Features8 Bootleggers, Baptists, and Bailed-Out Bankers by Bruce Yandle

14 Black Swans, Butterflies, and the Economy by Max Borders

16 The Financial Bailouts: “See the Needle and the Damage Done” by Lawrence H.White

25 Too Big to Fail by Michael Heberling

29 Did Deregulated Derivatives Cause the Financial Crisis? by Robert P. Murphy

34 Was Money Really Easy Under Greenspan? by David R. Henderson and Jeffrey Rogers Hummel

Columns4 Ideas and Consequences ~ What We Believe by Lawrence W. Reed

12 The Therapeutic State ~ Psychiatry:The Shame of Medicine by Thomas Szasz

23 Our Economic Past ~ Bailing Out the Big Three Repeats Britain’s Mistake

by Stephen Davies

40 Give Me a Break! ~ Government Sets Us Up for the Next Bust by John Stossel

47 The Pursuit of Happiness ~ Unintended Consequences in Energy Policy

by David R. Henderson

Departments2 Perspective ~ News Flash: FDR Didn’t Restore Prosperity! by Sheldon Richman

6 Greenspan Should Be Shocked by Risky Lending? It Just Ain’t So!

by Gerald P. O’Driscoll, Jr.

Book Reviews

42 The Cult of the Presidency: America’s Dangerous Devotion to Executive Power

by Gene Healy Reviewed by Brian Doherty

43 Bad Samaritans:The Myth of Free Trade and the Secret History of Capitalism

by Ha-Joon Chang Reviewed by Robert Batemarco

44 Are the Rich Necessary? Great Economic Arguments and How They Reflect Our

Personal Values

by Hunter Lewis Reviewed by George C. Leef

45 Gusher of Lies:The Dangerous Delusions of “Energy Independence”

by Robert Bryce Reviewed by William Anderson

Page 42

Page 25

Page 23

VOLUME 59, NO 2 MARCH 2009

The New Deal did not end the Great Depression.This statement will come as no shock to Free-man readers, but it will to the many people who

never encountered it before. Now people are encoun-tering it—in newspaper columns and news-talk shows.

Why, after years of being taught that Franklin Roo-sevelt’s economic intervention saved the country fromdisaster, is the general public now being told—by FDRfans, not critics—that this is not the case?

It’s the Rooseveltians’ way of helping PresidentObama get over any fear he has of deficit spending. PaulKrugman, the newest Nobel laureate, a Keynesian, and aNew York Times columnist, is explicit about this. “[H]owmuch guidance does the Roosevelt era really offer fortoday’s world?” Krugman asks.“The answer is, a lot. ButBarack Obama should learn from F.D.R.’s failures aswell as from his achievements: the truth is that the NewDeal wasn’t as successful in the short run as it was in thelong run. And the reason for F.D.R.’s limited short-runsuccess, which almost undid his whole program, was thefact that his economic policies were too cautious.”

By “too cautious,” Krugman means that FDR’sdeficits were too small. Roosevelt ran deficits (exceptfor one year), but they were about the same size as thoserun by his predecessor, Herbert Hoover. Roosevelt’sbiggest deficit, in 1936, was “only” 4.4 percent of GDP,Jim Powell points out in FDR’s Folly. Both Hoover andRoosevelt were big spenders—FDR doubled spendingby 1940—but they were also big taxers, which kept thedeficit from growing.This is confirmed by University ofArizona economist Price Fishback, who wrote, “Oncewe take into account the taxation during the 1930’s, wecan see that the budget deficits of the 1930’s and onebalanced budget were tiny relative to the size of theproblem. . . .”

Roosevelt was quite a tax enthusiast. He levied orraised taxes on liquor, tobacco, gasoline, corporate divi-dends, estates, incomes (top rate 75 percent versusHoover’s 63), “excess” profits, and undistributed profits.

2T H E F R E E M A N : I d e a s o n L i b e r t y

News Flash:FDR Didn’t Restore

Prosperity!

Perspective

Published byThe Foundation for Economic Education

Irvington-on-Hudson, NY 10533Phone: (914) 591-7230; E-mail: freeman@fee.org

www.fee.org

President Lawrence W. ReedEditor Sheldon Richman

Managing Editor Michael NolanBook Review Editor George C. Leef

ColumnistsCharles Baird David R. Henderson

Donald J. Boudreaux Robert HiggsStephen Davies John Stossel

Burton W. Folsom, Jr. Thomas SzaszWalter E.Williams

Contributing EditorsPeter J. Boettke Dwight R. Lee

James Bovard Wendy McElroyThomas J. DiLorenzo Tibor Machan

Joseph S. Fulda Andrew P. MorrissBettina Bien Greaves James L. Payne

John Hospers William H. PetersonRaymond J. Keating Jane S. Shaw

Daniel B. Klein Richard H.TimberlakeLawrence H.White

Foundation for Economic Education

Board of Trustees, 2008–2009Wayne Olson, Chairman

Lloyd Buchanan Walter LeCroyJeff Giesea Frayda Levy

Ethelmae Humphreys Kris MaurenEdward M. Kopko Roger Ream

Donald Smith

The Foundation for Economic Education (FEE) is anon-political, non-profit educational champion ofindividual liberty, private property, the free market,

and constitutionally limited government.The Freeman is published monthly, except for combined

January-February and July-August issues. Views expressed by the authors do not necessarily reflect those of FEE’s officers and trustees. To receive a sample copy, or to have The Freemancome regularly to your door, call 800-960-4333, or e-mail mnolan@fee.org.

The Freeman is available on microfilm from University MicrofilmInternational, 300 North Zeeb Road,Ann Arbor, MI 48106.

Copyright © 2009 Foundation for Economic Education,except for graphics material licensed under Creative CommonsAgreement. Permission granted to reprint any article from this issue, with appropriate credit, except “Government Sets Usup for the Next Bust.”

Cover: Paul Hocksenar

3 M A R C H 2 0 0 9

P E R S P E C T I V E : F D R D i d n ’ t R e s t o r e P r o s p e r i t y !

(The last tax was repealed in 1939.) And then there wasthe payroll tax that came in with Social Security. All inall, the New Deal more than tripled the tax burdenfrom 1933 to 1940 raising it from $1.6 billion to $5.3billion. Serious deficit-spenders don’t raise taxes. ButRoosevelt did. Is it any wonder that net investmentdropped $3.1 billion during the decade or that unem-ployment was about as high in 1939 as it was in 1932?

This raises the question of whether big-time deficitspending would have ended the Depression. Krugmanand others think so. But how could it have done so?Deficits are financed either by borrowing or by creatingmoney out of nothing.When the government borrowsmoney, that’s money no one else can borrow and invest.Where’s the gain? Moreover, the money is put to pur-poses selected by politicians, not entrepreneurs tryingto please consumers.

When the government creates money, three thingshappen. First, the new money lowers interest ratesbelow the level justified by society’s time preference;that creates perverse incentives to invest in longer-termprojects far from the consumer-goods level. Second, themoney changes relative prices (rather than raisingprices evenly) because particular economic interests getit earlier than everyone else.Third, prices later rise gen-erally, reducing everyone’s purchasing power.The resultis a distorted structure of production and a boom that is unsustainable because it is based not on real savingsbut on fiat money. When the inflation stops, the bustfollows.

Since the New Deal didn’t end the Depression anda New Deal on steroids wouldn’t have done so, Presi-dent Obama should pay no heed to Krugman and hisKeynesian economic advisers.The way to wake up theeconomy is reduce the total government burden onproducers and consumers by, among other things, slash-ing spending, taxes, and borrowing.

* * *

Years ago economist Bruce Yandle identified a phe-nomenon that accounts for a good deal of governmentintervention. Tacit alliances form between those who

seek a particular intervention for moralistic reasons andthose who seek it for financial advantage. Since Yandlefirst noticed such an alliance in efforts to outlaw Sun-day liquor sales, he dubbed this phenomenon “Boot-leggers and Baptists.” In this issue he applies this prin-ciple to the “affordable housing” policies that havepushed the economy into turmoil.

Government deserves the lion’s share of blame forthis turmoil, but private market actors don’t escape allculpability. As Max Borders points out, many cocksureinvestors let themselves be blindsided by a black swan.

Is it too much of a stretch to call this the Age of the Bailout? You may not think so after readingLawrence White’s catalog of federal largess and its likelyconsequences.

Of course all these bailouts are necessary becausethe rescued firms are “too big to fail.” Is there a moreridiculous doctrine? Michael Heberling thinks not.

Commentators frantically trying to blame the freemarket for the economic mess think they have found aculprit: the unregulated market for derivatives.Are theyright? Robert Murphy takes up that question.

Most free-market advocates attribute the infamoushousing bubble at least in part to Alan Greenspan’seasy-credit policies at the Federal Reserve. But noteveryone. David Henderson and Jeffrey Rogers Hum-mel offer a dissenting view.

Here’s what our columnists have come up with thisissue: Lawrence Reed provides a timely reminder ofFEE’s credo.Thomas Szasz demonstrates that psychiatryisn’t medicine but rather the medicalization of conflict.Stephen Davies counsels against auto bailouts. JohnStossel warns against inflation. David Henderson tracesthe unintended consequences of fuel-efficiency stan-dards. And Gerald O’Driscoll, reading that AlanGreenspan claimed to be shocked by risky lending,replies,“It Just Ain’t So!”

Books occupying our reviewers deal with the imperial presidency, free trade, the rich, and energyindependence.

—Sheldon Richmansrichman@fee.org

B Y L AW R E N C E W. R E E D

What We Believe

Ideas and Consequences

The Foundation for Economic Education, pub-lisher of this magazine since 1956, is now in itsseventh decade, and I am now in my seventh

month as its president. As we expand the outreach ofour programs and publications, now is a good time toremind our readers who we are and what we believe in.

FEE’s vision—the ideal we are striving to achieve—is a world where people flourish in a free and civil soci-ety. In such a world the individual’s creative, productiveenergies are unleashed; private property and the sanc-tity of contract are upheld; the use offorce is confined to protecting thepeace; competitive markets allocatescarce resources; and honesty is univer-sally regarded as the best policy in bothpublic and private affairs.

We believe a free society is not onlypossible; it is also imperative, because thereis no acceptable alternative for a civi-lized people. Our hope is that througheducation, men and women will under-stand the moral, philosophic, and eco-nomic principles that undergird a freesociety; that they will appreciate thedirect connection between those prin-ciples and their material and spiritualwelfare; that they will strive to passthose principles on from one generation to the next.

The future we envision is one in which individualexpression gives rise to great, even presently unimagin-able achievements in culture, medicine, science, andeducation. Men and women will engage one anotherpeacefully and voluntarily because they will respect oneanother’s uniqueness, rights, property, and aspirations.No one will be so lacking in humility and introspectionas to fancy himself better equipped to plan the lives ofothers than they, individually, are able to plan for them-selves, their families, and their businesses.

FEE aims to provide the best available instruction inthe principles of a free society to individuals of all ageswhose minds are open to freedom’s exciting challenge.Our organization seeks to be known as a beacon of avibrant, growing, international movement to educatefor liberty.

Our core values begin with the notion that ideasmatter. Indeed, ours is a battle of ideas exclusively,not a battle of personalities. Ideas can and do changethe world. Investing in them can ultimately reap the

highest of returns. Principles, notpragmatism or expediency, defineour work.

We are optimistic. Pessimism is aself-fulfilling prophecy.We are wag-ing a battle of ideas to win, not tomake a living, bide our time, or godown with the ship with a smile onour faces.

Politics is not our bailiwick.Indeed, we seek to de-politicize life.We want to enlighten public discus-sion by emphasizing that there is(and ought to be) much more to lifein a free and civil society than thepolitical apparatus.We do not advisepoliticians how to employ the use

of force, but rather we make the case against the initia-tion of force, period.

Within a broadly “pro-liberty” framework, FEE is a“big tent” organization, meaning we encourage dia-logue among friends of liberty who may differ withone another on such matters as the precise bounds ofgovernment or specific policy issues that are beyondFEE’s economic and philosophic focus. We seek tobuild bridges not burn them.

4T H E F R E E M A N : I d e a s o n L i b e r t y

Lawrence Reed (lreed@fee.org) is the president of FEE.

Our core valuesbegin with thenotion that ideasmatter. Indeed, ours is a battle of ideasexclusively, not abattle of personalities.Ideas can and dochange the world.

We are not religiously affiliated, but that does notmean we are unfriendly to people of faith.To paraphrasethe title of a book by FEE’s late scholar Edmund Opitz,faith and a free economy can be “allies, not enemies.”

A free economy in the long run is unlikely if notimpossible without the widespread practice of sturdycharacter—including such traits as humility, self-disci-pline, self-reliance, patience, and respect for others.The economic theories of the Austrian school figureprominently in FEE’s approach, but we welcome thecontributions of other schools of thought broadly sym-pathetic to us in their understanding of freedom and afree economy.

In material terms, free people arenot equal and equal people are not free.Attempts through the use of govern-ment to create equality of income andwealth not only work against ournatures as unique individuals, but alsolead inevitably to force and conflict.

Private property is a human rightfirst and foremost. Its protection is anindispensable foundation of economicactivity in a free society.

Central planning is, as economistLudwig von Mises stated, “plannedchaos.” The spontaneous order of freemarkets, competition, incentive, entrepreneurship, profitand loss, and flexible prices is infinitely superior in bothmoral and economic terms.

Pioneering inventors, risk-taking wealth creators,and visionary organizers of people and tools are amongsociety’s greatest heroes. Those whose business is theforcible redistribution of those heroes’ achievements areengaged in immoral, envious, demagogic, or otherwiseanti-social behavior.

Government has nothing to give anybody exceptwhat it first takes from somebody, and a government

that’s big enough to give us everything we want is bigenough to take away everything we’ve got.

Taking the Message of Liberty to the World

Nothing about liberty guarantees its future. It is notin any way automatic. It can be lost just as surely

and fully by our own choices and votes as it can betaken by a foreign invader.Those who believe in it cantake nothing for granted.We must work hard to fosterwidespread understanding of it or lose it to those whovalue money and power more.

FEE seeks no resources or special favors from anypolitical authority. We rely entirely on the voluntary

support of those who share our per-spective and support our mission.We treat the funds our supportershave entrusted to us as if we hadearned them ourselves in the firstplace. We are “entitled” to nothingbut the respect and support ourwork merits in the eyes and heartsof free men and women.

FEE thinks of itself not as a placethe world must come to, but as anorganization that takes its messageto the world. Our seminars are not held in one place but in many.

We are forging strategic partnerships with others who love liberty so that we may reach new audi-ences, especially the young, wherever eager ears desireto hear.

And in all matters we aim for the highest standardsof ethical speech and conduct, sound internal manage-ment, continuous quality improvement, and customerservice. We will never believe we’re so good at some-thing that we can’t get better.

So there you have it.This is what we believe at FEE.I hope you find it inspiring and worth supporting.

5 M A R C H 2 0 0 9

W h a t W e B e l i e v e

FEE thinks of itselfnot as a place theworld must come to, but as anorganization thattakes its message tothe world.

Toward the end of his tenure as Fed chairman inearly 2006, Alan Greenspan was the object ofpraise edging at times into adulation. It came

from some unlikely sources. Milton Friedman pennedan encomium for Greenspan in the pages of the WallStreet Journal titled, “The Greenspan Story: He Has Seta Standard.” After noting that the Fed had done “moreharm than good” for most of its history, Friedmandescribed Greenspan’s performance as “remarkable.”

In little more than two years, Greenspan’s legacy hasbeen reevaluated. At hearings ofthe House Oversight Committee,he tried to save as much of hisoriginal reputation as possible.Chairman Henry Waxman set thetone by observing that the entireeconomy was paying the price forGreenspan’s inattention to therisks in the subprime mortgagemarket.

Greenspan’s defense remindedme of a famous scene in themovie Casablanca. The flawed butultimately heroic Captain Renault(played by Claude Rains) announces that Rick’s wasbeing shuttered until further notice. Asked why, Cap-tain Renault stated (as he accepted his nightly win-nings) that he was “shocked” to discover that gamblingwas going on. In a similar vein, Greenspan expressed tothe House committee his “shocked disbelief ” that riskylending had been going on during his tenure

As Fed chairman, Greenspan was the architect—the“maestro”—of a low-interest policy that flooded theeconomy with cheap credit after the collapse of the

dot-com bubble in 2000-01. Real (inflation-adjusted)short-term interest rates were negative for several years.Risk premiums were driven down to historic lows—indeed, they all but disappeared. These elements madefor a classic asset bubble. As economic historian GaryGorton recently noted (in his paper, “The Panic of2007”), the whole subprime house of cards would havetumbled down if housing prices had simply stopped ris-ing, much less begun falling. They stopped rising andthen began falling in 2007 and into 2008.

We’re Forever BlowingBubbles

Economists have been observ-ing and analyzing asset bub-

bles for centuries. Adam Smithtalked about the South Sea com-pany (and its bubble) in TheWealth of Nations. The effects ofcredit policy—first of ease thenrestriction—were well-analyzedby nineteenth-century econo-mists. In the twentieth century,booms and busts were the central

focus of business-cycle theorists. These included suchfigures as the British economist J.M. Keynes and theAustrian economists Ludwig von Mises and Friedrich A.Hayek. Mises and Hayek in particular linked the devel-opment of asset bubbles to easy-credit policies of centralbanks. Later, entire schools of economics—Keynesian,Monetarist, etc.—wrote on the topic.

Greenspan Should Be Shocked by Risky Lending?It Just Ain’t So!

6T H E F R E E M A N : I d e a s o n L i b e r t y

B Y G E R A L D P. O ’ D R I S C O L L , J R .

Gerald P. O’Driscoll, Jr. (gpo@ix.netcom.com) is a senior fellow at theCato Institute. He has been a vice president at the Federal Reserve Bank ofDallas and a vice president at Citigroup.

Greenspan’s show trial appealed to a sense ofschadenfreude.Photo courtesy www.trackrecord.es

7 M A R C H 2 0 0 9

The elements of a classic bubble should not haveeluded the Fed chairman. The Fed sets the Fed fundsrate, the rate at which banks lend to each other. That rate greatly influences other short-term lending rates.For three years, the Fed funds rate was at or below 2 per-cent. For one year in that period, the rate was 1 percent.That cheap-money policy fostered the leveraged bor-rowing and risk-taking that characterized the subprimemortgage market. Elsewhere I have called this “casinocapitalism.” (See my “Subprime Monetary Policy,” TheFreeman, November 2007, http://tinyurl.com/66tnu5.)

