in defense of doing nothing

A Quarterly Message on Liberty

Spring 2009Volume 7 Number 2

Jeffrey Miron is a senior fellow at theCato Institute and director of under-graduate studies in the department of economics at Harvard University.He spoke at the 21st Annual Cato Institute Benefactor Summit onMarch 5, 2009.

ot so long ago, the U.S. economy was the envy of the world. As of September 2007, we had ex-perienced 24 consecutive quarters of positiveGDP growth. The stock market stood at histori-

cally high levels, and inflation and unemployment were lowand stable.

Things look different today. The U.S. economy is in reces-sion, as is the economy of most every nation in the world.Many forecasters predict a domestic downturn on par withthat of 1981–1982; some talk of another Great Depression.

Meanwhile, we’ve experienced a huge range of interven-tions in the economy. We’ve seen the bailout of the Wall Streetbanks and the passing of a massive stimulus bill. We’ve seencoordinated interest rate cuts, expansions of deposit insur-ance, and government ownership stakes in banks. The statedaim of these policies when they were debated was to stave off acredit crunch and recession, but we got both anyway. Now, theclaim is that they will prevent a bigger credit crunch or reces-sion than we would otherwise experience. I’m not so sure.

JEFFREY MIRON

N

In Defense of Doing NothingIn Defense of Doing Nothing

2 • Cato’s Letter SPRING 2009

Today, I’ll make the case fordoing nothing. More pre-cisely, I will argue that had

the federal government not under-taken any new policies in response tothe economic downturn, we wouldbe better off than we are now. I willfurther argue that if a stimulus wasnecessary, it should have come fromtax cuts and scaling back failed gov-ernment programs, not new govern-ment spending.

WHAT WENT WRONG?What caused the economic crisis?Although securitization, failures atrating agencies, and greed on WallStreet all played a role, at the root ofthe crisis, ultimately, were misguid-ed federal government polices.

The first of these was the at-tempt to expand homeownership.Let me begin by saying that govern-ment has no business taking astand on how many people should

or should not own homes, just as ithas no business trying to influencehow many toaster ovens we buy.There is no plausible market failurein the production of housing or inpeople’s decisions about whether tobuy homes. Yet government hasbeen interfering for decades.

A partial list of policies designedto increase homeownership includesthe Federal Housing Administra-tion, the Federal Home Loan Banks,Fannie Mae, Freddie Mac, the Com-munity Reinvestment Act, the de-ductibility of mortgage interest, thehomestead exclusion in the personalbankruptcy code, the tax-favoredtreatment of capital gains on hous-ing, the HOPE for Homeowners Act,and, most recently, the EmergencyEconomic Stabilization Act—alsoknown as the bailout bill.

The U.S. government’s pro-hous-ing policies did not have major dele-terious effects for decades. The rea-son is likely that the interventions in part substituted for activities theprivate sector would have undertakenanyway, such as providing a second-ary market in mortgages.

Over time, however, these mildinterventions began to focus on increased homeownership for low-

income households. In the1990s, the Department of Hous-ing and Urban Developmentramped up pressure on lendersto support affordable housing.In 2003, accounting scandals atFannie and Freddie allowed keymembers of Congress to pres-sure these institutions into sub-stantial risky mortgage lending.

By 2003–2004, therefore, federalpolicies were generating strong in-centives to extend mortgages to bor-rowers with poor credit characteris-tics. Financial institutions respondedand created huge quantities of assetsbased on risky mortgage debt.

This expansion of risky creditwas especially problematic because

There is no plausible market failure in the production of housing, nor in people’s decisionsabout whether to buy homes.

““

SPRING 2009 Cato’s Letter • 3

of the second misguided feder-al policy, the long-standingpractice of bailing out failuresfrom private risk-taking. Bail-outs have occurred often andwidely, especially in the bank-ing sector. In the context of therecent financial crisis, a crucialexample is the now infamous“Greenspan put,” the Fed’s practiceunder Greenspan of lowering inter-est rates in response to financial dis-ruptions in the hope that expandedliquidity would prevent or moder-ate a crash in asset prices. In theearly 2000s, in particular, the Fedappeared to have made a consciousdecision not to burst the housingbubble and instead to “fix things” ifa crash occurred.

The banking sector’s history ofreceiving bailouts meant that finan-cial markets could reasonably haveexpected the government to cush-ion any losses from a crash in riskymortgage debt. Since governmentwas also exerting pressure to ex-pand this debt, and since it wasprofitable to do so, the financialsector had every reason to playalong. It was inevitable, however,that at some point a crash wouldensue. The expansion of mortgagecredit made sense only so long ashousing prices kept increasing, butthis could not last forever. Oncehousing prices began to decline, themarket had no option but to sufferthe unwinding of the positionsbuilt on untenable assumptionsabout housing prices.

