Someone this week asked me what I thought of policy-makers who ex ante profess a free-market ideology and acute sensitivity to the dangers of moral hazard from financial bailouts, but who toss that ideology overboard when faced with a financial crisis. The reference was to Treasury Secretary Henry Paulson’s lobbying this week in support of a rescue for Fannie Mae and Freddie Mac, the two big home mortgage agencies, following on the rescue of Bear Stearns. My reply was: “They say there are no atheists in foxholes. Perhaps, then, there are also no libertarians in financial crises.”
The tendency to believe in state intervention whenever there is a crisis is what I called The Faith Trap.
The Fannie-Freddie duopoly was not an emergent phenomenon of markets. It was a top-down creation of government. The bailout will be another top-down creation. Jeff concludes,
The lesson for government officials is that wherever they choose to draw the bailout line – one hopes the line strikes an intelligent balance between the short-run advantages of ameliorating a serious financial crisis and the longer-run disadvantages of moral hazard — they should think through the system ahead of time. They should take the appropriate regulatory precautions during the boom times, which correspond to the bailouts that will inevitably come during the busts.
I believe that it was William McChesney Martin who said that it was the job of the Federal Reserve Board to take away the punch bowl just when the party was getting good. In the case of Freddie and Fannie, the punch bowl wasn't the Fed's to take. It was up to Congress to take it. Instead, their focus was how to get some punch. Even the current housing bill includes a "user fee" on Fannie and Freddie to go to Congress' pet "affordable housing" cause.
I think that allowing Fannie or Freddie to fail would be a bad thing. But the bailout could well turn out to be worse.