Too Big to Fail, or Succeed

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No. 11, August 2009

In a speech at the White House on June 17, 2009, Obama outlined what he envisions for future regulation of the financial system. He called his plan "a new foundation for sustained economic growth . . . a transformation on a scale not seen since the reforms that followed the Great Depression." Indeed it is.

His plan, if adopted, will fundamentally change the nature of our financial system and economy. The underlying concerns and assumptions are clear, and they are made clearer by considering other ways that his administration has dealt with the consequences of competition--particularly the faux bankruptcies of General Motors and Chrysler and the impending change in antitrust policy. Although the president said in his speech that he supports free markets, these initiatives confirm that the administration fears the "creative destruction" that free markets produce, preferring stability over innovation, competition, and change.

According to the administration white paper circulated prior to the president's speech, the Federal Reserve would be authorized to create a special regulatory regime--including requirements for capital, leverage, and liquidity--for any firm "whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed." In addition, if a large financial firm is failing, the Treasury is to be given the power--in lieu of bankruptcy--to appoint a conservator or receiver to "stabilize" it.

The fundamental point is that the administration used taxpayer money to overturn the market's verdict.

Designating particular financial firms for this kind of special regulatory treatment clearly signals to the markets that these institutions are too big to fail. It will reduce the perceived risk of lending to them, enabling them to raise funds at lower cost than their smaller competitors.

In other words, the administration's plan would create what are essentially government-sponsored enterprises like Fannie Mae and Freddie Mac in every sector of the financial economy--insurers, securities firms, finance companies, bank holding companies, and hedge funds--in which these specially regulated firms are to be designated. The result will be devastating for competition. Larger firms will squeeze out smaller ones, and aggressive small companies will have less opportunity to overcome the government-backed winners.

Moreover, the administration's proposal to provide a special bailout mechanism for large firms confirms the likelihood that these firms will never be closed down or liquidated. Citing the market turmoil that followed Lehman's collapse, the administration will argue that failures like this are "disorderly." But failure comes from risk-taking--the very source of our economy's strength--and it is ultimately risk-taking and its consequences that the administration's plan is intended to prevent.

The turmoil following Lehman's failure occurred because market participants expected, after the rescue of Bear Stearns, that any larger firm would also be rescued. When Lehman was not, all market participants were required to recalibrate the risks of dealing with all others, causing a freeze-up in lending and hoarding of cash. Lehman's failure itself did not cause any substantial losses, and within two weeks of its bankruptcy filing, Lehman's trustee sold its brokerage, investment banking, and investment management businesses to four different buyers.

Contrast this with AIG, the administration's paradigm, which was saved by the government because it was allegedly too big to fail. That firm is gradually wasting away under government control, with the taxpayers footing the bill.

The administration's fear of competitive outcomes is not reflected solely in financial-sector policies. Consider General Motors and Chrysler. They were defeated in the marketplace. Simply put, they failed to build automobiles enough Americans wanted to buy.

Their disappearance would not have threatened the stability of the financial system, although it would undoubtedly have been disruptive for suppliers, dealers, and employees. Yet the administration would not allow them to fail, either. Despite all the talk about credit priorities, the fundamental point is that the administration used taxpayer money to overturn the market's verdict.

If we want a preview of what the administration will do with the resolution authority it wants for large financial companies, we need look no further.

The same pattern with regard to competitive markets can be seen in the Justice Department's new antitrust policy. Christine Varney, the new assistant attorney general in charge of antitrust policy, has said that U.S. policy should be more like Europe's. Until now, U.S. antitrust policy has tried to protect competition. Europe attempts to protect competitors. Protecting competitors means blunting the skills of superior players, allowing inferior managers and business models to remain in business and thus preventing better managements and business models from emerging. Again, stability wins out over change and progress.

The president has said on several occasions, including in yesterday's speech, that "I've always been a strong believer in the power of the free market." But his administration's prescriptions tell a different story. In AIG, GM, Chrysler, Fannie Mae, and Freddie Mac, we can see the future that the administration envisions for our economy: a sclerotic and unchanging structure of big companies working with, protected by, and relying on big government.

Peter J. Wallison is the Arthur F. Burns Fellow in Fianancial Policy Studies at AEI. A version of this article appeared in the Wall Street Journal on June 18, 2009.

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