In an October 18 interview with theWall Street Jour-nal, Anna Schwartz, the eminent economic historian(and coauthor with Milton Friedman of A MonetaryHistory of the United States), observed that asset bub-bles—“manias,” as she calls them—always have thesame cause. “If you investigate individually the maniasthat the market has so dubbed over the years, in everycase, it was expansive monetary policy that generatedthe boom in an asset.” In the dot-com bubble it wasequity shares of high-tech start-up companies. In recentyears it has been residential real estate. The asset maychange, but not the cause—monetary policy.

Grant Me Fiscal Discipline, but Not Yet

Why do central bankers repeat the same mistakesover and over again? Dr. Schwartz has the

answer: “In general, it’s easier for a central bank to beaccommodative, to be loose, to be promoting condi-tions that make everybody feel that things are goingwell.” I guess we could call this “feel-good” monetarypolicy.

How did Greenspan answer the question of why hehad been so accommodative, so loose? He told us hewas merely following orders, complying with the will ofCongress. He had done “what I was supposed to do, notwhat I’d like to do.”This is followership, not leadership.It’s also just not so.

Under Article I, Section 8, of the U.S. Constitution,Congress has the power “to coin money, regulate theValue thereof, and of foreign coin, and fix the Standardof Weights and Measures.”Though at times controver-sial, courts have endorsed Congress’s power under thatclause to create a central bank and delegate to it theconduct of monetary policy.The Fed was designed and

structured to have operational independence.While theseven governors are political appointments, the presi-dents of the 12 reserve banks are not. The Fed hasalways been self-financing and needed no appropriationfrom Congress. That design has maintained its opera-tional independence.

The House hearing should have focused not onGreenspan’s personal failings but rather on institutionalfailure.The Fed was created in 1913 to save the coun-try from recurring financial panics. It was a bankers’bank that would provide liquidity to ordinary banks, sothat credit squeezes would no longer bring economicactivity to a halt. By the 1920s, economists like IrvingFisher were arguing that central banks could managemoney and keep its value more stable than did the goldstandard. So the promise of central banking was stableprices and the end of panics and credit squeezes.

The Fed got off to a rocky start. After World War I,the economy was hit by the panic of 1920-21. By somemeasures, it was the sharpest panic in U.S. history.TheGreat Depression followed, beginning in 1929 (fullrecovery did not occur until after World War II). Mon-etary policy was thought to have improved after thewar. But then came the inflation of the late 1960s,1970s, and into the 1980s. Some economists believedthey detected a “Great Moderation,” first in residentialconstruction in the 1980s and later in real growth(GDP) and inflation. Every time observers thoughtcentral bankers had got it right, there was anothermania, another panic, another recession.

Today, nearly 100 years after the founding of theFed, we are in the midst of financial panic, experiencinga credit squeeze, and caught between inflationary anddeflationary forces.

At some point even the most ardent supporters ofcentral banks must question whether there is an institu-tional flaw in them. Some critics think the restorationof the gold standard would be the cure. Some thinkcentral banks themselves must be abolished. More ofthe same is unthinkable. Financial instability is, unjustly,undermining the case for free markets.

Show trials of principals like that of Alan Greenspanappeal to a sense of schadenfreude, but they are no sub-stitute for some serious rethinking of our monetaryinstitutions.

G r e e n s p a n S h o u l d B e S h o c k e d b y R i s k y L e n d i n g ? I T J U S T A I N ’ T S O !

For more than a year now, people worldwide haveexperienced an extraordinary chain of economicevents. Led by crushing increases in U.S. mort-

gage-related bankruptcies, the world financial collapsethat followed has been termed the subprime crisis, thefinancial meltdown, the Wall Street bailout, the begin-ning of another Great Depression, and even the end ofcapitalism as we have known it.

How did it happen? How could so many smart peo-ple be struck dumb simultaneously?And what does any of this have to dowith Bootleggers and Baptists?

My Bootlegger/Baptist theory wasborn in 1983 when I was working atthe Federal Trade Commission anddoing my best to understand thepolitical forces that bring us so muchfederal regulation. I recalled how mykinfolk explained why Georgia andother states closed down the liquorstores on Sunday: The states that went dry on Sunday—meaning theydid not allow the legal sale of alco-holic beverages—were those wherethe local Baptists and bootleggerslobbied for the same end. The good Baptists justwanted the Lord’s Day to be relatively alcohol-free.Andthe bootleggers just loved the idea of having one daywithout competition from the legitimate sellers.

The Baptists did the highly visible lobbying andpreaching, while the bootleggers paid the politicians, orso the story goes.

“Bootleggers and Baptists” is now part of the bodyof theory used by economists and political scientists to

explain political behavior. Let’s see if the B&B theorycan help explain the subprime crisis.

Anatomy of the Subprime Crisis

The subprime crisis became part of national con-sciousness in the early fall of 2007. First described

as a real-estate bubble that somehow got pricked, thecrisis got its name from a category of mortgages thathad been made to unqualified borrowers. Lending

activity by banks, savings and loans,and mortgage lenders had beenexpanded to reach families withoutthe means to scrape together a downpayment or even make the monthlypayments normally required for fixed-rate mortgages. To accommodate theless-qualified borrowers, lenders cre-atively offered mortgages with adjust-able rates and balloon payments at theend. With billions of dollars of sub-prime loans being generated, U.S.mortgage lenders packaged the loansand sold them to America’s backstopmortgage lenders, Fannie Mae andFreddie Mac, two massive quasi-pri-

vate firms formed by Congress to help make real theAmerican dream that every family would own a homeon its own precious plot of land. From there, the mort-gage paper went to the four corners of the earth.

We have just identified the Baptist theme and someof the Baptists. The theme is achieving the American

B Y B R U C E YA N D L E

Bootleggers, Baptists, and Bailed-Out Bankers

8T H E F R E E M A N : I d e a s o n L i b e r t y

Bruce Yandle (yandle@bellsouth.net) is professor of economics emeritus atClemson University.

The good Baptistsjust wanted the Lord’sDay to be relativelyalcohol-free.And thebootleggers just lovedthe idea of havingone day withoutcompetition from thelegitimate sellers.

dream of home ownership.What could be more noblethan this? And the Baptists? The politicians who pridethemselves on helping ordinary people and even thehelpless to achieve the dream. But it is also possible thatthese Baptists are really bootleggers in Baptist clothing.Think about it.

This highly condensed story has more than a grainof truth in it. Indeed, the broad outline is gospel truth. But there is something strange about the story so far. Where did the money come from? Why wouldsmart bankers make loans to unqualified borrowers?And how could the lenders find a market for bondsbacked by subprime mortgages?

Mr. Bush Enters the Story

There is obviously more to thestory.

Government was committed tomaking homes affordable to all Amer-icans. That commitment took theform of banking regulations thatrequired financial institutions to makeloans in high-risk regions of cities.Added to this were special HUD(Housing and Urban Development)programs that favored lower-incomefamilies as well as long-standing pro-grams like the FHA-insured mort-gages that assisted families inpurchasing homes.

The affordable-housing programtook a serious turn in December 2003, when a smilingPresident Bush put his name on the American DreamDownpayment Act. The accompanying HUD pressrelease described the legislation this way:

“There is a reason why many American familiescan’t buy their first home—they can’t afford the down-payment and other upfront closing costs required toqualify for a mortgage. For as many as 40,000 low-income families, that will change as President Bushtoday signed The American Dream Downpayment Act intolaw.”

Congress authorized $200 million to bring assis-tance to some 5.5 million families by the end of thedecade. On signing the law, President Bush said:

“Today we are taking action to bring many thou-sands of Americans closer to the great goal of owning ahome.These funds will help American families achievetheir goals, strengthen our communities, and our entirenation.”

HUD Ups the Ante

While $200 million is a lot of money, it didn’t gofar enough to satisfy the Baptist urge.To extend

the reach of the taxpayer money, Congress instructedHUD to expand the affordable-home program. HUDput pressure on Fannie Mae and Freddie Mac to openthe money valves.

Reporting on the subprime crisis in 2008, Washing-ton Post writer Caroline Leonnigexplained the process this way:

“In 2004, as regulators warnedthat subprime lenders were saddlingborrowers with mortgages they couldnot afford, the U.S. Department ofHousing and Urban Developmenthelped fuel more of that risky lend-ing. Eager to put more low-incomeand minority families into their ownhomes, the agency required that two government-chartered mortgagefinance firms purchase far more‘affordable’ loans made to these bor-rowers. HUD stuck with an outdatedpolicy that allowed Freddie Mac andFannie Mae to count billions of dol-

lars they invested in subprime loans as a public goodthat would foster affordable housing.”

Leonnig goes on to describe HUD’s reaction tothose accusations:

“HUD officials dispute allegations that the agencyencouraged abusive lending and sloppy underwritingstandards that became the hallmark of the subprimeindustry. Spokesman Brian Sullivan said the agency andCongress wanted to increase homeownership amongunderserved families and could not have predicted that subprime lending would dominate the market soquickly.

“Congress and HUD policy folks were trying to doa good thing,” he said,“and it worked.”

9 M A R C H 2 0 0 9

B o o t l e g g e r s , B a p t i s t s , a n d B a i l e d - O u t B a n k e r s

The affordable-housing programtook a serious turn inDecember 2003,when a smilingPresident Bush puthis name on theAmerican DreamDownpayment Act.

Indeed.Of course, those who have followed the subprime

epoch know how this part of the story ended. On Sep-tember 7, 2008, CBS News described the demise oftwo secondary mortgage lenders this way:

“For decades, Fannie and Freddie fulfilled the Amer-ican dream, reports CBS News correspondent TonyGuida. Consumers took out loans from banks, which inturn sell those loans to Fannie or Freddie. Then themortgage giants repackaged those loans and sold themto investors, guaranteeing the mortgages would berepaid.

“As home ownership grew univer-sal, Fannie and Freddie prospered.Their CEOs, Daniel Mudd andRoger Syron, together earned around$30 million in 2007, reports Guida.

“But as they fattened, critics saythey got greedy, underwriting toomany home loans that never shouldhave been made.

“Fannie Mae and Freddie Mac losta combined $3.1 billion between Apriland June. Half of their credit lossescame from these types of risky loanswith ballooning monthly payments.”

Now we have found two morebootleggers: Mr. Mudd and Mr.Syron, along with countless unnamedWall Street executives who prosperedmightily while designing, packaging,and handling the new mortgage-backed instruments that the worldseemed eager to purchase.To these wemight add some realtors and developers who supportedaffordable-housing programs.

How Do You Fool That Many People?

There is yet another important piece to the story.We still need to understand how major financial

institutions worldwide simultaneously could be fooledinto buying paper that turned out to be trash. Whatdoes due diligence mean?

It turns out that by U.S. law, all credit instrumentsassociated with mortgage-backed paper must be rated

by one of three rating agencies. These are Moody’s,Standard and Poor’s, and Fitch. No competing ratingagencies are allowed to enter the market. These threewidely-respected rating agencies often assigned theirhighest rating to mortgage-backed products that con-tained subprime loans. By mixing pieces of subprimewith high-quality mortgages, the mortgage packerswere able to obtain the highest possible credit ratingfor instruments that were not 100 percent high-qualitypaper. When the default avalanche started, interna-tional buyers and sellers could no longer rely on thecredit rating that had been given to the mixed-bag

products. Credit markets fell into adeep sleep.

Of course, there is far more to thestory than just this part about sub-prime mortgages and the Americandream. The money for making it allhappen had to come from some-where, and from where else but theFed along with an inflow of fundsfrom international lenders? A longperiod of Fed credit easing during2000-2004 laid a foundation forinterest rates so low that people werepractically paid to borrow money.That’s right: At times, interest rateswere lower than the inflation rate. Atother times, the cost of borrowing—especially with federal assistance—was less than the expected priceappreciation of the property, or so itappeared. It seemed too good to betrue.And sadly, it turned out that way.

With easy money and subsidized lending, the greatmortgage-making machine had nowhere to go butup—that is, until inflation reared its ugly head and theFed reversed course.

When the Fed hit the money brakes in 2006, inter-est rates rose, adjustable-rate mortgages reset monthlypayments, and people at the family-budget marginfound they couldn’t make the payments.The Americandream turned into a nightmare. Mortgage defaults fol-lowed. Glutted housing markets followed that. Fallingprices followed that.And Fannie Mae and Freddie Mac

10T H E F R E E M A N : I d e a s o n L i b e r t y

B r u c e Ya n d l e

At times, interest rateswere lower than theinflation rate.Atother times, the costof borrowing was lessthan the expectedprice appreciation ofthe property, or so itappeared. It seemedtoo good to be true.And sadly, it turned out that way.

found themselves in a heap of trouble—along witheveryone else who had purchased mortgage-backedsecurities, including Lehman Brothers, Morgan Stan-ley, UBS, and a host of other international lenders.Obviously, not all banks and lending institutions werecaught in the American-dream squeeze play, butenough large ones were caught for “too big to fail”to become the lobbying cry innational capitals.

Bailouts and Lobbying

Fallout from the Bootlegger/Baptiststory brought massive cash flow to

major banks and delivered mergers thatwould not likely pass antitrust musterunder other circumstances. The acqui-sition of Countrywide by the nation’slargest bank, Bank of America (BOA),is a case in point.This was followed byBOA’s acquisition of Merrill Lynch,the nation’s largest brokerage firm.Countrywide’s merger was arranged bythe Federal Home Loan Bank (FHLB)with funds provided by FHLB memberbanks. The stronger banks that did itright were taxed to assist a competitorwho didn’t. Ayn Rand must be turning over in hergrave.

Along the way, BOA and eight other major bankswere tapped by the secretary of treasury to become part

of the nationalized U.S. banking system. They werehardly in a position to turn down the invitation. WithWashington now the center of the financial universeand the home of the agents of taxpayer equity owners,bankers who previously were not so engaged decidedto invest more in lobbying the politicians.

This is hardly the end of capitalism, but it is anothercase of “Crisis and Leviathan,” themodel of political behavior told sowell by economic historian RobertHiggs. Once again a crisis hasemerged, driven partly by Bootleg-ger and Baptist interest groups. Andonce again, a crisis has fed theleviathan, and the leviathan hastaken a larger bite from the marketeconomy.

Will Robert Higgs’s forecastcome to pass?

Higgs predicts that once a crisishas passed, the fattened leviathancontinues to hold sway. The agen-cies that emerge to manage thenationalized banks will become apermanent part of the govern-ment landscape, and those quasi-

private businesses supported by government will con-tinue to be important players in a Bootlegger-and-Baptist saga.

Betting on Higgs would be a safe bet for sure.

11 M A R C H 2 0 0 9

B o o t l e g g e r s , B a p t i s t s , a n d B a i l e d - O u t B a n k e r s

Once again a crisishas emerged, drivenpartly by Bootleggerand Baptist interestgroups.And onceagain, a crisis has fedthe leviathan, and theleviathan has taken alarger bite from themarket economy.

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B Y T H O M A S S Z A S Z

Psychiatry:The Shame of Medicine

The Therapeutic State

The practice of medicine rests on cooperationand the ethical-legal premise that treatment isjustified by the patient’s consent not his illness.

In contrast, the practice of psychiatry rests on coercionand the ethical-legal premise that treatment is justifiedby the mental illness attributed to the patient and mustbe “provided” regardless of whether the patient consentsor not. How do physicians, medicalethicists, and the legal system recon-cile the routine use of involuntarypsychiatric interventions with thebasic moral rule of medicine, Primumnon nocere, a Latin phrase meaning“First do no harm”?

The answer is: by the medicaliza-tion of conflict as disease and coer-cion as treatment. Carl Wernicke(1848–1905), one of the founders ofmodern neuropathology, observed,“The medical treatment of [mental]patients began with the infringementof their personal freedom.”Today, it ispsychiatric heresy to note, much lessemphasize, that psychiatry-as-coer-cion is an arm of the punitive appara-tus of the state. Absent the coercivepromise and power of mental-healthlaws, psychiatry as we know it would disappear.

Ever since its beginning approxi-mately 300 years ago, psychiatry’s basic function hasbeen the restraint and punishment of troublesome indi-viduals justified as hospitalization and medical care. Fortwo centuries all psychiatry was involuntary psychiatry.A little more than 100 years ago individuals began to seek psychiatric help for their own problems. As aresult the psychiatrist became a full-fledged doubleagent and psychiatry a trap.The film Changeling—writ-

ten by J. Michael Straczynski and directed by ClintEastwood—is a current example.

The story, set in Los Angeles in 1928, is said to bethe “true story” of Christine Collins, whose son Walteris kidnapped. The corrupt police make little effort tofind Walter. Months pass. To repair their damagedimage, the police decide to stage a reunion between an

abandoned youngster pretending tobe Walter and his mother, played byAngelina Jolie. Unsurprisingly, sherealizes that the fake Walter is not herson. After confronting the police andcity authorities she is vilified as anunfit mother, branded delusional,and incarcerated in a “psychopathicward.” There she is subjected to thebrutalities of sadistic psychiatrists andnurses and watches fellow victimsbeing punished by electric shocktreatment—ten years before its inven-tion. So much for the truth of thestory.

Clueless about the true nature ofthe psychiatric terrorization to whichthe Jolie character is subjected, filmcritic Kirk Honeycutt praises ClintEastwood, who, he says, “again bril-liantly portrays the struggle of theoutsider against a fraudulent system.. . . Changeling brushes away the

romantic notion of a more innocent time to reveal aLos Angeles circa 1928 awash in corruption andsteeped in a culture that treats women as hysterical andunreliable beings when they challenge male wisdom.”

12T H E F R E E M A N : I d e a s o n L i b e r t y

Thomas Szasz (tszasz@aol.com) is professor of psychiatry emeritus atSUNY Upstate Medical University in Syracuse. His latest books, both fromSyracuse University Press, are The Medicalization of Everyday Life:Selected Essays and Psychiatry:The Science of Lies.

The practice ofpsychiatry rests oncoercion and theethical-legal premisethat treatment isjustified by themental illnessattributed to thepatient and must be“provided” regardlessof whether thepatient consents or not.

The Jolie character does not simply challenge “malewisdom.” Instead, her actions illustrate the insight of theHungarian proverb, “It is dangerous to be wrong butfatal to be right.”The psychiatrist as brutal agent of thestate enters the story only after the mother proves—bysecuring the testimony of her son’s teacher and den-tist—that “Walter” is an impostor. The psychiatricallyincarcerated individual’s greatest crime—for whichpsychiatrists cannot forgive her—is that she is innocentof lawbreaking and objects to being deprived of liberty.

Medicalized Terrorism

Psychiatric coercion is medicalized terrorism. So-called critics of psychiatry—who often fail or

refuse to distinguish coerced from contractual psychia-try—are unable or unwilling to acknowledge this dis-turbing truth. As a result, the more things change inpsychiatry, the more they remain thesame, as the following convenientlyforgotten example illustrates.

