Paulson’s Courageous Action

The Treasury man puts an end to bailout fever.

Treasury Secretary Henry Paulson is the man of the hour. This weekend he drew a clear line in the sand: no more federal bailouts. Not for Lehman Brothers. Not for global insurer AIG. Not for Merrill Lynch. Not for anyone, at least as of this writing.

It was a gutsy decision for the former Wall Street bigwig. Paulson came to Washington two years ago thinking he could reform Social Security and perhaps the tax system as well. In the process he hoped to clean up the federal budget books, maintain an open trading system, and persuade China to take on a more flexible currency and reform its own banking system. But history can be a cruel master, and Paulson’s agenda was completely altered by one of the worst financial crises in American history.

Last March, acting in conjunction with Fed head Ben Bernanke, Paulson safeguarded the banking system and the whole global financial structure by backstopping a JPMorgan-Chase deal to acquire the ailing Bear Stearns with $29 billion of loan guarantees. The action succeeded in stabilizing markets, but it put U.S. taxpayers on the hook big-time.

Then last week Paulson stepped into the breach again by backstopping mortgage lenders Fannie Mae and Freddie Mac. It was a necessary action. It stopped a global money meltdown. But it raised the stakes for taxpayers once more.

So this time around, as the Lehman stock headed for zero, Paulson said enough is enough.

Paulson’s view — supported by Bernanke and former Clinton Treasury official Timothy Geithner (now the president of the New York Fed) — is that the private sector has to take responsibility, including a consortium of private bank funds to assist the beleaguered AIG insurance company. We are now in for some Schumpeterian gales of creative destruction. But this is how it must be.

“Moral hazard,” said Paulson, “is something I don’t take lightly.” He’s saying bad financial behavior must be penalized, not rewarded. That’s the essence of the issue. The risk of failure is essential to an efficient economic system, and that includes financial risk.

In our capitalist system there are losers as well as winners. There are failures as well as successes. Harking back to the eminent economist Joseph Schumpeter, the old failures will be replaced by new enterprises.

The alternative, of course, is that the U.S. goes down the old European path of government domination of markets and the economy. But the moment the U.S. becomes bailout nation, that is the moment our economy and country heads irrevocably down the road of decline. However, Paulson set down a marker and said, “No we won’t.” As difficult as the next days may be, the primacy of economic freedom has been given a boost while the economic future of the U.S. looks brighter. Paulson’s decision was both momentous and transformative.

Obama is on the campaign trail predictably charging that a lack of regulations during the Bush era is responsible for the current mess. But he’s misreading history. As George Mason economist Tyler Cowen wrote in the New York Times, one of the problems with the U.S. financial system is not a lack of regulation, but a lack of smart and effective regulation.

During the Bush years, financial regulations increased exponentially, beginning with the misbegotten Sarbanes-Oxley act. That put accountants and lawyers in the driver’s seat rather than entrepreneurs. And it turns out that neither the Fed, the FDIC, the Comptroller of the Currency, nor the SEC properly supervised high-risk leveraged borrowings and the capital-adequacy ratios necessary to safeguard against losses. Accounting standards need reform, especially the notion of fair value. Economist David Malpass wants to throw out mark-to-market all together. He has a good point.

Then there’s Congress, led by Democrats in the last two years and Republicans before that, which mandated substandard lending to low-income groups. And as the high-risk loans mounted, this very same Congress — under the gun of political contributions — continued to promote the excesses of lenders, including Fannie Mae and Freddie Mac.

There are many more issues wound up in all this. But one thing’s for sure. Keeping tax rates low, holding back cheap-money inflation, strengthening the dollar, and building a more effective regulatory structure that does not stifle free enterprise is what will promote long-run economic prosperity. For optimists like myself, the plunge in oil and gas pump prices is already producing a sizable tax-cut effect, planting the seeds of recovery for mortgage-holding consumers and everyone else.

It’s easy to be overly pessimistic right now. But that negativism is not written in stone. Mr. Paulson talks about a housing and financial recovery in terms of months, not years. And I think he’s right. But his courageous action to put a stop to bailout fever will do as much as anything to move the nation toward recovery.