This interpretation of the finan-cial crisis therefore puts primaryblame on federal policy rather than

on Wall Street greed, inadequateregulation, failures of rating agen-cies, or securitization. These otherforces played important roles, but itis implausible that any or all wouldhave produced anything like the re-cent financial crisis had it not beenfor the two misguided federal poli-cies. Wall Street greed, for example,certainly contributed to the situa-tion, if by “greed,” one means prof-it-seeking behavior. Many on WallStreet knew or suspected that theirrisk exposure was not sustainable,but their positions were profitableat the time. Further, markets workwell when private actors respond toprofit opportunities, unless thesereflect perverse incentives createdby government. The way to avoidfuture crises, therefore, is for gov-ernment to abandon polices thatgenerate such incentives.

BAILING OUT THE BANKSThe Treasury’s bailout plan was anattempt to improve bank balancesheets and thereby spur bank lend-ing. The justification offered wasthat, as of early September 2008,major banks were facing imminentfailure because their mortgage-backed assets had declined rapidlyin value.

No one disputes that several

The expansion of mortgage credit madesense only so long as housing prices kept increasing, but this could not last forever.

“ “

banks were in danger of failing, but this does not justify a bailout.Failure is an essential aspect of capitalism. It provides informationabout good and bad investments,and it releases resources from badprojects to more productive ones.As noted earlier, housing prices andhousing construction were too highat the end of 2005. This conditionimplied a deterioration in bank balance sheets anda retrenchment inthe banking sector,so some amount of failure was bothinevitable and ap-propriate.

Thus, an eco-nomic case for thebailout needed toshow that failure bysome banks wouldharm the economybeyond what wasunavoidable due tothe fall in housing prices. The usualargument is that failure by onebank forces other banks to fail, gen-erating a credit freeze. That out-come is possible, but it does notmean the Treasury’s bailout planwas the right policy.

To see why, note that allowingbanks to fail does not mean the gov-ernment plays no role. Federal de-posit insurance would prevent lossesby insured depositors, thus limitingthe incentive for bank runs. Federalcourts and regulatory agencies (suchas the FDIC) would supervise bank-ruptcy proceedings for failed institu-tions. Under bankruptcy, moreover,the activities of failing banks do not

necessarily disappear. Some contin-ue during bankruptcy, and some re-sume after sale of a failed institutionsor its assets to a healthier bank. Inother cases, merger in advance of failure avoids bankruptcy entirely.Private shareholders and bondhold-ers take the losses required to makethese mergers and sales attractive tothe acquiring parties. Taxpayer fundsgo only to insured depositors.

The bailout dis-tracted attentionfrom the fact thatgovernment was thesingle most impor-tant cause of the cri-sis. More broadly,the bailout will con-tinue to encourageperverse actions byinstitutions that areeligible for themoney, such as ac-quiring toxic assetsthat the Treasury

might buy or taking huge risks withTreasury capital injections.

The Treasury bailout of 2008 alsoinitiated a government ownershipstake in the financial sector. Thismeans that, going forward, politicalforces are likely to influence deci-sionmaking in the extension of cred-it and the allocation of capital. Gov-ernment might (again) push banksto aid borrowers with poor credithistories, to subsidize politically con-nected industries, or to lend in thedistricts of powerful legislators. Gov-ernment pressure is difficult forbanks to resist, since governmentcan threaten to withdraw its owner-ship stake or promise further injec-



tions whenever it wants tomodify bank behavior. Further,bailing out banks sets a prece-dent for bailing out other industries. Thus, the long-runimplications of the bailout areunambiguously bad.

Ironically, the bailout itselfmay have exacerbated the creditcrunch. The announcementthat the Treasury was considering abailout likely scared markets by sug-gesting the economy was worse thanmarkets recognized. Likewise, the an-nouncement may have encouraged acredit freeze because bankers did notwant to realize their losses or selltheir institutions to acquiring firmsif government was going to get themoff the hook. The bailout introduceduncertainty because no one knewwhat the bailout meant: how much,what form, for whom, with what re-strictions, and for how long.

THE STIMULUSThe American Recovery and Rein-vestment Act of 2009—better knownas the “stimulus”—represents a mas-sive transfer of resources away fromthe private sector to politically con-nected interest groups. The fundswill come from our taxes and flow tothe education sector, the health caresector, the creation of “green jobs,”and federal contractors and unions.