On May 21, 1839, Elizabeth ParsonsWare (1816–1897) married the Rev-erend Theophilus Packard. The coupleand their six children resided inKankakee County, Illinois. After yearsof marriage, Mrs. Packard began toquestion her husband’s religious andpro-slavery beliefs and express opinionscontrary to his. In 1860 Mr. Packarddecided that his wife was insane andproceeded to have her committed. Shelearned of this decision on June 18, 1860, when thecounty sheriff arrived at the Packard home to take herinto custody. The law at the time stated that marriedwomen “may be entered or detained in the hospital[the Jacksonville State Insane Asylum] at the request ofthe husband of the woman or the guardian . . . withoutthe evidence of insanity required in other cases.” Mrs.Packard spent the next three years in the Asylum. In1863, due largely to pressure from her children, whowished her released, the doctors declared her incurableand released her. Mrs. Packard stayed close to her chil-dren, retained their support, founded the Anti-InsaneAsylum Society, and published several books, includingMarital Power Exemplified, or Three Years Imprisonment for

Religious Belief (1864) and The Prisoners’ Hidden Life, OrInsane Asylums Unveiled (1868).

The Beginning, Not the End

Little did Mrs. Packard realize that she was living atthe beginning, not the end, of the Psychiatric

Inquisition. Today, “inquiry” into the minds ofunwanted others is a pseudoscientific racket supportedby the therapeutic state. Millions of schoolchildren, oldpeople in nursing homes, and prisoners are persecutedwith psychiatric diagnoses and punished with psychi-atric treatments. Nor is that all. Untold numbers ofAmericans are now psychiatric parolees, sentenced byjudges—playing doctors—to submit to psychiatrictreatment as so-called outpatients or face incarcerationand forced treatment as inpatients.

The subtext of films such as Changeling is alwayssubtle psychiatric propaganda seekingto make people believe they are wit-nessing past “psychiatric abuses.” Thetruth is that every new psychiatric pol-icy or practice labeled an “advance” is astep toward making psychiatric decep-tion and brutalization more legal andmore difficult for the victim to resist.

As I write this column, I learn froman “antipsychiatry” website that a mannamed Ray Sandford is being subjectedto court-ordered outpatient elec-troshock treatment. “Each and everyWednesday, early in the morning, staff

shows up at Ray’s sheltered living home called VictoryHouse in Columbia Heights, Minnesota, adjacent toMinneapolis. Staff escorts Ray the 15 miles to MercyHospital. There, Ray is given another of his weeklyelectroconvulsive therapy (ECT) treatments, alsoknown as electroshock. All against his will. On an out-patient basis.And it’s been going on for months.”

As the forced psychiatric treatment of competentadults living in their own homes becomes the “standardof medical practice,” the failure to provide such betrayaland brutality becomes medical malpractice. In ademocracy people are said to get the kind of govern-ment they deserve. In a pharmacracy they get the kindof psychiatry they deserve.

13 M A R C H 2 0 0 9

P s y c h i a t r y : T h e S h a m e o f M e d i c i n e

Psychiatric co-ercion is medical-ized terrorism.So-called critics of psychiatry fail toacknowledge thisdisturbing truth.

One side blames the market.The other blamesgovernment. We get two causal stories goingin opposite directions and a lot of animus.

But both perhaps are missing something important inthis titanic debate about our current financial crisis. It’stime we exposed a complicated truth about the econ-omy of the 21st century.

Nassim Nicholas Taleb is famous for introducing usto black swans. Though these rare creatures have longbeen used among academic philosophers to explain theshortcomings of reasoning by induction (“Every swanI’ve ever seen has been white,therefore all swans are white.”),Taleb uses the black swan as a starkmetaphor for the inevitability ofhighly improbable events. In otherwords, black swans are rare, butone will swim by eventually.

As far as Wall Street—particu-larly the people with a large stakein getting things right—is con-cerned, this financial crisisinvolved a confluence of events.Some of these black swans wereset in motion by government, likeflexible lending standards toextend home ownership, Fannieand Freddie, and a mortgage-friendly tax code. Otherswere set in motion by willfully ignorant bankers, bigshot risk-modelers, and people believing they couldlive beyond their means. It all came together in a fan-tastic cascade of failure.The trouble is, no one—neithergovernment nor market actors—can predict such alarge-scale event. Black swans happen.

The other important thing to remember is that theeconomy is a chaotic system. Most of the time chaoticsystems achieve a sweet spot between order and chaos,which is a good thing if an economy is to be robust.Chaotic systems, though, change constantly and involvedynamics that are highly sensitive to initial conditions.

An Ecosystem, Not a Machine

Sadly, we’re getting a whole lot of precisely the wrongkind of thinking in response to this crisis. Indeed

most of the bad thinking arises from viewing the econ-omy through the lens of a falsemetaphor: economy as machine.We’ve heard pundits accuse thegovernment or banks of being“asleep at the switch.” But in acomplex system, there is noswitch. We’ve heard people askhow to “fix it,” “run it,” or “reg-ulate it,” suggesting if just theright sort of genius controlledthe rheostats, we’d get just theright sort of economy.

The economy is not like amachine at all. It is rather morelike an ecosystem that no onecan run, fix, or regulate. The

hubristic sort of person who thinks he or anyone canrun an economy is the victim of what Hayek called the“fatal conceit.” If given power, the planner will end upmaking the rest of us the victims of his false metaphor.

B Y M A X B O R D E R S

Black Swans, Butterflies, and the Economy

14T H E F R E E M A N : I d e a s o n L i b e r t y

Max Borders (Maxborders@gmail.com) is executive editor with Free toChoose Media.

Black swans happenPaul Hocksenar

It is ironic that Alan Greenspan—once adored bythe press but now pilloried by it—is being blamed notonly for wielding a laissez-faire ideology that suppos-edly caused the crisis, but also for failing to predict ablack swan. Greenspan was a single, powerful govern-ment bureaucrat in charge of gathering enough data todetermine the “right” interest rate for a multitrillion-dollar economy. Given the size of that task, he didpretty well for many years. But he was one man. He washoused in a government building. He held an unelectedoffice and made decisions in a bureaucracy that has amonopoly on money and influences the price of credit,at least in the short run. One can hardly call that free-market fundamentalism. Whether Greenspan offeredartificially cheap credit or not, interest rates were onlyone factor among many. To have asked him to predictthe best of all possible worlds and adjust interest ratesaccordingly would have been to ask him to be an ora-cle channeling the knowledge only God would have.Greenspan is not omniscient. Nor is Bernanke. No oneis. But to “run” an economy would require not onlyomniscience, but omnipotence as well—a power thatwould bend the actions of millions to its singular will.

Whatever your ideological persuasion, the economyis a complex system that cannot be planned, designed, orhave its black swans regulated away. Far from the carica-tures sketched in the papers, this is precisely what seri-ous free-market types have been saying for years.That’swhy it’s a little more than silly to blame free-market ide-ology for the current mess, and a little more than men-dacious to claim that government fingerprints won’tappear all over the crisis when the postmortem is done.

Hunting Black Swans with Shots in the Dark

The timeless nostra of the politician are to primethe pump (machine metaphor) and to regulate. It

seems so simple. But that response is deceptively linear.If you could ask FDR, might he now concede his poli-cies stretched the Depression out for a decade beyondwhat was necessary? He listened to J.M. Keynes and acoven of interventionists. If we agree that our mixedeconomy is a complex system, then we also have toagree that the benefits the partly free market confers are

an emergent property of that system. If we attempt toregulate away the rare, unforeseen black swan event, thecosts of our hubris will be terrible, for we will regulateaway untold benefits, too.

In the real world the question may come down towhether we should accept a couple of years of painfulmarket adjustments or decades of recession caused bythe blunt instrument of politics. Devastating unin-tended consequences and unseen effects will followgovernment attempts to clean up a mess made in greatmeasure by its own hand. Why? Because no one pos-sesses a God’s-eye view of the economy. Governmentintervenes within the system as part of it, not from out-side of it. Nor is the economy an instrument to bemanipulated to positive effect—at least not over thelong term.That is why Keynes got it so terribly wrongand why the economy must heal itself from within in adistributed, holistic way.

People want government, like God, to come downand fix the unfixable, or explain the inexplicable.That’swhy they’re finding it easier to blame greed for ourcurrent financial crises. But greed is rather more likegravity: When you fall, you can blame either Newtonor the banana peel on the ground.

The profit motive is a good thing when it operatesin an environment where bad bets are punished withlosses and good investments are rewarded. Only gov-ernment can distort that healthy profit-and-loss system,giving people incentives to make bad decisions.And it’sin this environment that greed is no good to anyone. Itturns out, however, that greed—or better, rational self-interest—can help our economy stabilize faster thangovernment ever could. As the lubricant of our eco-nomic system, self-interest will cause a million marketactors to recalibrate and to direct resources to projectsthat create value in our society.We the people will tem-per our irrational urges and mitigate our risks if gov-ernment restores the rules that let profit and loss bringdiscipline. But if government continues to change therules to bias the market in favor of irrational behavior,rent-seeking, and corporatism, the chaotic aspects ofthe system will continue to wobble out of equilibrium.Black swans will become commonplace.

15 M A R C H 2 0 0 9

B l a c k S w a n s , B u t t e r f l i e s , a n d t h e E c o n o m y

On Wednesday, September 17, 2008, accordingto the New York Times, Fed Chairman BenBernanke used “a speaker phone from his

ornate office” to tell Treasury Secretary Henry Paulson“that it was time to adopt a comprehensive strategy thatCongress would have to approve” for dealing with thefinancial-market troubles.After a second call on Thurs-day morning, Paulson agreed. The next day he calledpublicly for what the Times described as “far-reachingemergency powers to buy hundreds of billions of dol-lars in distressed mortgages despite many unknownsabout how the plan would work.”

Just one day later, September 20, the Bush adminis-tration announced a price tag: It would ask Congressfor what the Times described as “unfettered authorityfor the Treasury Department to buy up to $700 billionin distressed mortgage-related assets from the privatefirms.” News reports noted that $700 billion amountsto more than $2,000 for every man, woman, and childin the United States. Secretary Paulson released a three-page draft of the legislation he wanted. It did not spec-ify how the money would be spent, but did say that nocourt could review the Treasury’s decisions aboutspending the money. Paulson warned of dire conse-quences should Congress not approve the legislationquickly and as proposed.

In asking for huge sums and unrestrained power forgovernment to intervene in financial markets, Bernankeand Paulson discarded any pretense of adhering to free-market principles.The Times reported that an attendeeat a strategy meeting quoted Bernanke as justifying theabandonment of principles by declaring that, “There are no atheists in foxholes and no ideologues in finan-cial crises.” The aim of avoiding a deeper crisis, in other

words, rationalizes whatever seems expedient. Weshould flee from the threat of a “financial meltdown”even into the arms of a constitutional meltdown. Sur-prisingly, many “free-market” commentators and econ-omists echoed this sentiment. Some of them pledged toreaffirm free-market principles in the future even whilecalling for their abandonment for the duration of thefinancial turmoil. Their questionable judgment seemsto have been that more government intervention wasneeded to offset—and would offset rather than com-pound—the previous interventions that had createdfinancial chaos.

Few in Congress questioned the figure of $700 bil-lion. Some House Republicans proposed a nominallyless-interventionist plan that would have had the federal government not purchase—“only” guarantee—home-mortgage assets. Instead of putting an explicitprice tag on the taxpayers’ burden for the bailout, gov-ernment guarantees of mortgages and mortgage-backedsecurities would have obliged taxpayers to pay lendersand bond holders whenever and wherever borrowers orsecurity issuers defaulted, implying off-balance-sheet taxpayer exposure on an unspecified scale. A blank check rather than a $700 billion check—someimprovement.

After congressional wrangling for nine days overwhat to add to the three-page Treasury proposal, a billof 110 pages emerged. A deal had been struck. TheTreasury’s authority to purchase had grown beyondmortgage-related assets to include “any other financialinstrument that the Secretary, after consultation with

B Y L AW R E N C E H . W H I T E

The Financial Bailouts:“See the Needle and the Damage Done”

16T H E F R E E M A N : I d e a s o n L i b e r t y

Lawrence White (lwhite@umsl.edu) is the F.A. Hayek Professor ofEconomic History at the University of Missouri-St. Louis.

the Chairman of the Board of Governors of the FederalReserve System, determines the purchase of which isnecessary to promote financial market stability.” Inother words, whatever the two wanted.

Shock in the House

On Monday, September 29, the House of Repre-sentatives shocked political pundits by voting

down the bailout bill 228–205.With constituent emailand phone messages to Congress running heavilyagainst the bailout (some estimates said 30–1), themajority that day disregarded dire warnings that Con-gress had “no time” to put any more careful thoughtinto what it was doing.

Two days later, however, the U.S. Senate approved afurther-revised bailout bill 74–25. Although they hadnot taken time to put a lot of addi-tional thought into it, senators hadnonetheless added a lot of text: Thebill had now grown to 422 pages.TheEmergency Economic StabilizationAct of 2008 now not only provided$700 billion for a Troubled AssetsRelief Program, but also includedsections and subsections on Renew-able Energy Incentives, Carbon Mitigation and Coal Provisions,Transportation and Domestic Fuel Security Provisions,a grab-bag of tax-credit extensions, a subtitle for Men-tal Health Parity and Addiction Equity, another forHeartland and Hurricane Ike Disaster Relief, anincrease in federal deposit insurance, and authority forsecurities regulators to relax accounting rules thatfinancial firms facing mortgage-related losses werefinding inconvenient. The height of special-interestabsurdity was reached in Section 503 of the Act which,according to the official Library of Congress summary,“Exempts from the excise tax on bows and arrows cer-tain shafts consisting of all natural wood that, afterassembly, measure 5/16 of an inch or less in diameterand that are not suitable for use with bows that wouldotherwise be subject to such tax (having a peak drawweight of 30 pounds or more).”

Two days after the Senate vote, on Friday, October3, the once-reluctant House approved the bailout bill

263–171. In the second House vote 33 Democrats and25 Republicans switched from no to yes. One con-gresswoman unashamedly explained to National PublicRadio that she had switched because the new billincluded solar-energy tax credits. President Bushimmediately signed the bill. Prices on the New YorkStock Exchange, which had closed way down the daythe first bill had failed to pass, closed down again on theday the revised bill passed and was signed into law.

“Plan” A

The “plan” for how to spend the $700 billionbailout has always been extremely vague, from its

inception in the Bernanke-Paulson phone call, throughthe case Paulson made before Congress, to the passageof the enabling legislation. Improvisation continued up

to the date this account was writtenin late November.The Treasury origi-nally announced an intention to buytroubled mortgage-related assets, andhence the bill refers to a TroubledAsset Relief Program, or TARP. Buton what terms would they buy theseassets? More than a month after pas-sage, that had yet to be made clear.American Public Media’s Marketplaceprogram reported on November 7

that, “A securities industry trade group just came outwith a survey, and it found that financial players are sounclear about how TARP would work, they aren’t surethey want to participate.”The Treasury had to schedulea meeting with banking industry representatives onNovember 10 to fill them in on the evolving specificsof TARP.

The “troubled” assets to be purchased are mortgageloans, bundles of such loans (“mortgage-backed securi-ties”), and apparently any other financial assets the Trea-sury wants to include. What makes them “troubled” isbasically that financial institutions can’t sell them forwhat they paid for them. The basic reason is that anunexpectedly huge share of mortgages has gone bad:Mortgage-default rates have skyrocketed. Further, thesecondary market for mortgage-backed securities hasdried up. A firm trying to sell some of its holdingswould fetch only fire-sale prices.

17 M A R C H 2 0 0 9

T h e F i n a n c i a l B a i l o u t s : “S e e t h e N e e d l e a n d t h e D a m a g e D o n e ”

The “plan” for howto spend the $700billion bailout hasalways beenextremely vague.

There is a basic problem with having the Treasurybuy assets that the market won’t buy except at fire-sale prices. Either the Treasury outbids the marketand overpays for the assets—which benefits financialinstitutions at taxpayer expense—or the governmentpays the current market price, which would compelbanks to mark other assets down accordingly andbook the losses they’ve been trying to avoid booking.

In arguing for the bailout, Bernanke proposed that an “auction” of troubled assets for taxpayer-provideddollars would enable accurate “price discovery,” eventhough the Treasury would be the only bidder, andthereby would restore an active market. How such anauction would work, how it couldbe designed to arrive at hoped-forprices—above current market pricesbut not above what the assets wouldsupposedly be worth in a normalmarket—was never spelled out. Inmid-November “Plan A” appearedto have been more or less officiallyshelved. Never mind that Paulsonhad told Congress that hundreds ofbillions for troubled-asset purchaseswere urgently and immediatelyneeded to avoid financial Armaged-don.

On November 25 the idea oftroubled-asset purchases made a dra-matic comeback under the auspicesof the Federal Reserve, which is dis-cussed below.

“Plan” B

On October 13 the Treasury announced a new wayto spend $250 billion of the $700 billion: It

would inject equity capital into banks, buying newlyissued preferred shares. It soon thereafter injected $125billion into nine major banks: Citigroup, Bank ofAmerica, Wells Fargo, JPMorgan Chase, Bank of NewYork Mellon, State Street, Merrill Lynch, Morgan Stan-ley, and Goldman Sachs. The last-named is the formerinvestment bank, recently converted into a commercialbank, previously headed by Paulson. From the group ofnine banks the Treasury took “preferred shares” with

fixed 5 percent dividends (increasing to 9 percent if theshares have not been repurchased in five years).

On November 23 the Treasury announced it wouldinject an additional $20 billion of equity into Citi-group. For this second injection it took preferred shareswith an 8 percent dividend.The Treasury together withthe FDIC also provided an off-balance-sheet guaranteeagainst losses on about $300 billion of Citibank’s trou-bled real estate assets, in exchange for which the Trea-sury and FDIC took additional preferred shares.

The federal government is now part-owner of thenine banks. The banking system has been partiallynationalized.The preferred shares are ownership claims

of a type falling between debt obliga-tions (bonds) and common stockshares. They are riskier than bondsbecause preferred shareholders muststand behind bondholders in the lineto get paid in the event that the bankcan’t pay everyone.

To compensate for its risk the Treasury also took stock warrants—contracts that give it the right to buyshares in the future at a specified priceso that it can make a profit should thebanks’ stock prices someday risehigher than that price. “Recapitaliz-ing” a firm normally leads to lowershare prices, however, because it meansmore shares dividing ownership of thesame asset portfolio. The infusion

dilutes existing shares. For this reason two of the ninebanks reportedly objected to participating in the Trea-sury’s capital infusion with attached strings.The Treasuryexplained that it did not make participation voluntarybecause it did not want to stigmatize as weak the banksthat chose to participate. A financial analyst’s report inlate November named Bank of America, Citigroup,Goldman Sachs, JPMorgan, Morgan Stanley, and WellsFargo as the weakest institutions.

