assets.

     When rumors surfaced that Bear Stearns would run short of cash, the Federal Reserve invoked a clause of its charter that, according to Alan Greenspan, had last been used in the 1930s. The clause allowed the Fed to give JP Morgan a $29 billion non-recourse loan to help finance an emergency takeover of Bear Stearns that it had engineered along with Treasury.

     AIG, then the world’s largest insurer, was given a loan of $85 billion on Sept. 16 and another $37.8 billion loan on Oct. 8, with further access to another $20.9 billion through the Fed’s commercial paper program. This was followed by a further restructuring of the bailout in November resulting in a total commitment of more than $150 billion.

     On the other hand, Lehman Brothers was allowed to go into bankruptcy.

     The Treasury within days of proposing the Troubled Asset Relief Program (TARP) was given $700 billion to purchase troubled assets. Treasury Secretary Henry Paulson later declared that Treasury would not use the $700 billion to buy troubled assets, but would instead use it to take equity positions in banks.  Investment banks, such as Goldman Sachs, were allowed to quickly become bank holding companies in order to be eligible for the TARP funds. Other financial institutions, such American Express, a credit card company, followed suit, with GMAC also applying. Citigroup was given more than $300 billion in loan guarantees.

     The point is that this does not appear to be rule of law, but rule of men. This creates uncertainty in the markets in the short term as investors become uneasy about investing in a company because the next day some new rule may change the economic landscape. And in the long term, how long will the federal government own large shares in our financial institutions and will Congress begin to micro-manage the banking sector.

     One reason that there is no rule of law during the current crisis may be that there is no economic theory that is generally agreed upon on how to restore credit markets while minimizing the transition costs of the de-leveraging that must occur in order to clear out the mortgage-based derivatives market.

     Paulson and Federal Reserve Chairman Ben Bernanke may be just making it up as they go along. If this is the case, then this is not likely to inspire confidence that government action is likely to get to the correct answer. If Paulson and Bernanke do have some theory behind their actions, then this should be made explicit so economic actors may make the best decisions possible for them given the rules.

     To quote Alan Greenspan’s book The Age of Turbulence, “We need laws that specify and limit the conditions for bailouts—laws that authorize the Treasury to use taxpayer money to counter systemic financial breakdowns transparently and directly rather than circuitously through the central bank, as was done during the blow-up of Bear Stearns.” Without such laws and transparency market participants will be saddled with uncertainty and the transition to market equilibrium and renewal of economic growth will be delayed.

     There is a long term danger in moving from rule of law to rule of men. Even if it were the best solution to our current economic problem, granting unrestrained and uncertain powers to the governmental authorities will damage both the economy and jeopardize out freedom. Hayek argued in his book, The Constitution of Liberty, that it would be better in the long run to abide by the constitution and fail to solve a particular economic problem than to allow government arbitrary power even under special circumstances. We may be setting a precedent that will be used in ten years in ways unimagined by the Congress that voted for the Federal Reserve Act of 1913 or the Troubled Asset Relief Act of 2008.

Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College and a Business & Media Institute adviser.