Some proponents argue that thestimulus money was needed to em-bark on projects that are not beingsupported by the market but shouldbe. This is the “market failure” argu-ment for government spending. Infact, federal spending is already toohigh in most areas. From the $15

billion we spent on the failed Big Digin my town of Boston to tens of bil-lions we spend per month fightingin Iraq, there’s plenty of ill-conceivedgovernment spending to be cut. Thespending that was included in thestimulus bill went in many cases tosectors that are neither facing espe-cially high unemployment nor expe-riencing the worst declines in activity(e.g., health care, education, alterna-tive energy development).

The stimulus was not about im-proving economic efficiency butabout distributing funds to favoredinterest groups. If the administra-tion was really concerned about edu-cation, for example, it should havepromoted policy changes that im-prove outcomes while saving money,such as reduced restrictions on whocan become a teacher. The adminis-tration instead chose to shovelmoney to the teacher’s unions.

Part of the stimulus bill came in the form of tax cuts, but thesewere mainly one-shot cuts aimed atredistribution rather than improvedeconomic efficiency. Although shift-ing money to private citizens andaway from government is a goodthing, repeal of the corporate in-come tax would have improved

“The stimulus was not about improving economic efficiency but about distributingfunds to favored interest groups.

“Continued on page 7


You’re a veteran cable news host, most recently of MSNBC’s Tucker. Now that youhave the freedom to go beyond the soundbite in making your arguments, what do you plan to say?I have no intention of giving up the soundbite. It has served me well for a long time. Thelast thing Washington needs is more windy,imprecise answers to things. If everyone inpolitics was forced to speak in clear, short sen-tences, I suspect you’d see far less nonsensecoming out of Congress.

So I plan to make the same case I’ve alwaysmade: for personal liberty; against collec-tivism in all its forms. And I plan to make it inthe same way I always have, except with fewercommercial breaks.

Tell it like it is. Is there bias in the media?Of course, and there always has been. Mostjournalists are lifestyle liberals, but their biasesextend beyond politics. They favor the new overthe old, the trite over the deep, the simple and

dramatic over the complicated and nuanced. It was this way 30 years ago when my father was in journalism. Thirty years from now those biases will almost certainly remain. What haschanged is the undisguised partisanship. Re-porters didn’t used to be allowed to root openlyfor a candidate, much less weep with joy on television when he won. Unfortunately thatchanged with Obama.

You’re in the process of writing a book. Canyou give us a preview?I’ll be spending the next several months cata-loging all the many ways the modern statehas made us less free. Once you give politi-cians the power to decide what sort of toiletyou’re allowed to use—and we have—there’svirtually nothing they can’t make you do, as the Obama administration is swiftly mak-ing clear. I can’t promise an uplifting read.Bracing is what I’m aiming for. But I do thinkit’s worth describing the problem in detail,unpleasant as it may be.

Cato Scholar Profile:TUCKER CARLSONTUCKER CARLSON is a senior fellow at the Cato Institute. Previously, hewas the host of MSNBC’s Tucker, and before that, PBS’s Tucker Carlson:Unfiltered and CNN’s Crossfire.

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long-run incentives and created the founda-tion for economic growth in the future. Al-ternatively, the stimulus could have takenthe form of lower employment taxes, whichwould have encouraged more hiring.

PEERING INTO THE LOOKING GLASSPresident Obama’s new budget is at leasthonest; it is an unapologetic attempt to restructure the U.S. economy and expandthe role of government.

The budget forecasts that have come fromthe administration appear extremely opti-mistic. In particular, the extra revenue beingprojected from repealing the Bush tax cuts understates the dynamic response of the econ-omy to this higher rate. Faced with highertaxes, people will cut back on their work orwithdraw from the labor force. On the spend-ing side, the new initiatives will surely cost

many times as much as projected; that is theiron law of government spending. Combined,if Obama enacts half of what he has slated, wewill see trillion-dollar deficits for years to come.

The stunning thing about the proposedbudget is that nothing announced looks likeit will improve the efficiency of the economy.Nothing looks like it’s in the direction of free-dom or liberty. Nothing looks like it has anyfaith whatsoever in markets. It’s all about re-warding interest groups: unions, the greenlobby, the education lobby, and the healthcare sector.

To sum up, the crisis was at its most fundamental level the result of governmentpolicies, not market failures. The governmentpolicies adopted have been misdirected, atbest. The lesson for policymakers is thereforeclear; it is better to do nothing than to makethings worse. In economics, as in medicine,the dictum is “first, do no harm.”

Continued from page 5

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