The other half of the Treasury’s $250 billion hasbeen designated for assignment to smaller banks to benamed later. Among other things, the Treasury report-edly hopes these capital injections will enable recipientbanks to buy up other, weaker banks. An anonymous

18T H E F R E E M A N : I d e a s o n L i b e r t y

L a w r e n c e H . W h i t e

“Plan A” appeared tohave been shelved.Never mind thatPaulson had toldCongress thathundreds of billionswere urgently andimmediately neededto avoid financialArmageddon.

Treasury official told reporters: “One purpose of thisplan is to drive consolidation.”Thus taxpayer money isbeing allocated to influence the shape of the bankingmarket.

“Plan” C?

What will “Plan” C be? As the Treasury continuesto improvise, everything and anything is possi-

ble. So says Neel Kashkari, the former Goldman Sachsemployee under Paulson who is now the Treasury’schief bailout administrator under Paulson. Askedwhether funds might go to insurance companies, otherfinancial firms, and even nonfinancial firms likeautomakers, one news story reported, “Kashkari indi-cated that everything was on the table. ‘We are lookingat everything,’ he said.‘We are trying to figure out whatwill provide the most benefit to the financial system.’”

House Speaker Nancy Pelosi, Senate majority leaderHarry Reid, and other congressmen have urged theTreasury to use some of the $700 billion to inject capital into the leading U.S. automakers. These samelawmakers specified no such authority in the bailoutbill. Some $1.5 billion of the $700 billion will go tolocal governments for reasons unrelated to the financial system.

Insurance executives have reportedly lobbied for thebailout to include troubled insurance company assets.There is now a precedent: The Treasury has given $67.5 billion of the bailout to AIG, the failed insurancegiant brought down by its imprudently massive guaran-tees on mortgage-backed securities, in exchange fortroubled assets and preferred shares. AIG was already on an $85 billion life-support loan from the FederalReserve.

Second Bailout

The Treasury’s $700 billion bailout is actually thesecond federal bailout program underway.The press

has widely reported on the Treasury bailout bill and thepost-bill spending improvisations. Columnists and thepublic have openly debated the dubious wisdom of thatprogram. Congress has held hearings and has voted onthe bailout bill, even if it has left it to the Treasury todecide how the $700 billion will be spent. But flyingunder the radar, attracting much less public attention

and almost zero congressional scrutiny, have been theFederal Reserve’s ongoing efforts that in mid-Novem-ber added up to a $1.7 trillion shadow bailout programfor favored financial institutions, more than double thesize of the Treasury’s bailout. On November 25 the Fedannounced two new lending lines that will add another$800 billion, bringing the total to $2.5 trillion—morethan triple the size of the Treasury’s bailout. (This sec-tion draws heavily on my paper for the November2008 Cato Institute monetary conference, “FederalReserve Policy and the Housing Bubble.”)

The Fed’s bailout efforts began back in March 2008with the Fed putting up $29 billion to sweeten a deal inwhich the commercial bank JPMorgan Chase wouldtake over the teetering investment bank Bear Stearns.Anew Fed-owned subsidiary (“Maiden Lane LLC”) wasset up to cleanse the Bear Stearns balance sheet byacquiring troubled mortgage-backed securities for the$29 billion.The transformation of the Federal Reserve’sbalance sheet, which used to hold virtually nothing butsafe Treasury securities, had begun. Between March andNovember, as the Fed improvised new interventionsinto financial markets, the dollar amounts of the Fed’scommitments grew and grew.

The interventions are visible among the assets onthe Fed’s balance sheet for November 5, where manynew entries appear that were absent one year ago.Thelist begins with “Term Auction Credit” at $301 billion,representing 28-day and 84-day loans to banks. Previ-ously loans to commercial banks were limited toovernight loans for meeting reserve requirements.Banks were expected to attract longer-term funds fromdepositors or private institutional investors in themoney market. Next on the list is “Primary Dealer andother Broker-Dealer Credit” of $72 billion—that is,loans to securities dealers. A year ago the Fed did notlend to securities dealers. Third is the “Asset BackedCommercial Paper Money Market Mutual Fund Liq-uidity Facility”—loans to banks or bank holding com-panies to allow them to purchase assets frommoney-market mutual funds. Previously money-marketfunds that needed to liquidate commercial paper hold-ings were expected to sell them in the money market.“Other credit extensions,” a catchall fourth new entry,amount to $81 billion.

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T h e F i n a n c i a l B a i l o u t s : “S e e t h e N e e d l e a n d t h e D a m a g e D o n e ”

The fifth new entry is “Net portfolio holdings ofCommercial Paper Funding Facility LLC,” $243 bil-lion. A memo to the Fed’s balance-sheet releaseexplains: “On October 27, 2008, the Federal ReserveBank of New York began extending loans . . . to Com-mercial Paper Funding Facility LLC.This LLC is a lim-ited liability company that was formed to purchasethree-month U.S. dollar-denominated commercialpaper from eligible issuers and thereby foster liquidityin short-term funding markets and increase the avail-ability of credit for businesses and households.”That is,the Fed has formed a new subsidiary for directly allo-cating funds to a particular segment of the financial sys-tem, the commercial paper market. Previously the Fedpurchased only Treasury securities, and let privatebanking and financial markets allocate the funds it thusinjected to their best uses.

Sixth is “Net portfolio holdings of Maiden LaneLLC,” $27 billion, representing the troubled assetsacquired from Bear Stearns. Note that the assets havebeen marked down from their acquisition price of $29billion: the Fed has suffered a loss of $2 billion. Byholding the assets the Fed is speculating that the marketfor selling them will be better later on. Previously theFed did not get involved in financial takeovers byabsorbing troubled assets to sweeten the deal. TheFDIC sometimes did, but only in mergers between twoinsured commercial banks. Bear Stearns was an invest-ment bank, not an insured commercial bank.

Last September the Federal Reserve began buyingfederal agency notes—short-term IOUs of Fannie Mae,Freddie Mac, and the Federal Home Loan Banks—fromsecurities dealers. As of November 5 the Fed was hold-ing $13 billion of such notes, where it held zero oneyear ago, though it has held small amounts of agencydebt in the past. The Fed’s “primary” (overnight) loansto commercial banks are currently at $110 billion, upfrom only $1.4 billion a year ago. In total the Fed’s assetshave more than doubled, from $889 billion a year ago toan astounding $2.08 trillion in mid-November. Furtherincreases are on the way.

Two items make the Fed’s bailout loan programeven larger than the $1.2 trillion increase in its totalassets. First, the Fed has funded $303 billion of its newloans by selling off Treasury securities from its portfolio.

Second, off its balance sheet (but recorded as a “memo-randum item”), the Fed also runs a “Term SecuritiesLending Facility” that has lent $197 billion of its Trea-sury securities to broker-dealers, giving them some-thing liquid to sell in exchange for IOUs collateralizedby less liquid securities like mortgage-backed securities.As of November 5 the Fed’s new loans and purchaseshad extended $1.7 trillion in new credits to financialinstitutions over the past year.

On November 25 the Federal Reserve announcedthat in the following week it would begin purchasingup to $600 billion in securities issued or guaranteed byFannie Mae, Freddie Mac, and the Federal Home LoanBanks. It would buy them from its primary securitiesdealers through “a series of competitive auctions.” Italso announced the creation of a $200 billion TermAsset-Backed Securities Lending Facility to make newterm loans to financial institutions, loans to be collater-alized by nonmortgage pools of consumer and small-business loans. In both cases the Fed is engaged inprice-setting, trying to drive interest spreads (the differ-ential yields over Treasury bills required to attract pur-chasers) on riskier securities back into their historicalranges.Thus the Fed is second-guessing the risk premi-ums set in competitive financial markets.As of Thanks-giving, the new facilities had not yet appeared on theFed’s balance sheet.

Unprecedented Credit Expansion

From $1.2 trillion of added bank reserves, the late-November lending programs (if not somehow off-

set) will push added bank reserves to $2 trillion. TheFed has no clear exit strategy from its unprecedentedcredit expansion. It has too few Treasury securities leftto sell in order to pull the credits back in, the traditionalmethod for contracting bank reserves. No doubt theFed hopes that the new loans will be repaid (and notre-extended) as financial market conditions improve.But borrowing firms whose ability to repay depends onthe prices of their mortgage-backed securities recover-ing may be unable to repay any time soon because theeffects of overbuilding during the housing bubble willdepress the price of real estate and thus of mortgage-backed securities for a long while. Moreover, they maybe unwilling to repay. Nonbank financial firms that are

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now enjoying the Fed’s below-market lending rates willhave no incentive to wean themselves and every reasonto lobby for keeping the new bargain lending windowsopen indefinitely.“Temporary emergency” governmentsubsidies have a way of living on and on. Just ask therecipients of federally subsidized farm loans.

The Fed’s new activities deserve to be called abailout program because they seek to channel creditselectively at below-market interest rates, or purchaseassets at above-market prices, in hopes of rescuing, orenhancing profits for, favored sets of financial institu-tions.The Fed’s new lending facilities are not parts of acentral bank’s traditional “lender of last resort” role. Alender of last resort injects reserves into the commercialbanking system to prevent the quantity of money fromcontracting—and thereby to protect the economy’spayment system—when there is an “internal drain” ofreserves (bank runs and the hoarding of cash).There hasbeen only one bank run (on IndyMac) and no contrac-tion in the money stock. Investment banks do not issuechecking deposits, are therefore not subject to depositorruns, and are not part of the payment system. Neitherare securities dealers. Money-market mutual funds playa limited payment role, but because they do not issuedemandable debt, they are not subject to runs. TheFed’s expansions of its own activities therefore hadnothing to do with protecting the payment system orstabilizing the money supply.

The “lender” in “lender of last resort” has long beenan anachronism. Central banks in sophisticated financialsystems discovered decades ago that they can injectbank reserves without lending by purchasing govern-ment securities in the open market. By doing so, thecentral bank supports the money stock while avoidingthe danger of favoritism associated with making loansto specific banks (or nonbanks) on noncompetitiveterms. It also avoids the potential favoritism in purchas-ing other securities. The Fed’s new activities, by con-trast, extend an array of loans to various financialinstitutions and purchase securities from nonbankissuers and holders. These activities pose the risk offavoritism—of substituting the Fed’s judgment for themarket’s about what kinds of institutions and what par-ticular firms should survive. They have nothing to dowith replenishing the reserves of the banking system or

preventing contraction in the stock of money.The Fed’sactivities seem rather to aim at protecting financialinstitutions from the consequences of imprudent port-folio decisions.

The Federal Reserve’s new interventions into finan-cial markets over the past year have proceeded at itsown initiative and without precedent.They seem to beenjoying the complete freedom from oversight thatSecretary Paulson unsuccessfully sought for the Trea-sury’s bailout program.The Fed’s program has attractedlittle attention mostly because it has not required acongressional appropriation. The Fed is “self-financ-ing”: It can “print up” any funds it needs to make loansor purchase assets by simply expanding the quantity ofunbacked claims on itself.This does not mean that Fedcredit expansion provides a free lunch. When the Fedincreases the stock of dollars, it levies an implicit tax onholders of existing dollar balances by creating an infla-tionary depreciation of the dollar.

An Evaluation of the Bailouts

The financial turmoil of 2008 was the result of whatmay be briefly described as a government-policy-

induced cluster of entrepreneurial errors by financial-market participants. Paulson’s and Bernanke’s bailoutprograms are disabling the key market mechanisms forcorrecting entrepreneurial errors: price adjustments andbankruptcies. Delays in the correction of mortgageasset prices, and delays in the necessary resolution ofinsolvent financial institutions, do not promote butrather hinder a sound economic recovery. As ABCNews commentator John Stossel has written: “We doneed protection from reckless businessmen. But there is

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T h e F i n a n c i a l B a i l o u t s : “S e e t h e N e e d l e a n d t h e D a m a g e D o n e ”

only one way to provide that: market discipline. Thatmeans no privileges and no bailouts.”

When government does not intervene with tax-payer-financed bailouts, private market participants willrecapitalize banks (as Mitsubishi Bank recently did forMorgan Stanley) and buy distressed assets in genuinelyprice-discovering market transactions, to the extentthat those risking their own money think warranted.The resolution (sale or liquidation) of firms that are notworth recapitalizing makes room in the market for bet-ter-run institutions to take their place. As the UnitedStates discovered in the savings-and-loan fiasco of the1980s, and as Japan discovered in the 1990s, a govern-ment policy of keeping insolvent financial firms openbeyond their expiration date makes survival more diffi-cult for healthy firms.

Along these lines, the eminent monetary historianAnna J. Schwartz candidly criticized the bailout pro-grams in an interview with the WallStreet Journal on October 18. To pro-mote recovery the Fed and Treasury“should not be recapitalizing firmsthat should be shut down,” Schwartzsaid. Rather, “firms that made wrongdecisions should fail. You shouldn’trescue them. And once that’s estab-lished as a principle, I think the mar-ket recognizes that it makes sense.Everything works much better when wrong decisionsare punished and good decisions make you rich.”

Schwartz observed that “Lending freezes up whenlenders are uncertain that would-be borrowers have theresources to repay them.” Removing the uncertainty byenforcing the usual rules requiring insolvent firms toexit the market promptly would provide greater clarityto financial markets. The economist Pedro H. Albu-querque has drawn out the implications of this insight:bailout plans make “the information problem worse bykeeping unhealthy banks afloat,” which “endangers theentire economy through planned obfuscation.”A hypo-thetical used-automobile market in which buyers arereluctant to buy because they fear that sellers are tryingto palm off unreliable vehicles is known to economistsas a “lemons” market. Albuquerque observes that “Thegovernment is artificially creating a lemon market

when it does not allow discrimination between healthyand unhealthy banks to occur via bank failures.”

Some editorial and op-ed writers have claimed thatmany financial institutions have been “unregulated” toolong and must now become regulated. But financialinstitutions have never been unregulated. They havebeen regulated by profit and loss.The failure of LehmanBrothers and the near-failure of Merrill Lynch raisedthe interest rate at which profit-seeking lenders werewilling to lend to highly leveraged investment banks.The market thereby forced Goldman Sachs and Mor-gan Stanley to change their business models drasticallyand to convert to commercial banks. If that isn’t effec-tive regulation, what is? Protecting firms from failure(Bear Stearns,AIG, Fannie Mae, Freddie Mac, GoldmanSachs, Citibank) and mitigating their losses withbailouts renders this most appropriate form of regula-tion much less effective.

The eagerness of Ben Bernankeand Hank Paulson to substitute theirown judgment for the dispersedjudgments of a freely competitivefinancial market may reflect simpleintellectual error. Or, less innocentlyin the case of former Goldman SachsCEO Paulson, it may be error com-pounded with partiality. In an openletter to Congress on the eve of the

bailout bill’s passage, John A. Allison, CEO of the largeand successful regional bank BB&T, pointed out that“There is no panic on Main Street and in sound finan-cial institutions.The problems are in high-risk financialinstitutions and on Wall Street.” The bailout seemeddesigned, in his view, to benefit a select group of WallStreet firms: “The primary beneficiaries of the pro-posed rescue are Goldman Sachs and Morgan Stanley.. . . [T]his is primarily a bailout of poorly run financialinstitutions.”This design, Allison continued, was not anaccident but the result of partiality in the designers’interests and perspective:“Treasury is totally dominatedby Wall Street investment bankers. They do not haveknowledge of the commercial banking industry.There-fore they cannot be relied on to objectively assess allthe implications of government policy on all financialintermediaries.”

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Financial institutionshave never beenunregulated.Theyhave been regulatedby profit and loss.

B Y S T E P H E N D AV I E S

Bailing Out the Big Three Repeats Britain’s Mistake

Our Economic Past

Amajor reason for any kind of historical writ-ing is to provide guidance for the present. Aswe read an account of the past, we may see

similarities to the present and (we may hope) avoidrepeating the same kinds of mistakes. In this sense his-toriography forms part of the collective memory of asociety (which is one reason why history can be a verycontroversial subject). Sadly, many people lack this kindof perspective, while others who know about the pastseem incapable of learning from it. Consequently, thesame type of error gets repeated, often at great cost. Itseems the U.S. political class, as represented by Con-gress and much of the commentariat, has done just thatby trying to “save” the Big Three automanufacturers. In doing this they willrepeat a catastrophic series of mistakesmade by British governments 30-40years ago. It is worth recounting thissorry tale.

At one time British-owned automanufacturers were world leaders. In1952 the merger of Austin and Morristo form the British Motor Corporation(BMC) created the world’s fourth-largest producer of cars. By the 1960s, however, theBritish auto industry faced growing problems. Themain firms had lost an increasing share of the market toforeign-owned competition both at home and abroad.The profitability of many firms was steadily declining.This reflected a number of problems, such as old-fash-ioned or low-quality products or those, like the iconicMini, that were triumphs of design but whose produc-tion costs made them unprofitable. Also, the manage-ment of many firms was both incompetent andhindered by chaotic organization of sales and produc-tion. Most seriously, the industry was plagued by badlabor relations, with frequent strikes and disputes andrigid enforcement of job demarcation.

Faced with this, British governments intervened toencourage mergers and the takeover of the failing firmsby the remaining successful ones.This led ultimately toalmost all the remaining British-owned firms beingbrought into one firm in 1968 with the creation ofBritish Leyland (BL) via a state-sponsored merger ofBMC and Leyland Motor Company. The underlyingproblems were not addressed, however, and the laborrelations and chaotic management in particular became even worse. In the early 1970s the Heathadministration gave financial assistance despite havingopposed aid to failing firms during the 1970 election.By 1975 British Leyland was insolvent and on the verge

of going out of business.

To Nationalize or Not toNationalize

At this point the British govern-ment had a choice. It could allow

BL to go bankrupt, with many of its 40plants closing and the remainder beingsold off, or it could act to prevent this.The government decided to take thefirm into public ownership. The idea

was to invest several billion pounds in the firm, and sev-eral hundred million pounds were indeed put in. Thetaxpayers also took on most of the outstanding debt.This did not stop the losses, however. The firm (withvarious name changes) continued to decline whilesoaking up a steady stream of government money. Sev-eral parts of the business were sold off, and eventuallythe core (the old BMC) was sold by the government in1988. It never made money and finally closed in2005—during a general election. In other words, theBritish government (or rather the taxpayers) spent 23

23 M A R C H 2 0 0 9

Stephen Davies (steve365@btinternet.com) is a senior lecturer in history atManchester Metropolitan University in England.

Prime Minister Edward HeathPhoto courtesy the Sir Edward Heath CharitableFoundation.

years and a fortune trying to preserve an enterprise thatwent out of business anyway.

This was a classic case of trying to prevent theinevitable. The parts of the original firm that survivedwould almost certainly have done so in any event, asthey were always profitable and would have found pur-chasers had BL been allowed to go bankrupt in 1975.Some might argue that at least jobs were preserved—for up to 30 years in some places.This is wrong for tworeasons. First, the number of jobs actually preserved forthat length of time was quite small because there was asteady loss from 1975 onward as a succession of man-agements made desperate efforts tokeep the ship afloat.

Even more serious were the hid-den costs of this bailout. All themoney put into BL and its successorswas capital that could have beenemployed profitably, creating worksomewhere else. Instead it was simplywasted. The British-owned autoindustry was essentially doomed bythe mid-1970s. Trying to resist thisdid nobody any favors in the long runand simply prolonged the agony of re-adjustment to a painful and disrup-tive change.

Ominous Parallels

The parallels with the current position of the BigThree are not exact, but they are disturbingly close.

The firms in question are also run down by a generationor more of bad management decisions, bad investments,and crippling wage, healthcare, and pension costs. It isnot that auto manufacturing in America is unviable.Honda,Toyota, and others manufacture very profitably inthe United States, just as Nissan does in the UK.There isnothing to suggest that giving the Big Three the massiveamounts of money they want will do anything otherthan delay their demise and create a slow and lingering

death rather than a swift one. In fact, so dire is the posi-tion of General Motors and Chrysler that even withassistance they are unlikely to survive as long as parts ofBritish Leyland did. Meanwhile, all the money given tothese firms will be money that could have been used tomore effect elsewhere in the economy.

The U.S. political class is probably aware of this,even if it does not realize it will simply be repeating ona much larger scale what the British government did 30 years ago. They are motivated by two main con-cerns. The first is economic nationalism—the fear thatif these firms and their suppliers go out of business, the

United States will be weakened. Theanswer to this is straightforward, nomatter how unpalatable it may be tonationalists: The aim of production isconsumption, not national power andprestige. In the longer term policiesthat weaken productivity (which anydiversion of capital will do) will actu-ally reduce the power of the nation-state (if that is your main concern).

The second concern is for themany who would lose their jobs andthe communities that would losemost of their employment. Thiscomes down to an argument about

whether concerns of this kind (which are serious andimportant) should be a matter for government action.Even if you think they should be, however, it does notfollow that the right course is for Uncle Sam to supportthese firms financially. The example of Britain showsthat the much more effective policy would be to let thefirms be wound up and use the money to try to revital-ize the local economy of places like Michigan. As peo-ple here in England watched the goings-on inWashington and Detroit, there was an overwhelmingurge to shout, “Don’t do it!” Sadly, even if the folks inCongress had heard, I doubt they would have followedthe advice of history.

24T H E F R E E M A N : I d e a s o n L i b e r t y

S t e p h e n D a v i e s

The Britishgovernment (orrather the taxpayers)spent 23 years and afortune trying topreserve an enterprisethat went out ofbusiness anyway.

“Once you lose your freedom to fail, you also lose yourfreedom to succeed and you cease to be a free society.”

—U.S. Rep. Jeb Hensarling of Texas

In March 2008 the investment banking firm BearSterns failed and the federal government quicklystepped in. The public was inundated with the

phrase “too big to fail” (TBTF) by the financial newsmedia.You had to go back to 1998 for the last time itwas used so often. In that year the troubled hedge fundLong-Term Capital Management had $4.6 billion inlosses. The Federal Reserve steppedin to orchestrate a restructuring dealto avoid bankruptcy.With this gov-ernment intervention, the precedentwas established for future calls forhelp. In 1999 Kevin Dowd, writingfor the Cato Institute, stated: “[T]heintervention implies a return to thediscredited doctrine that the Fedshould prevent the failure of largefinancial firms, which encouragesirresponsible risk taking. . . .”

An institution is deemed “too big to fail” if its col-lapse would be expected to create a devastating rippleeffect throughout the economy, creating a “systemicrisk.”When this occurs the government is expected toprovide some form of assistance. This can vary from aguaranteed loan, where management and stockholdersget off scot-free (as with Chrysler in 1979), to guaran-teeing the assets of a failing bank, to facilitating an out-side takeover (Bear Stearns). In the event of an outsidetakeover thousands of employees could be shown thedoor and stockholders left with pennies on the dollar.

Since the public only notices that it is paying the bill, ithas a hard time discerning these subtle differences.As aresult, the term “bailout” is used broadly to describeany form of government financial intervention to assista crashing TBTF company or its creditors.

Too Big to be Free-Market

There are no clear guidelines on who is (or whatconstitutes) TBTF. As a result the “systemic risk”

scare is ad hoc and apparently meant to be taken onfaith. Any large company can claim it is vital to the

health of the economy because itsfailure would have a domino effecton suppliers. Other firms can pickup the slack and even acquire theassets of the failed firm, but this isusually ignored.

TBTF is problematic because itindirectly influences how compa-nies are managed. If there is a real,or implied, government safety netshould things “head south,” man-

agement might be inclined to take on more risk forgreater profit.This illustrates the concept of “moral haz-ard,” an insurance term. If you are insured, you may beless cautious. TBTF is actually a state of mind thatafflicts the senior management of our largest corpora-tions. If they think they are TBTF, even if they aren’t,they still behave as if they are. This is the crux of ourcurrent financial problem.

B Y M I C H A E L H E B E R L I N G

Too Big to Fail

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Michael Heberling (mheber01@baker.edu) is president of the BakerCollege Center for Graduate Studies in Flint, Michigan. He is also on theboard of scholars of the Mackinac Center for Public Policy in Midland,Michigan.

She probably thought she was too big to fail, too.

In an ideal free-market environment, entrepreneurswould be willing to take on risk based on an expectedreturn. Since returns are never guaranteed, the entre-preneur’s willingness to take on risk is tempered by thepotential downside (a loss), if things don’t pan out.While the rewards for extremely risky investments may be great, so too are the penalties. In severe casesthe company could go bankrupt. As a result, this risk/reward/loss relationship in the free market would forcerational behavior into the business decision-makingprocess.

TBTF companies are no longer on their own to suc-ceed or fail.With TBTF we now have the governmentin the game—not so much as another player but as anon-neutral referee ready to step in if the game gets toorough. What’s more, TBTF companies operate under adifferent set of rules from merely mortal ones. In 2004Gregory Mankiw, then chairman of thePresident’s Council of EconomicAdvisers, said, “Expecting a govern-ment bailout if things go wrong createsan incentive for a company to take onrisk and enjoy the associated increase inreturn.”

So if you are (or think that you are)TBTF, there is little or no perceivedpenalty to counterbalance risky behav-ior. With a guaranteed—or at least animplied—government safety net, the sky is the limitwhen it comes to risk-taking. The siren song of bigreturns (with little or no risk) becomes irresistible—andyou no longer operate in a free-market environment.According to Thomas Sowell, “The hybrid public-and-private nature of these activities amounts to ‘privatizingprofit and socializing risk’ since taxpayers get stuck withthe tab when high-risk finances don’t work out.” Inother words, it is a travesty to say or imply that our cur-rent crisis stems from market failure.

Mixed Signals

What makes the TBTF phenomenon so difficult tofollow (and understand) is that there is no offi-

cial list of “too big” companies put out by the TreasuryDepartment. The taxpayer only finds out that a com-pany is on the list after the company fails.

The tab to the taxpayer for bailing out Bear Stearnsis $29 billion and counting. What remained of BearSterns’ assets, along with government guarantees, weretransferred to JPMorgan Chase. The next TBTF firm to run into trouble was the investment bank LehmanBrothers Holdings Inc.Although conventional wisdomheld that Lehman, with $615 billion in debt, wasTBTF, this time the Fed said no.

These mixed signals about what was and what wasnot TBTF sent the financial markets into a tailspin.Some federal policymakers and many in the financialnews media saw this as the beginning of the credit“crunch.” (In fact, while credit standards have tight-ened, money is still being lent for all kinds of loans.) Itwas no longer prudent to do business with any “trou-bled” bank. Since no one knew which banks the gov-ernment would or would not bail out, inhibition set

in.The next TBTF firm to ask for

federal help was the world’s biggestinsurance company, American Inter-national Group Inc. (AIG). Notwishing to mishandle another TBTFfirm, the Fed quickly agreed to lend$85 billion to AIG in September toavert bankruptcy. The followingmonth AIG came back to the Fedasking for an additional $37.8 bil-

lion, citing liquidity problems. The Fed’s response: Noproblem. But are you sure $123 billion will be enough?AIG is intricately involved in America’s money-marketfunds. In November AIG came back and said:“On sec-ond thought, could you make that an even $150 bil-lion?”The government response: Fine, but only on onecondition, and you may find this to be exceedinglyharsh. We absolutely insist that your top 70 executivesnot get any bonuses this year.AIG’s response:“You drivea hard bargain, but we have a deal.”

As a result of this action, the government now owns80 percent of the company’s assets.

In September the federal government took over twomore TBTF firms.The quasi-governmental Fannie Maeand Freddie Mac own or guarantee about 40 percent ofthe nation’s mortgages. This bailout will cost the tax-payer $200 billion. Egged on by influential members of

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M i c h a e l H e b e r l i n g

TBTF is problematicbecause it indirectlyinfluences howcompanies aremanaged.

Congress, Freddie and Fannie blatantly abused theirgovernment-sponsored-enterprise (GSE) designations,and no two firms better exemplify the “moral hazard”argument. Since they were chartered by Congress,many believed their mortgage-backed securities wereguaranteed by the federal government.Then-Fed chair-man Alan Greenspan told Congress in 2004:“The Fed-eral Reserve is concerned that Fannie Mae and FreddieMac were using this implicit reliance on a governmentbailout in a crisis to take more risks, in order to multi-ply the profitability of subsidized debt.”When housingprices started to tank we found out that this was exactlywhat was going on.

Bad Medicine and a Hail Mary

One would think that with all of the government oversight

these TBTF events would not keeppopping up. Since the governmentdoctor has utterly failed to prevent thisdisease, why should we think the same government doctor suddenlyknows how to cure the disease nowthat it has metastasized throughout theeconomy?

The Treasury, with the help ofCongress, has thrown a $700 billion“Hail Mary” called the Troubled AssetRelief Program (TARP). Whether ornot this bailout “restore[s] confidencein our financial system” (Treasury Sec-retary Henry Paulson) remains to beseen. Judging by the stock market, the early results arenot good. Ironically, the first step of the plan was toidentify publicly the banks that are really TBTF by buy-ing their preferred stock. Nine TBTF banks, whichaccount for 50 percent of all U.S. deposits, will get halfthe $250 billion earmarked for banks and thrifts.Theseinclude JPMorgan Chase,Wells Fargo, Citigroup, Bankof America (plus Merrill Lynch, which is beingacquired by BoA), Goldman Sachs, New York Mellon,Morgan Stanley, and State Street. The bailout bill alsoincludes a provision for the FDIC to offer an unlimitedguarantee on bank deposits in business accounts that donot bear interest. For individual depositors, the FDIC

insurance limits will increase from $100,000 to$250,000. How do these actions reduce the “moral haz-ard” problem? The last time the individual depositinsurance limit was raised—from $40,000 to $100,000in 1980—we had the S&L crisis, which ended up cost-ing the taxpayer $150 billion.

Being on the official TBTF list has its pros and cons.On the positive side, you can’t fail. The governmentguarantee is no longer implied. It’s real. But being onthe official TBTF list has a severe downside: additionalregulation.The government will be very close at handto make sure that our biggest banks become and remainstodgy. In other words:We’re from the government and

we’re here to make sure that yourrisk level remains in the “safe zone.”In October New York SenatorCharles Schumer, a member of boththe finance and banking committees,wrote Paulson demanding that“banks receiving capital eliminatetheir dividends, restrict executive payand stick to safe and sustainable,rather than exotic, financial activi-ties.” Given the makeup of the newCongress and administration, expecteven more intrusive micromanagingof our financial institutions—but thatis only to be expected if the Treasurybecomes a stockholder. From now oninnovation will be discouraged,downplayed, or slow-rolled by thegovernment. As a result of these res-

cue actions, our entire financial system has effectivelybecome nationalized.

A Troubling Cultural Shift

The most troubling aspect of the ever-increasingnumber of government bailouts is the subtle change

overtaking the entire country.The mindset of companiesand individuals today is shifting away from self-responsi-bility.We blame everyone else for our mistakes and lookto others (the taxpayer) to come to the rescue.

When it comes to handouts and bailouts the gov-ernment is no longer simply on the slippery slope—it’sin free-fall. Every bailout makes it harder to say no

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To o B i g t o F a i l

The most troublingaspect of the ever-increasing number ofgovernment bailoutsis the subtle changeovertaking the entirecountry.The mindsetof companies andindividuals today isshifting away fromself-responsibility.

when the next TBTF request comes forward.Aren’t theBig Three automakers too big to fail as well? In manypeople’s eyes the answer is yes.At the end of SeptemberCongress approved a $25 billion low-cost loan packageto help the automakers and their suppliers modernizetheir facilities so as to be “more green.” But this wasn’tenough. General Motors CEO Rick Wagoner, whosecompany was hemorrhaging cash, sought another $10billion in federal assistance the next month to helpfinance the merger of GM and Chrysler. However, thisrequest was denied. Then in November the Big Threefound sympathetic ears from the big two in Congress,House Speaker Nancy Pelosi and Senate MajorityLeader Harry Reid, for yet another $25 billion“bridge” loan for the Big Three.The Bush administra-tion ultimately dished out $17.4 billion from the $700

billion TARP fund to assist GM and Chrysler. It alsohanded the problem of deciding the long-term futureof the bailouts to the Obama administration, which hadalready expressed support for a bailout package.(Notably, the several profitable foreign-owned auto-makers with facilities in the United States weren’tlooking for help.)

It shouldn’t need pointing out that the “too big tofail” doctrine fundamentally changes the nature of amarket economy, which when free is a profit-and-losssystem. Not only does the doctrine reward error, sloth,and inefficiency, it deprives other, more competententrepreneurs of the scarce resources they need to serveconsumers.Who knows what products and opportuni-ties would arise if the free market, not politicians, deter-mined who had access to capital?

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M i c h a e l H e b e r l i n g

For a few months in 2008 I naively thought thatthe disastrous financial “rescue” actions led byTreasury Secretary Henry Paulson would at least

be counterbalanced by widespread recognition that oureconomic turmoil had been government’s handiwork.

How wrong I was. By the time of this writing, themainstream press had delivered the “consensus” judg-ment that blind faith in the free market fostered the housing bubble. Jacob Weisberg’s Slate column,“The End of Libertarianism” (http://tinyurl.com/57835b), sums up this official verdict:“We have narrowly avoided a globaldepression and are mercifully pointedtoward merely the worst recession in along while. This is thanks to a globaleconomic meltdown made possible bylibertarian ideas. . . . [A]ny competentforensic work has to put the libertar-ian theory of self-regulating financialmarkets at the scene of the crime.”

Just to make sure that the free mar-ket got the blame for the financialmeltdown, Alan Greenspan himself testified to Congress that he had been “shocked” thatself-interest (in the absence of paternalistic regulation)did not compel financial institutions to adopt adequaterisk controls. Greenspan—viewed by the average punditas a staunch libertarian—went so far as to say that he“found a flaw in the model that I perceived is the crit-ical functioning structure that defines how the worldworks.”

I will argue that government interventions, not lais-sez faire, caused the housing bubble and the ensuingfinancial crisis. In addition to describing some of the

general factors involved, we will focus specifically onthe blame attributed to the “unregulated” market forcredit default swaps.

Despite their confident judgments of guilt, criticssuch as Jacob Weisberg point to very few specific regula-tory changes that (allegedly) fostered the housing boomand the related vulnerability of so many financial insti-tutions to the ensuing crash in home prices. The onlytwo concrete examples I have seen are the gradualrepeal of Glass-Steagall throughout the 1990s and the

Commodity Futures ModernizationAct in 2000. To his credit, Weisbergcandidly admits that he can’t point to a smoking gun: “[N]eglecting to prevent the crash of ’08 was a sin of omission—less the result of deregulation per se than of disbeliefin financial regulation as a legitimatemechanism.”

Generally speaking, Weisberg andothers accuse Alan Greenspan, PhilGramm (former chairman of theSenate Banking Committee), and

SEC chairman Christopher Cox of willfully ignoring,for ideological reasons, warnings about the growingmarket in credit derivatives.

At this point, we note that even if this were the wholestory, it wouldn’t necessarily prove that these men (andother policy makers) were mistaken in their actions.Two exaggerated analogies will illustrate the point:Suppose an environmentalist group had lobbied for the

B Y R O B E R T P. M U R P H Y

Did Deregulated Derivatives Cause the Financial Crisis?

29 M A R C H 2 0 0 9

Robert Murphy (rpm@consultingbyrpm.com) is the author ofThe Politically Incorrect Guide to Capitalism.

The mainstream presshad delivered the“consensus”judgment that blindfaith in the freemarket fostered thehousing bubble.

government to ban all new house construction startingin 2002, or suppose a Marxist organization had lobbiedfor the nationalization of all real estate in 2002. Eitherof these moves, in retrospect, probably would haveaverted the housing bubble and its related conse-quences. But surely that doesn’t mean government offi-cials back in 2002 would have been wrong to rejectthese proposals.

By the same token, Greenspan and others had validreasons for resisting new regulations on the evolvingmarkets in derivatives. As we will explain below, thesecomplex assets can promote efficiency through risktransference. In other words, theworld economy grew faster than itotherwise would have because of theproliferation of derivatives. So even ifWeisberg and others are right, and thefinancial crisis is the fault of unregu-lated derivatives, it is still an empiricalquestion whether avoiding the hous-ing boom and bust would have beenworth more than the extra consump-tion made possible all over the worldfrom the market-driven growth inderivatives.

Government Mistakes: Sins ofCommission

In contrast to the vague declarationthat “someone should have done

something!” offered by the critics ofthe Invisible Hand, proponents of thefree market can point to specific government interven-tions that fostered the excesses of the housing boom.Most obvious is Greenspan’s handling of the Fed fundstarget rate and the growth of the monetary base fol-lowing the dot-com crash. Greenspan’s easy-moneypolicy coincided with the upswing in the housingboom. When the Fed began raising rates, housingprices tapered off and then began plunging. The con-nection between Fed policy and the housing bubble isso obvious that even mainstream analysts endorse thetheory.

Other possible culprits include the CommunityReinvestment Act (CRA), a Carter-era measure that

was strengthened in 1995 and used to pressure banksand thrifts that enjoyed deposit insurance into lendingin all neighborhoods where they accepted deposits,including low-income, weak-credit areas. Many analystshave also placed at least some blame on the FederalHousing Administration as well as the government-sponsored enterprises Fannie Mae and Freddie Mac.Through explicit or implicit federal backing, theseagencies were able to bolster the secondary market formortgages and allow applicants who otherwise wouldnot have qualified to obtain mortgages.

When cataloging government interventions thatmay have contributed to the housingboom, we should mention the exis-tence of the Working Group onFinancial Markets—also known as the“plunge protection team”—that wasestablished in response to the 1987stock-market crash, as well as belief inthe “Greenspan put,” the Fed’s per-ceived promise to provide bank liq-uidity when needed. As we will see,the financial crisis of 2008 was largelythe result of institutions failing toprotect themselves from (whatseemed to be) improbable but cata-strophic scenarios. Even though writ-ers such as Nassim Nicholas Talebhave been famously warning about“fat tails” or “black swan” events,investors could quite rationally havedownplayed these warnings. “After

all,” high-level managers could have reasoned in themidst of the housing boom,“in the event of an absolutemeltdown, the federal government will swoop in tosave us. They couldn’t possibly stand back and let theentire investment banking industry collapse.” Thebailouts engineered by Paulson and Bernanke have vin-dicated this belief. In retrospect it is not obvious thatfirms such as Lehman Brothers and Bear Stearnsbehaved foolishly. If politicians tell a man playingroulette that he can keep all of his winnings but willonly suffer 20 percent of his losses, is it really irrationalfor him to borrow large sums of money to wager onthe game?

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R o b e r t P. M u r p h y

It is still an empiricalquestion whetheravoiding the housingboom and bustwould have beenworth more than theextra consumptionmade possible all overthe world from themarket-drivengrowth in derivatives.

Credit Default Swaps

The poster child for the (alleged) failure of thederegulated financial sector is the market for

credit default swaps (CDSs).These contracts are tradedover the counter, so no one knows exactly how muchexposure they contain, but estimates place the world-wide notional value of all CDSs in the neighborhoodof $50 trillion at the end of 2007. It was largelybecause of its issuance of CDSs that the giant insurerAIG needed a government bailout. The AIG episodeshowed that the financial panic was not limited tofirms that foolishly overinvested in mortgage-backedsecurities but also could spread to those companiesthat had issued credit default swaps on the bonds ofthese now at-risk firms.

Although in practice CDSs can becomplex, the idea behind them issimple.The seller of a CDS agrees tocompensate the buyer in the event of a “credit event,” such as GM’sdefaulting on its bonds. In return, thebuyer makes periodic payments tothe seller. The obvious analogy is toan insurance contract, but the differ-ence is that people can buy a CDSon GM bonds even if they don’t ownGM bonds. It is as if someonebought fire insurance on his neigh-bor’s house.

One reason these contracts arestructured as “swaps,” rather than standard insurance, isto evade the regulations governing traditional insuranceproducts. For example, if AIG wanted to sell life insur-ance to a man in Florida, it would have to set asidereserves according to Florida law in order to make itmore likely that AIG could fulfill the policy if the mandied a week later. In contrast, if AIG sold a Florida manprotection against a bond default by GM, then the gov-ernment allowed AIG much more discretion in how ithandled this new potential liability on its books.

It is easy to see why critics of pure free markets havesuch disdain for the credit-default-swap market. Thisseems to be a clear case where short-term greed led toreckless behavior, which would have been prevented byprudent government oversight.

Yet matters are not so simple. After all, the share-holders and creditors of AIG were presumably notcomplete idiots. Did they care less about protectingtheir wealth than politicians in D.C. did? Did theyunderstand derivatives less well than governmentbureaucrats understood them? Looking at the matterfrom a different angle, why would the buyers of CDSs simply assume that the counterparty would makegood on the contracts if government regulations didnot enforce the same safeguards applied to traditionalinsurance?

It turns out the Invisible Hand did lead everyone toseek safety.Although all the details are not yet available,as of this writing it appears that AIG’s risk models (pri-

marily developed by academic con-sultant Gary Gorton) were not toblame for sinking the company.Rather, AIG was driven into thearms of the government because itslarge clients (such as Goldman Sachs)insisted on larger and larger amountsof collateral as the financial crisiscontinued.

Plagued by Illiquidity

In other words, Gorton’s modelsmay still prove to be fairly accu-

rate. AIG was not crippled by astring of unexpected credit events(and consequent payouts). What

actually happened is that the holders of CDSs issuedby AIG became scared about its ability to honor itscontracts, and AIG could not continue to operatewhile satisfying all of the growing calls to put up morecollateral against these outstanding time bombs. Inshort,AIG was plagued by illiquidity, not necessarily byinsolvency. It is true that AIG executives failed to pre-pare adequately for this contingency, but it nonethelessremoves some of the mystery behind its failure whenwe realize that AIG may very well have correctlyassessed the risk of its positions—it just failed to pre-dict correctly how its customers would assess this risk, inthe midst of a global financial panic and also during aperiod when there was a “credit crunch” among largeinstitutions.

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D i d D e r e g u l a t e d D e r i v a t i v e s C a u s e t h e F i n a n c i a l C r i s i s ?

One reason thesecontracts are structured as “swaps,”rather than standardinsurance, is to evadethe regulations governing traditionalinsurance products.

The case of AIG also reinforces our earlier pointabout government intervention muting the potency ofmarket incentives. It takes two to tango.The problem ofAIG on the eve of its rescue was the fault not just ofAIG’s managers and shareholders, but also of the coun-terparties who had bought billions of dollars worth ofCDSs from the insurer. In a completely free market,these counterparties would be subject to the hazards ofa potential AIG bankruptcy. In reality, however, hugefirms such as Goldman Sachs could rely on the U.S.government to rescue them from their reckless expo-sure to AIG. In fact, the New YorkTimes reports that Lloyd Blankfein,the current CEO of Goldman Sachs,was the only investment bank execu-tive in the room when federal officialsdecided to rescue AIG—and this wasmere hours after they had decided tolet Lehman Brothers fail. (As forGoldman’s demands for more AIGcollateral, even “too big to fail” com-panies exercise some caution—justnot enough.)

People Make Mistakes in theMarket

In situations such as the present crisis, there is a temptation for lib-

ertarian economists to look for spe-cific government interventions that“caused” the problems.This is under-standable, and indeed we have listedsome of these factors. Yet we shouldalso remember that failure is a normal part of the mar-ket process. Investors and entrepreneurs are not omnis-cient. Bankruptcies do not signal the inefficiency of themarket any more than the overthrow of Newtonianphysics proved the weakness of the scientific method—let alone that government should take charge of all sci-entific research.

In addition to the definite contributions of govern-ment policies, it is also true—and proponents of the freemarket should feel no shame in admitting—that manyinstitutions were seduced by fancy mathematical financemodels. Part of what happened is that the whiz kids

from MIT and other top-flight programs made simplify-ing assumptions on the underlying probabilities of vari-ous events. For example, Moody’s might have rated aparticular mortgage-backed security as extremely safe,since it was composed of thousands of small bits ofmortgages spread all over the country. Before the hous-ing crash, the conventional wisdom held that “real estateis local.” It was considered virtually impossible that allmarkets—from San Francisco to Las Vegas to Miami toChicago—would experience a large spike in mortgage-default rates simultaneously. Nobody had ever seen such

a correlated fall, so it seemed like areasonable assumption. The models,based on this assumption, producedresults confirming the safety of mort-gage-backed securities.

When confronted with this realitymany free-market thinkers want toblame a government policy. In thecase of the ratings agencies, we dohave some contenders. The mostobvious example is that the dominantfirms (Moody’s, Standard and Poor’s,Fitch) benefit from government regu-lations placed on banks and otherinstitutions. If a bank or insurancecompany wants to invest in bonds thegovernment insists that these bondsmeet a certain level of safety. Ofcourse, the bank can’t simply hire Joethe Bond Rater to slap “AAA” onthem. The regulations insist that areputable ratings agency meet certain

criteria. In practice these rules ossify the ratings market,and partially protect Moody’s and the others from therepercussions they would have suffered after their disas-trous evaluations of mortgage-backed securities duringthe housing boom.

But even if the critics were right and the present cri-sis was largely caused by faulty forecasts made in the pri-vate sector, it would not prove a crushing defeat for freemarkets. After all, there are plenty of examples of horri-ble business decisions made by private individuals. TheEdsel and “New Coke” flops, Decca Records’ 1962rejection of the Beatles because “guitar music is on the

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R o b e r t P. M u r p h y

Bankruptcies do notsignal the inefficiencyof the market anymore than theoverthrow ofNewtonian physicsproved the weaknessof the scientificmethod—let alonethat governmentshould take charge ofall scientific research.

way out,” and the rejection by a dozen publishers of theinitial Harry Potter manuscript are all examples of stu-pendous entrepreneurial error. Given the advantage ofhindsight, it is easy enough for us to laugh at the busi-nesspeople who made such boneheaded calls, and criticsof the marketplace could easily enough infer that the freemarket can’t be trusted with the task of innovation.

However, the mere existence of entrepreneurialerror is not an indictment of free markets. People canonly achieve bold successes whenthey take risks.The virtue of the mar-ket is that it allows individuals thefreedom to risk their own money—orthat of investors whom they can con-vince to fund them voluntarily—reap-ing the rewards if they succeed andbearing the losses if they fail.There isno reason to suppose that governmentbureaucrats would have designed bet-ter models of risk assessment. Indeed,two Fed economists wrote a paper in2005 claiming that there was no hous-ing bubble (http://tinyurl.com/6jcx3v)!

What is truly ironic is that the gov-ernment’s rescue efforts—supposedlymade “necessary” by the “unregulated”market—only ensure that market discipline will beweaker. Not all major institutions were taken in by thederivatives hysteria during the housing boom. WarrenBuffett famously warned his own investors in 2002 thatderivatives were “financial weapons of mass destruction”that would at some point wreak unexpected havoc.Thetakeovers of AIG, Fannie, and Freddie, as well as the $700billion bailout, reduce the relative strength of those firmsthat behaved more sensibly during the boom. If and

when the next crisis occurs, it will be in part because thegovernment has just shown that playing it safe andadopting a long-term perspective doesn’t pay in U.S.financial markets. It’s much more profitable to go for therisky yet lucrative payouts, and then run to the govern-ment if things turn sour.

Amidst the efforts to “control the narrative” andassign blame for the financial crisis, fans of the free mar-ket should not lose sight of the real benefits of deriva-

tives. Futures contracts on oil, forexample, allow producers and majorconsumers such as airlines to lock inguaranteed prices and confidentlyengage in long-term projects thatwould otherwise be too risky. Eventhe much-maligned credit defaultswap allows the transfer of risk inmutually beneficial trades. Especiallyin an uncertain financial environ-ment, CDS contracts allow certainfirms to raise cash more easily—because those lending them moneycan buy CDSs on their bonds—andthe price of a particular CDS con-tract itself communicates informationabout the market’s view of the firm

being insured.These benefits will all be seriously mutedif the government stampedes in and imposes top-downregulations.

Despite the claims of their critics—and even of someof their fair-weather friends—unregulated markets arenot to blame for the systematic mistakes of the housingboom.Yet even if private errors were the primary cause,it still would not follow that government bureaucratswould make wiser decisions in the future.

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D i d D e r e g u l a t e d D e r i v a t i v e s C a u s e t h e F i n a n c i a l C r i s i s ?

If and when the nextcrisis occurs, it will bein part because thegovernment has justshown that playing itsafe and adopting along-term perspectivedoesn’t pay in U.S.financial markets.

Former Federal Reserve chairman Alan Greenspanhas become everyone’s favorite scapegoat. Hispolicies allegedly caused, or at least contributed

to, the current financial crisis. He is attacked from theleft for lax financial regulation, from the right for loosemonetary policy, and from the middle for both. Yet two years ago, on leaving office,Greenspan was widely heralded as afinancial wizard whose wise, discre-tionary macromanagement hadbrought an unprecedented twodecades of low inflation, high pros-perity, and infrequent and mildrecessions. Both viewpoints, in real-ity, are mistaken.

During the Keynesian dark agespersisting through the mid-1970s,no one—except a few monetarycranks and monetarist economistscloistered in their academic ivorytowers—believed that the FederalReserve’s monetary policy evenmattered. This was a period whenPaul Samuelson, who would go on to win the 1970Nobel Prize in economics the second time it wasawarded, could proclaim in a 1969 Newsweek columnthat “there is no sight in the world more awful thanthat of an old-time economist, foam-flecked at themouth and hell-bent to cure inflation by monetary dis-cipline. God willing, we shan’t soon see his like again.”Today almost everyone—economists, investors, and thegeneral public alike—seems to have swerved to theopposite extreme.The Fed controls not only inflation,they seem to think, but also everything else that hap-

pens to the American economy, good or bad.The truth,however, is somewhere in the middle.

We are not arguing that Greenspan’s policies wereperfect. Nor should anything that follows be construedas a defense of central banking or of the FederalReserve. Particularly alarming is the way the lender-

of-last-resort function has beenexpanding the moral-hazard safety netand mispricing risk—trends to whichGreenspan no doubt contributed. Ourideal would combine abolition of theFed and unregulated free banking.

Nonetheless Alan Greenspan standsout as the most competent—arguablythe only competent—helmsman of U.S.monetary policy since creation of theFederal Reserve System. As MiltonFriedman observed on Greenspan’sretirement, “For the first 70 years afterit opened in 1914, the Fed did far more harm than good, presiding overinflation in two World Wars, convertinga moderate recession into the great

B Y D AV I D R . H E N D E R S O N A N D J E F F R E Y R O G E R S H U M M E L

Was Money Really Easy Under Greenspan?

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David Henderson (davidrhenderson1950@gmail.com) is a research fellowwith the Hoover Institution and an economics professor at the GraduateSchool of Business and Public Policy at the Naval Postgraduate School inMonterey, California. Jeffrey Rogers Hummel is an economics professor atSan Jose State University, where he also teaches history.A version of thisarticle first appeared as Cato Institute Briefing Paper 109,“Greenspan’sMonetary Policy” (November 3, 2008). The original paper, withcitations, is online at http://tinyurl.com/6njtgx.They received helpfulsuggestions from Less Antman, Mark Brady, Gregory Christainsen,Williamson Evers, Fred Foldvary, Roger N. Folsom,Warren Gibson,Gerald P. O’Driscoll, Jr., Benjamin Powell, George A. Selgin, EdwardStringham, Richard H.Timberlake, Jr., Lawrence H.White, and ChristianWignall. None of them bear any responsibility for the final content.

Today almosteveryone seems tothink the Fedcontrols not onlyinflation but alsoeverything else thathappens to theAmerican economy,whether good or bad.

depression, and then, in the 1970s, producing the mostserious peacetime inflation in our nation’s history.” Bycontrast, Greenspan’s “performance has indeed beenremarkable.”

Greenspan oversaw relatively low and stable inflationand ushered in a striking decline in the volatility of realgross domestic product. Although defenders of macro-economic intervention often suggest that governmentpolicies after World War II dampened business cycles,the truly significant change should be dated at 1987,the year Greenspan assumed office. The current fussabout a recession that, according to standard indicators,still is no worse than the minor recessions of 1990 and2001 testifies to how high his legacy has raised the bar.Until a year or so ago many observershad therefore credited Greenspan withbeing the best at reading the eco-nomic tea leaves. But as we willdemonstrate, the source of Greenspan’sapparent success has little to do withmonetary discretion.

Freezing Total Reserves

Recently-converted critics arenow charging Greenspan with

having carried on an excessivelyexpansionary monetary policy, partic-ularly following the recession of 2001and possibly during the dot-com boom that preceded it. But an objective examina-tion of his record of nearly two decades shows that he did not. Instead, however unintentionally andunwittingly, he came close to freezing the domesticmonetary base and deregulated the broader monetaryaggregates.

Why do people now believe Greenspan was an“inflationist”? For one main reason: They note howlow interest rates were from 2002 through 2004. Butinterest rates have never proved an adequate gauge ofwhat the Fed is doing—not during the Great Depres-sion, when rates were very low despite a collapsingmoney stock; not during the Great Inflation of the1970s, when rates were high despite an expandingmoney stock; and not under Greenspan. A focus oninterest rates ignores the simple fact that interest rates

can change as a result of real factors involving supplyand demand and are not simply “set” by the Fed.

The market ultimately determines interest rates.While central banks are big enough players in the loanmarket (and the quintessential noise traders to boot)that they can push short-term rates up or down some-what, that ability is increasingly diminished—even fora major central bank like the Fed—as globalizationintegrates world financial markets. In defending his actions, Greenspan is correct in attributing the unusu-ally low interest rates early this decade mainly to a mas-sive flow of savings from emerging Asian economiesand elsewhere.

A better, although now unfashionable, way to judgemonetary policy is to look at themonetary measures: MZM, M2, M1,and the monetary base (see chart,p. 36). From 2001 to 2006 the annualyear-to-year growth rate of MZMfell from over 20 percent to nearly 0percent. During that same time M2growth fell from over 10 percent toaround 2 percent and M1 growth fellfrom over 10 percent to negativerates. Admittedly the Fed’s controlover the broader monetary aggre-gates has become quite attenuated,for reasons elucidated below. Buteven the year-to-year annual growth

rate of the monetary base since 2001 fell from 10 per-cent to below 5 percent in 2006.When all these meas-ures agree, it suggests that monetary policy was not allthat expansionary during 2002 and 2003 underGreenspan despite the low interest rates.

The key to what was really going on is the mone-tary base, which the Federal Reserve controls directly.The base consists of reserves held by the banks andother depositories, either in their accounts at the Fed oras vault cash, plus currency in circulation among thegeneral public. Between December 1986—eightmonths before Greenspan became Fed chairman—andDecember 2005, the monetary base rose by a heftyamount, from $248 billion to $802 billion (no figuresare seasonally adjusted). True, that doesn’t sound like afreeze. But virtually the whole increase was in currency

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Why do people nowbelieve Greenspanwas an “inflationist”?For one main reason:They note how lowinterest rates werefrom 2002 through2004.

in circulation. (See the graph of the monetary base andits two components on p. 37.) During that same timetotal bank reserves grew from $65 billion to $73 billion,for an average annual growth rate of a mere 0.65 per-cent. (These figures are unadjusted for any changes inreserve requirements and—unlike the somewhat mis-leading reserve totals reported by the Fed’s Board ofGovernors—include all vault cash, clearing balances,and float.) In some years aggregate reserves rose; in oth-ers they fell, with the major bump surrounding Y2K,when the accumulation of reserves by banks appears tohave induced the Fed to accommodate a 40 percentjump followed by a 30 percent drop. Total reserves arealso the one monetary measure whose growth rateshows a slight uptick into 2003, when interest rateswere down. But that is thin backing for the extravagantaccusations that “easy Al” was conducting an excep-tionally expansionary monetary policy.

Currency in Circulation

During the same 19 years, currency in circulationexploded faster than the monetary base—at an

annual rate of 7.54 percent. Before this explosion cur-rency was less than three-quarters of the total monetarybase; by the end of Greenspan’s tenure it was over 90percent. In a period when debit cards and possiblyATMs were reducing currency demand, analysts wereaware that all this new cash was not bulging in the wal-lets and purses of the average American. It was goingabroad as a stable dollar evolved into an internationalcurrency. These growing foreign holdings of FederalReserve notes became an additional factor increasingmoney demand and keeping U.S. inflation in checkduring the 1990s.

Ideally we should adjust the monetary base andmonetary aggregates downward to account for thisdrain abroad. Richard G.Anderson of the St. Louis Fedestimates that the proportion of U.S. currency heldabroad doubled between 1986 and 2005, from 25 tonearly 50 percent. Although his estimates may be toolow, the Fed makes no such adjustment. Doing sowould reduce the average annual growth rate of themonetary base between December 1986 and Decem-ber 2005 from 6.4 to 4.9 percent.

Furthermore, in a fully deregulated monetary sys-tem, private banks—not the Fed—would be the insti-tutions issuing currency. Currency would become anadditional bank liability like deposits and respond tomarket forces. In our current system, the public stilldetermines how much of the base becomes currency incirculation by their decisions to withdraw and redepositcash.The Fed controls only the total base whereas cur-rency passively expands to accommodate people’s pref-erences. This suggests that a more meaningfulapproximation of the base would be simply to subtractall currency in circulation, leaving us with only aggre-gate reserves as our proxy. Thus the virtual freezing ofreserves turns out to be the most salient yet ignoredfeature of Greenspan’s tenure. Interestingly, the lateMilton Friedman had recommended in the 1980ssomething similar to what Greenspan did de facto:freeze the base.

Greenspan also helped deregulate the broader mon-etary aggregates: M2, MZM, and M3. The Depository

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D a v i d R . H e n d e r s o n a n d J e f f r e y R o g e r s H u m m e l

Money Definitions

M1: currency in circulation, travelers’ checks,and transaction deposits (accounts that permitunlimited checking).

M2: M1 plus savings deposits, small timedeposits, money-market deposit accounts, andretail money-market mutual fund shares.

M3 (which the Fed ceased reporting in March2006): M2 plus bank-issued repurchase agree-ments, Eurodollar deposits held by U.S. residentsin foreign branches of U.S. banks, large certifi-cates of deposit (over $100,000), and institu-tional money-market mutual fund shares.

MZM (Money of Zero Maturity and reportedonly by the St. Louis Fed): M2 minus small timedeposits plus institutional money-market mutualfund shares.

Institutions Deregulation and Monetary Control Act of1980 had begun phasing out interest-rate ceilings ondeposits and modified reserve requirements in complexways. Combined with later administrative deregulationunder Greenspan through January 1994, these changesleft all the financial liabilities that M2 adds to M1—sav-ings deposits, small time deposits, money marketdeposit accounts, and retail money-market mutual fundshares—utterly free of reserve requirements andallowed banks to reclassify many M1 checking accountsas M2 savings deposits. M2 and the broader measuresbecame quasi-deregulated aggregates with no legal linkto the size of the monetary base.

A result noted by Milton Friedman in 2003 is that fluctuations in the velocity of M2 were offset by

fluctuations in the amount of M2. Interestingly, this issimilar to what monetary economists George A. Selginand Lawrence H. White predicted would happen under free banking—or a market-determined mone-tary system void of government involvement. Theyargued that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rose, signaling a fall in money demand, mar-ket mechanisms would cause banks to reduce the quantity of money they created. And if velocity fell,signaling a rise in money demand, banks would enlargethe quantity of money.The response of M2 to changesin velocity in the 1990s offers stunning confirmation of this claim. The result was that inflation was held incheck.

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Wa s M o n e y R e a l l y E a s y U n d e r G r e e n s p a n ?

Since the total monetary base and currency in circulation increased in line with one another, total reserves were more or less frozen under Greenspan.

Thus during the dot-com boom of the 90s thevelocity of M2 rose as people shifted into stocks. Butthis was offset by the declining growth rate of M2,which fell to near zero between 1994 and 1996.Assorted Fed watchers reached opposite conclusionsdepending on which variable they chose to focus on.Some warned that Greenspan’s policies were deflation-ary. Others looked at the higher growth rates of thebase and M1, which remains more closely tied to thebase and more distorted by currency going abroad, andpredicted higher inflation. Both were wide of the mark,of course, but not because of Greenspan’s miraculouscentral-bank discretion.The result was a product of themarket process, and when the collapseof the dot-com boom burst the M2velocity bubble it induced a newspike in M2 growth.

Why Any Inflation?

If Greenspan approximately frozetotal reserves, why was there any

inflation at all during his tenure?Rather than averaging 2.5 percentannually, shouldn’t prices haveremained constant or actually fallen?Indeed, in a thoughtful critique of anearlier version of this article, Selgindenied that the broader monetarymeasures were responding to changesin velocity, since productivity growthwould have therefore generated justsuch a gradual deflation. The answerrelates to the market’s extraordinarycapacity for financial innovation.Until the recent, extraordinary changes in Fed opera-tions, bank reserves in the United States paid no inter-est, giving banks a strong incentive to economize ontheir use and maximize lending.They figured out waysto do so even under reserve requirements, as amplyillustrated by the origins and growth of the Federalfunds market, where banks regularly lend each otherexcess reserves.

Financial deregulation gave the process an additionalboost. From December 1986 to December 2005—thesame period during which aggregate reserves remained

almost constant—the aggregate de facto reserve ratio ofthe banking system as a whole backing M2 fell by half,from 2.52 percent to 1.23 percent. So the quantity ofM2 deposits grew at a secular rate of 4.6 percent,enough to generate mild, sustained inflation. And thequantity of domestically held currency grew alongside atan accommodating rate.

This steady, long-term decline of reserve ratios can-not easily be halted and confronts government fiatmoney with a fatal long-run problem. Re-tightening ofreserve requirements would only burden banks with animplicit tax not faced by other financial institutions,encouraging the development of new, highly liquid

money substitutes that effectivelyavoid the requirements. Congress has,moreover, moved in the oppositedirection, permitting the Fed to elim-inate all remaining reserve require-ments in 2011, thereby bringing theUnited States into line with suchcountries as Australia, New Zealand,Canada, the United Kingdom, andSweden, which have already done so.True, the Fed has now started payinginterest on bank reserves, which hasenormously increased demand forthem in the short run. Nonethelessbanks will still be able to earn greaterinterest on loans and securities undernormal economic circumstances.Moreover, paying interest on reservesin effect transforms that portion ofthe monetary base into Treasury secu-rities payable in fiat money, rather

than genuine fiat money itself.In short, the ongoing spread of electronic funds

transfers and assorted cashless payments is essentiallyreplacing money with a sophisticated network of com-puterized barter. The demand for fiat money will thusapproach zero asymptotically. So long as the moneybase is built on a fiat foundation with no other sourceof demand, the price level will slowly but inexorablyhead toward infinity. Only a commodity base with anonmonetary demand—say gold, although it could justas well be silver, some combination of the two, or a

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D a v i d R . H e n d e r s o n a n d J e f f r e y R o g e r s H u m m e l

Some economistswarned thatGreenspan’s policieswere deflationary.Others predictedhigher inflation. Bothwere wide of themark, of course, butnot because ofGreenspan’smiraculous central-bank discretion.

more complex basket of commodities or financialassets—will anchor the price level over the long haul.Under free banking, the expansion of monetary substi-tutes would drive down the demand for gold-as-money, but gold’s value can never drop below itscommodity value. Gold would continue to provide theunit of account, the common numeraire in nearly alltransactions, without ever needing to be used as amedium of exchange.

Greenspan cannot be held responsible for this ulti-mate unviability of fiat money, although his deregula-tion accelerated the inflationary bias. A steady, secularcontraction of total reserves could in theory have offsetthe declining reserve ratio, deliveringa constant price level or even seculardeflation over the last two decades.But the continued fall of base-moneydemand is itself inevitable as long asdeveloped economies wish to capturethe enormous welfare gains of finan-cial innovation and a more efficientallocation of savings.

An Ironic Legacy

So what did cause the currentfinancial crisis? That is similar to

asking what caused the minor recessions of 1990 and2001. Unlike the cause of inflation the cause of businesscycles is not obvious, which is why economists still vig-orously debate the question. Minor blips in totalreserves under Greenspan may have played some poorlyunderstood role in any of these three events. BecauseGreenspan only imperfectly implemented Friedman’srule of freezing the monetary base, without intendingto do so, his policy may have ended up slightly too dis-cretionary. But that possibility hardly justifies the “assetbubble” hubris of those economic prognosticators who,only well after the fact, declaim with absolute certainty

and scant attention to the monetary measures how theFed could have pricked or prevented such bubbles.

The misunderstanding of Alan Greenspan’s manage-ment of the U.S. money stock has an ironic coda.Before his appointment the Federal Reserve hadproved so palpably inept as to all but discredit discre-tionary monetary policy. Both monetarist rules and freebanking were gaining adherents among economists.But today, despite the recent financial turmoil, mostinterpret Greenspan’s record as showing either that dis-cretionary policy can be done right or that what isneeded is some activist pseudo-rule such as that devel-oped by John B.Taylor of Stanford University. Central

bankers, after half a century or moreof failure, have allegedly learned fromtheir past mistakes. Finally, accordingto this view, they have the knowledgeto plan the money stock properly.

In a review of Greenspan’s mem-oirs Harvard economist BenjaminFriedman claims that Greenspan wasa practitioner par excellence of mone-tary discretion (despite paying lipservice to laissez faire) and thatGreenspan’s major failing was that hewas not more of a regulator. Fried-

man is wrong on both counts. Greenspan, like the Wiz-ard of Oz, was a lousy wizard—but he was a goodderegulator. And that made all the difference. His suc-cess stemmed from weakening Fed discretion with theunintentional approximation of a rigid monetary ruleand the very deregulation that Benjamin Friedmandeplores. Rather than demonstrating that monetaristrules are obsolete and free banking unnecessary,Greenspan’s policies suggest that the more thoroughlyeither of those two objectives is implemented, thegreater the macroeconomic stability our economy willenjoy.

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Wa s M o n e y R e a l l y E a s y U n d e r G r e e n s p a n ?

Greenspan, like theWizard of Oz,was alousy wizard—but he was a goodderegulator.And that made all thedifference.

If an athlete injures himself and suffers great pain,we recognize the shortsightedness of giving himpainkillers to keep him going. The pain might be

masked, but at the risk of greater injury later.That’s a good analogy for the inflationary policies

now pursued by Washington. These policies may tem-porarily “stimulate the economy,” but they also disguiseand aggravate the underlying problems.We will all paya serious price.

Policy makers have thrown caution to the wind.Twelve-digit dollar figures are tossed about casually.Late last year, after then-Treasury Secretary HenryPaulson changed course—yet again—and announced that the FederalReserve would commit $800 billionmore in “new loans and debt pur-chases,” the New York Times reported,“Fed and Treasury officials made itclear that the sky was the limit.”

The total federal commitment as ofthat date was over $7 trillion.

The Fed had given up trying tomake it easier for banks to lend toeach other. Now, the Times reported, it“is directly subsidizing lower mort-gage rates . . . doing so by printing unprecedentedamounts of money, which would eventually createinflationary pressures if it were to continue unabated.”

No kidding.When we hear that the U.S.Treasury is doing this or

the Federal Reserve is doing that, we should rememberthat these agencies are run by mere mortals, and assuch, they cannot know how to “fix” something ascomplex as an economy. But they certainly are capableof wrecking one.

That’s what their inflationary policies will do.In a free market, prices do more than tell us what we

have to pay for things.They are messages emitted by an

intricate communications system that inform us of the relative scarcity of resources, labor and consumergoods, and the relative intensity of consumer demand.Thanks to prices, we can tell producers how we rankour preferences, and they in turn can arrange produc-tion according to our priorities. Without prices, eco-nomic coordination is impossible, which is whyattempts at state planning produce, in Ludwig vonMises’ words,“planned chaos.”

We associate inflation with a rising price level, butequally important, relative prices change when newmoney is created. That garbles the messages. As Mises

writes, “The additional quantity ofmoney does not find its way at firstinto the pockets of all individuals;. . . [P]rice changes which are theresult of inflation start with somecommodities and services only. . . .[T]here is a shift of wealth andincome between different socialgroups.”

The Fed gives money to AIG orCiticorp, but not to Lehman Broth-ers, or you and me. The new bankreserves also push interest rates below

what the market would have set, further distorting pro-duction by encouraging investment plans to be madeon the basis of artificially low rates.

How can the economy straighten itself out if it isbeing systematically skewed by government inter-ference with prices?

We are in the mess we’re in precisely because of ear-lier government interference. Easy mortgage terms andguarantees contrived a housing boom and irresponsible

B Y J O H N S T O S S E L

Government Sets Us Up for the Next Bust

Give Me a Break!

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John Stossel is co-anchor of ABC News’“20/20” and the author ofMyths, Lies, and Downright Stupidity: Get Out the Shovel—WhyEverything You Know is Wrong, now in paperback. Copyright 2008 byJFS Productions, Inc. Distributed by Creators Syndicate, Inc.

How can theeconomy straightenitself out if it is beingsystematically skewedby governmentinterference withprices?

lending that could not be sustained.The consequenceshave shaken the foundation of the financial industry.But instead of freeing the market and allowing theerrors to be corrected, the government is seducing theeconomy into a whole new set of errors.That will leadto the next bust.

“But doesn’t the government have to act?” peopleask.“We can’t just let financial companies fail!”

I say,“Why not?”Jim Rogers, the successful investor and author, puts

it well:“Why are we bailing out Citibank? Why are 300

million Americans having to pay for Citibank’s mis-takes? The way the system is supposed to work [is this]:People fail. And then the competent people take overthe assets from the failed people, and then you startagain with a new, stronger base.What we’re doing thistime is . . . taking the assets from the competent people,giving them to the incompetent people, and saying,‘OK, now you can compete with the competent peo-ple.’ So everybody’s weakened: The whole nation isweakened, the whole economy is weakened.That’s notthe way it’s supposed to work.”

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G o v e r n m e n t S e t s U s U p f o r t h e N e x t B u s t

Book ReviewsThe Cult of the Presidency: America’s DangerousDevotion to Executive Power by Gene HealyCato Institute • 2008 • 264 pages • $22.95 hardcover;$13.00 e-book

Reviewed by Brian Doherty

Gene Healy relates a sad anddisturbing “kids say the darn-

dest things” anecdote in his newbook.The story typifies an attitudetoward government that Healy,senior editor at the Cato Institute,rightly identifies in his book’s titleas The Cult of the Presidency. A littlegirl, on hearing that President

Kennedy had been murdered in 1963, wondered sadlyto her mother “where would we get our food andclothes from?”

That little girl with her bizarre beliefs about thepowers and responsibilities of the president is a votingadult now—as are millions whose attitudes about gov-ernment are at least somewhat like hers. She’s probablynow wondering if our new president can fill the impos-sible role Americans expect of their chief executive.

As Healy demonstrates, the perceived responsibilitiesand powers of the president of the United States havemetastasized dangerously since their original concep-tion at the American founding. The president wasmeant merely to preside over the execution of the lawsof the United States, not to be an all-powerful super-hero unconstrained in an endless quest to right allwrongs, foreign and domestic. When President JohnAdams craved the title of “His Highness,” Congresswould have none of it; Pennsylvania Senator WilliamMacley called the notion “base,” “silly,” and even “idolatrous.”

Healy charts the resilience of this constrained visionof presidential power, even after the upheaval andpower grabs of the Lincoln era. The accumulation ofpower and hubris at 1600 Pennsylvania Avenue acceler-ated with the rise to power and prominence of men

such as Theodore Roosevelt (who wanted to legislatechanges in the English language from the White Houseand started foreign military adventures without con-gressional approval) and Woodrow Wilson (whodeclared that God ordained him to be president andcheered a “spirit of ruthless brutality [in the] fiber ofour national life. . . . [E]very man who refuses to con-form will have to pay the penalty.”).

From Franklin D. Roosevelt on, all the traditionalrestrictions on the president’s powers crumbled.We findourselves in a political world where, as in a 1992 presi-dential debate, candidates are asked to “make a commit-ment [to] meet [the] needs” of all Americans. Not asingle candidate even raised his brow at the extraconsti-tutional implications of that request.

This book provides a depressing dissection of mod-ern trends in political power—and in Americans’ concep-tion of that power, which underlies the problem ofexecutive overreach. As Healy notes, that makes anyquick fix to the “cult of the presidency” unlikely. Butthe book also contains touches of delightful nostalgiafor an America gone by.

One can’t help admiring such derided “do-nothing”presidents as Warren Harding. He gets sneered at by his-torians and political science professors for lacking thehubris of power, but he pardoned the peaceful protes-tors his predecessor Woodrow Wilson tossed in jail.Every American should feel a yearning for a past inwhich a presidential candidate like William Taft couldsay bluntly that the president “cannot create good times. . . cannot make the rain to fall, the sun to shine, or thecrops to grow;” a world where it took five years afterthe third assassinated president for Congress to grantthe holder of the office his own armed janissaries; atime when presidents before Wilson thought that giving their state of the union addresses in person wasdemagogic.

Healy rightly notes that Congress is complicit inthe failure of the Founding Fathers’ system wherebyjealousy of their respective prerogatives was supposedto keep any one branch of government from over-powering the others. Our craven Congress grantsvague powers and then complains about how theexecutive uses them—both in war-making anddomestic policy.

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If Congress is to blame for giving way, the WhiteHouse is to blame for pushing. Healy details the manyways in which the recent Bush administration champi-oned a wildly expansive vision of executive power inthe wake of 9/11. The administration’s leading scholarof executive omnipotence, John Yoo, formerly of Bush’sOffice of Legal Counsel, once said in a public debatethat the president might well be able to order theextralegal crushing of a child’s testicles if he had theproper national-security reason for doing so.

Gene Healy has ably cast down the idols of the cultof the presidency. But it remains a limited devotion in a larger cult: that of government itself. That cult’scomplications and crises loom even larger than thepresidency.

Brian Doherty (brianmdoherty@gmail.com) is a senior editor at Reasonmagazine and author of Radicals for Capitalism:A FreewheelingHistory of the Modern American Libertarian Movement(PublicAffairs).

Bad Samaritans: The Myth of Free Trade and theSecret History of Capitalismby Ha-Joon ChangBloomsbury Press • 2008 • 288 pages • $26.95 hardcover;$17.00 paperback

Reviewed by Robert Batemarco

Most people seize on the fail-ure to practice what one

preaches as proof of the error ofthe message preached. This is thelogical fallacy known as tu quoque.It is far more often the case, how-ever, that the message is virtuousbut virtue is not what the hypo-critical preacher truly seeks. Ha-

Joon Chang, author of Bad Samaritans, similarly draws afallacious conclusion when he takes the wealthy nationsof the West to task for not adhering to the doctrines offree trade, monetary stability, and fiscal responsibility towhich they pay lip service.

But tu quoque is the least of the logical errorsinforming this book’s misguided policy conclusions.Once we get beyond the silly comparison of an infant

industry with his six-year-old son, we see the realshortcoming of his attack on free trade: his attenuatedunderstanding of entrepreneurship. Entrepreneurs useresources for which they are responsible (either theirown or those they have borrowed and must repay)based on their appraisals, in the face of uncertainty, ofconsumer demand and resource availability in thefuture. The infant-industry argument central to thisbook implicitly assumes that the only investments thatcan contribute to economic growth are those thatcompete with imports. But of all the import-compet-ing industries in any developing country, which onesshould be fostered through protectionism? Also, there’sno reason to presume that government leaders makingthose choices would do so on the basis of objectiveappraisal of their profitability. Favoritism towards rela-tives and cronies is far more likely.

Rather than let real entrepreneurs bear the risk andreap the rewards, infant industry protectionism is little more than a socialization of risk. While it mayyield more investment, the investment to be protectedis likely to be misdirected and thus less conducive to growth than investment that must meet a harshermarket test.

The author rails against “neo-liberal” ideologues(the bad Samaritans of his title), blissfully unaware of hisown ideological biases—namely, a touching faith in theability of government leaders to make the right choicesmore often than private entrepreneurs risking theirown capital. Entrepreneurs are not necessary in thisview, since the government can do their job at least aswell. The government can determine pragmaticallywhich industries to protect, how much inflation willmaximize growth, which foreign investments to per-mit, and which enterprises it should own.

Not only does Chang get the big picture wrong,he commits a lot of smaller errors along the way. Hemisplaces Jean-Baptiste Colbert’s tenure as France’sfinance minister by 200 years (1865–1883 instead of1665–1683). He cites the “failure of electricity deregu-lation in California, which resulted in the infamousblackout in 2001,” oblivious to the continued pricecontrols that made “deregulation” a terrible mischarac-terization of what really went on. He avers that“[s]trengthening of the welfare state . . . will also help

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reduce political corruption by making the poor lessvulnerable to vote buying,”—as if the welfare statewere much more than vote-buying on a wholesalebasis. Another howler is his description of the latesocialist John Kenneth Galbraith as a non-leftist. I guesshe was just another non-ideological pragmatic centristlike Chang himself.

He also sneaks some subtle premises into his work,which helps explain why he supports so many badpolicies. His tacit approval of Britain’s ban on themigration of skilled workers in the 1700s could onlycome from someone who believes the state owns itsresidents. Much of his discussion of less-developedcountries’ lack of respect for intellectual propertyrights seems to be based on the premise that if youneed something you can’t afford you have the right tosteal it.Throughout the book he cites the existence ofspecific policies as prima facie evidence that they arejustified. For example, “When they were backwardsthemselves in terms of knowledge, all of today’s richcountries blithely violated other people’s patents,trademarks and copyrights.”

Even when Chang raises interesting points his statistviews put him on the wrong side of the issue. Forexample, he is critical of what he calls the unholy trin-ity of the IMF, World Bank, and WTO, but for thewrong reasons—downplaying the high taxes and addi-tional regulations they impose in exchange for theputative “benefits” they provide.

Overall, Bad Samaritans gives us a good picture ofwhat we champions of freedom are up against. Theauthor J. Wallace Day once said, “Always keep yourfriends close, but your enemies keep closer.”That is thebest rationale I can come up with to recommend thatsupporters of economic liberty read this book—toknow what enemies of free trade are saying today.

Robert Batemarco (rbate@verizon.net) is a vice president of a marketingfirm in New York City.

Are the Rich Necessary? Great Economic Arguments and How They Reflect Our Personal Values by Hunter LewisAxios • 2007 • 231 pages • $20.00

Reviewed by George Leef

In my high school days I had afriend who had been thoroughly

imbued with the socialist mindset.He was willing to concede theremight be some adverse conse-quences if the government wenttoo far toward equality and eco-nomic control, but was adamantlyin favor of the “humanity” of

socialism.We amiably debated the role of profit, incomeinequality, just prices, greed, and similar questions.

Reading Hunter Lewis’s Are the Rich Necessary? mademe think back on those discussions, for it delves into thebasic economic and philosophical disputes betweenadvocates of socialism and advocates of laissez-faire capi-talism. Throughout, Lewis gives readers a dialoguebetween opposing points of view similar to but muchmore learned than my debates back then. I regard hispresentation of the socialist/egalitarian philosophy as fair(Lewis is not merely pummeling a strawman), but thepro-market side clearly comes out on top. If you were togive the book to a libertarian son or daughter, you neednot worry about turning him or her into a Marxist.

At the outset Lewis says he isn’t trying “to propagatea particular set of ideas.” It is obvious, however, that heknows the free-market arguments very well and is notindifferent between the two camps.

His first chapter digs into the title question: Are therich necessary? Lewis presents several arguments thatthey are not: that they are parasites, cause poverty, andexploit the poor. In support of that litany of complaintsLewis quotes Abby Rockefeller (yes, a descendent of oilbillionaire John D. Rockefeller), who said,“Many sufferbecause of the few.” Lewis then follows up by makingthe case that the rich (at least those who earn theirmoney) are beneficial.

In presenting the pro-market side, Lewis quotesextensively from Henry Hazlitt: “No matter whether it

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is their intention or not, almost anything that the richcan legally do tends to help the poor.The spending ofthe rich gives employment to the poor. But the savingof the rich and their investment of these savings in themeans of production gives as much employment and inaddition makes that employment constantly more pro-ductive and highly paid.”

It’s hard not to notice that the argument againstincome inequality has a bumper-sticker quality to it,while Hazlitt’s rejoinder aims at the rational faculties. Idon’t think Lewis is being unfair here.You could makethe anti-capitalist argument longer, but you can’t makeit any better.

Another topic Lewis addresses is profit. My high-school friend was against profits because in his view they made things more expensive. We find thatchildish notion in the arguments that profit is unnec-essary. Lewis cites historian Howard Zinn, who con-tends that the profit system “distorts our whole economic and social system . . . leaving importantthings unproduced.”

In the following pro-profit arguments he presents,Lewis adduces facts that show the silliness of Zinn’sposition. For example, he refers to Mark Kurlansky’sbook Cod to show how the profit motive led people tomake the discoveries and investments necessary forlarge-scale cod fishing to begin, which in turn made itpossible for great numbers of Europeans to increasetheir protein intake substantially. People made theinvestments in commercializing the cod fishery becausethey thought they would be profitable. Progress inovercoming hunger hinged on the market’s profitmotive. Lewis also goes into the alternatives to privatelyowned, profit-seeking business (government ownershipand worker-owned firms) and points out that theyentail serious difficulties.

How about economic depressions? Opponents ofthe free market often point to depressions as proof ofthe need for pervasive government regulation of theeconomy or even state ownership. Freeman readers willbe delighted to read the counterarguments that Lewisgives.They are based on Austrian insights that govern-ment manipulation of money and credit causes wide-spread misallocation of capital to projects that have tobe liquidated once the tinkering ends. Lewis deserves a

round of applause for making Austrian business cycletheory comprehensible to the average reader.

Are the Rich Necessary? also plows into other keyaspects of the intellectual battle between free-marketadvocates and their opponents, including globalization,central banking, and “just prices.”

This highly readable book would be an excellent giftfor anyone whose economic thinking is at the same levelas my friend’s was. I am going to pass my copy along tomy sons. Their economic understanding is much betterthan his was, but the book is certain to sharpen theirunderstanding and give them an arsenal of arguments to use against the anti-capitalist mentality.

George Leef (georgeleef@aol.com) is book review editor of The Freeman.

Gusher of Lies: The Dangerous Delusions of“Energy Independence.” by Robert Bryce Public Affairs • 2008 • 384 pages • $26.95 hardcover;$16.95 paperback

Reviewed by William Anderson

Al Gore recently called for aten-year plan to phase out all

electric plants powered by fossilfuels and replace them with wind-mills and other “renewable” energysources. While the media fawnedover Gore’s speech, I decided toread Robert Bryce’s Gusher of Liesto see if the speech made sense.

It doesn’t. Bryce’s book has a big dose of somethingthat Gore and his followers ignore: reality. Indeed, areader of this book is going to receive mega-doses ofreality.

Those who believe the political classes in this coun-try have created a colossal mess in the energy industrywill find Gusher of Lies very helpful.At a time of volatileenergy prices, it pays to be informed.

It is important to note that Bryce is not a person ofthe right. While he is critical of the government’s oilprice-control policies of the 1970s (unlike most politi-cal liberals, who supported them), this book is not anapology for oil companies. He is especially contemptu-

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ous of the Bush administration and its neoconservativepolitical allies for the invasion of Iraq. Bryce’s political“liberalism” gives the book even more credibility, sincehe can’t be easily dismissed as yet another right-wingshill.

Bryce is an oil expert, and he gladly passes on muchof his own knowledge and expertise in his book. Heprovides a good history of oil production both in theUnited States and abroad, giving this book a vast scope.

Two crucial points leap out, however. One is thefraud of “alternative” fuels, and especially corn-basedethanol, which Bryce rightly calls a “scam.”The other isthe larger issue of understanding our economicallydependent world.

Most important, Bryce writes that the mantra of“energy independence” is ignorant at best and delu-sional at worst. “Energy independence,” he shows, isjust a cheap political slogan to con people into accept-ing a terribly interventionist stew of policies to subsi-dize alternatives to oil.

Bryce devotes more than 50 pages to Chapter 12,“The Ethanol Scam,” filling it with fact after fact show-ing clearly that the real scammers have been our electedofficials and people tied in with the corn industry. Hebegins by declaring, “Ethanol isn’t motor fuel. It’s reli-gion. And America is divided into two camps: thebelievers and the heretics.” Exactly.

Other gems include: “Mixing morality and politicscan lead to bad policies. But mixing morality andmotor fuel makes for a truly lethal cocktail. And fewpoliticians dare look too closely at the ethanol moon-shine.”And this:“If America is ‘addicted’ to oil, then it’sequally true that the corn ethanol industry is a world-class junkie when it comes to subsidies.”

Besides Congress and the late Bush administration,Bryce points a finger at Archer Daniels Midland(ADM), the self-proclaimed “Supermarket to the

World.” Bryce goes through the billions of dollars insubsidies ADM has received for producing ethanol—and the millions it has given to politicians, bothRepublican and Democratic.

Bryce does not stop with the political payoffs. Hedeals with the economic and scientific issues that makecorn-based ethanol a loser. First, the “net energy gain”that comes with producing ethanol is vastly inferior tothat of petroleum; second, when one considers the eco-nomics of ethanol, one finds that it costs more to makethe fuel than it can bring in revenues on a free market.Without subsidies, ethanol would soon die.

In a refreshing change from the political rhetoric of“energy independence,” Bryce calls for engagement ofthe Arab and Muslim world instead of promotion of theclimate of fear that American politicians are sowing. Hewrites, “The continuing use of fear as a political tool—along with the constant drumbeat of terrorism—hasbecome part and parcel of America’s dementedapproach to energy policy.”

That engagement includes Iran, the very country the Bush administration has tried to isolate. Further-more, Bryce points out that China is going to continuegrowing economically, and that means Americans mustpay attention to that country and work with it, notagainst it.

While Gusher of Lies is not an entirely free-marketbook, it exposes the folly of government central planning in the energy industries and demonstrates thatthe political class is perpetrating a massive deception.This is cold comfort, given the hardcore statism thatdominates our politics, but it is good to know that atleast one energy expert has blown the whistle on thisscam.

William Anderson (banderson@frostburg.edu) is an associate professor ofeconomics at Frostburg State University.

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B Y D AV I D R . H E N D E R S O N

Unintended Consequences in Energy Policy

The Pursuit of Happiness

On the first day of every economics class Iteach I start with The Ten Pillars of Eco-nomic Wisdom. This is a list I have put

together of the ten most important principles in eco-nomics. Pillar number six is, “Every action has unin-tended consequences; you can never do only onething.” U.S. energy policy illustrates this to tragiceffect. Costly policies that have reduced economicfreedom and had nasty economic consequences riddlethe landscape.

Start with the Corporate Average Fuel Economy(CAFE) law, which requires each auto producer in theU.S. market to make fleets that aver-age at least 27.5 miles per gallon forcars and at least 20.7 mpg for trucks.(Former President Bush and Congressincreased that to 35 mpg by 2020,with no lower standard for lighttrucks.) That law had the unintendedbut totally predictable consequence ofmaking cars less safe. The reason isthat one relatively cheap way to raisefuel economy is to make cars lighter,and the lighter they are, other thingsbeing equal, the more dangerous theyare to their occupants. In 1989 twoeconomists, Robert Crandall of theBrookings Institution and John Graham of HarvardUniversity’s John F. Kennedy School, found that,adjusting for the downsizing of cars that would haveoccurred anyway, the CAFE laws would cause an extra2,200 to 3,900 deaths over the life of a 1989-model-year car.

But the CAFE law is itself the result of anotherunintended consequence of government policy, namelyprice controls on oil and gasoline. President Nixon’seconomy-wide wage and price controls, imposed in1971, did not cause much difficulty at first. But when

the Organization of Petroleum Exporting Countries(OPEC) raised the world price of oil from about $3 abarrel to about $11 over a few months in late 1973,Nixon’s price controllers refused to allow refiners topass on the whole increase in the price of gasoline.Theresult was a massive shortage of gasoline, with long linesat the pump. Rather than remove the controls, Nixonhad government officials start allocating the gasoline byvarious arbitrary criteria, a process the Ford and Carteradministrations continued.

Government officials in the Ford administrationand in Congress noticed that American car buyers

were not buying as many high-fuel-economy cars as these officialsthought they should. In otherwords, Americans were respondingto the artificially low price of gaso-line by acting as if the price of gaso-line were low! Gee, what a surprise.Of course, instead of removing theprice controls, Congress and Forddecided to regulate the fuel econ-omy of new cars—that’s how wegot CAFE. Like all regulations, thisone bred its own lobby, featuringRalph Nader and Clarence Ditlow.They had been, until that time,

advocates of car safety. But they wanted enforced fueleconomy even more.

That’s not the end. One way the companies couldmeet their CAFE targets was by importing small, high-fuel-economy cars from their foreign production facil-

47 M A R C H 2 0 0 9

David Henderson (davidrhenderson1950@gmail.com) is a research fellowwith the Hoover Institution and an economics professor at the GraduateSchool of Business and Public Policy at the Naval Postgraduate School.He is the editor of The Concise Encyclopedia of Economics (LibertyFund, 2008).

Americans wereresponding to theartificially low priceof gasoline by actingas if the price ofgasoline were low!Gee, what a surprise.

ities.The United Auto Workers union noticed this andlobbied for—and achieved—separate standards. Autocompanies then had to hit the standard with theirdomestic production and, separately, with theirimports. That caused the companies to produce moresmall cars at home rather than import even successfulcars from abroad. According to William Niskanen, thechief economist at Ford in the late 1970s, Forddropped its Fiesta in the late 1970s not despite, butbecause of, the car’s potentially large market: Fordfeared that its German-made Fiesta would “steal” salesfrom its U.S.-made Escort, thus lowering its domesticCAFE average.

Moreover, even the increase in the world price ofoil engineered by OPEC in late 1973 was in part theunintended consequence of U.S. energy policy. Why?Because OPEC had been formed inresponse to President Eisenhower’srestrictions on oil imports.As econo-mist Ben Zycher points out, in 1959the U.S. government established theMandatory Oil Import Quota Pro-gram (MOIP), which restricted theamount of imported crude oil andrefined products allowed into theUnited States. It also gave preferen-tial treatment to oil imports fromCanada and Mexico. Two majorgrowing sources of supply at the time were the MiddleEast and Venezuela. By reducing a major market forMiddle Eastern and Venezuelan oil, the import-quotasystem drove down the demand for that oil, causing itsprice to fall in February 1959 and again in August1960.

In September 1960 governments of four PersianGulf countries—Iran, Iraq, Kuwait, and Saudi Arabia—facing discrimination against their oil, joined withVenezuela to form OPEC. Their goal was to getmonopoly power to offset the monopsony power cre-ated by the U.S. oil import quota system and thus gethigher prices. Although OPEC was at first relativelypowerless, by 1973 the governments of eight othercountries—Algeria, Ecuador, Gabon, Indonesia, Libya,Nigeria, Qatar, and the United Arab Emirates—hadjoined. In 1973, OPEC made its move.

From the CAFE to the Mess Tent

CAFE laws and other fuel-economy standards arenot the only unintended consequences of U.S.

price controls on oil and gasoline. One can even spec-ulate reasonably that these price controls led to twomajor wars initiated by the U.S. government.The rea-son is that instead of blaming their government for linesat gas stations,Americans have tended to blame foreigngovernments—especially the government of Saudi Ara-bia, the leader of the OPEC cartel and its largest pro-ducer. In 1979 President Carter formed the RapidDeployment Force to train for combat mainly indeserts. President Reagan kept this force and renamedit the U.S. Central Command.

Whatever Carter’s motives or understanding informing this force, the hardwiring in Americans’ minds

led them to associate gas lines withnasty Middle East governmentsrather than with the nasty U.S.government. That made them morewilling than otherwise to supportintervention in Middle Eastern affairsto secure the continued flow of oil.Thus when Henry Kissinger claimedin August 1990 that Saddam Hus-sein’s invasion of Kuwait, if leftunopposed, “would cause a world-wide economic crisis,” many Ameri-

cans believed him. In a Wall Street Journal article thatmonth, I showed that, in fact, the absolute worst harmHussein could do to the U.S. economy, even if hegrabbed Saudi Arabia and the United Arab Emirates,was a loss of less than half of 1 percent of GDP annu-ally. But because so many Americans feared the returnof gas lines, they were more open than otherwise to aU.S. attack on Iraq.

Later, in 2003, the U.S. government still had the mil-itary capability to invade Iraq.The stated issue this timewas Saddam Hussein’s alleged weapons of mass destruc-tion. Still, the fact that the U.S. government had thecapability to attack Iraq was due in part to Carter’sbuildup of the Rapid Deployment Force.

As poet Robert Burns might say, “Oh what a tan-gled—and tragic—web government weaves when firstit practices to intervene.”

48T H E F R E E M A N : I d e a s o n L i b e r t y

D a v i d R . H e n d e r s o n

Because so manyAmericans feared thereturn of gas lines,they were more openthan otherwise to aU.S. attack on Iraq.