Thomas Sowell on the Bailout

by Don Boudreaux on September 30, 2008

in Current Affairs, Financial Markets, Government Intervention, Politics, Reality Is Not Optional, Regulation, Seen and Unseen

Thomas Sowell’s latest is spot-on.

Here’s an excerpt:

N. Gregory Mankiw, his {Pres. George W. Bush’s] Chairman of the Council of Economic
Advisers, warned in February 2004 that expecting a government bailout
if things go wrong "creates an incentive for a company to take on risk
and enjoy the associated increase in return."

Since risky investments usually pay more than safer
investments, the incentive is for a government-supported enterprise to
take bigger risks, since they get more profit if the risks pay off and
the taxpayers get stuck with the losses if not.

The government does not guarantee Fannie Mae or Freddie Mac,
but the widespread assumption has been that the government would step
in with a bailout to prevent chaos in financial markets.

Alan Greenspan, then head of the Federal Reserve System, made
the same point in testifying before Congress in February 2004. He said:
"The Federal Reserve is concerned" that Fannie Mae and Freddie Mac were
using this implicit reliance on a government bailout in a crisis to
take more risks, in order to "multiply the profitability of subsidized

(HT Walter Williams)

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dave smith September 30, 2008 at 12:19 pm

So the bailout caused the crisis.

I wish we had an economic literate citizenry and congress that would understand this fact.

Crusader September 30, 2008 at 1:26 pm

As usual Professor Sowell is the calm voice of reason in a nation full of shrill harpies. The anti-McCardle.

Randy September 30, 2008 at 2:39 pm

Just thinking… the reason that the stock market fell when the bailout failed is that the market had already priced in the prospect of a government bailout. Still thinking… that for that reason alone, the bailout should be stopped. A market that has priced in government support is a market that the government owns, and a market that has little understanding of risk other than political risk.

Speedmaster September 30, 2008 at 3:07 pm

God bless Drs. Sowell and Williams … two wonderful and brilliant men. I read everything they write.

Ray G September 30, 2008 at 6:09 pm

On the market; I explained it to some coworkers today like this.

John, my coworker, likes to bet the football games. So if he is wanting to bet on an upcoming game, and the star QB from team X is rumored to not be playing, John is going to withhold his bet until he knows for sure, or if his hand is forced prematurely, he might go small, and spread thin.

Uncertainty is what the market hates. Everyone was already convinced of the bailout being voted in, that the market – as noted above – had already factored it in to their plans.

Any market watcher has seen the Dow rise on supposedly bad news. This always confounds the "experts" but the market had already factored in the bad news, and was simply waiting to get past that small point of uncertainty.

Methinks September 30, 2008 at 7:28 pm

Well put, Randy.

Charlie October 1, 2008 at 10:10 am

I don't mind the analysis, but no one ever seems to extend it to a realistic time inconsistency. The GSEs weren't given implicit backing just because they were originally government organizations. A whole host of completely private corporations have implicit backing due to systemic risk and political realities. The problem is, though, that Walter Williams can't wish these realities a way. The government can't credibly precommit to a no bailouts policy, because by the time the government has the opportunity to choose a no bailouts policy it will have to take on an increased chance of systemic risk.

Thus, the market knows that there is an implicit bailout (though it doesn't know exactly what it will be) and because it acts that way, the government will be forced to choose bailout.

The only answer is to regulate on the front end. The government should not allow the market to hold it hostage through systemic risk.


Hammer October 1, 2008 at 11:14 am

So… just because corruption happens sometimes, it is pointless for the government to not at least try to avoid corruption? Sorry Charlie, but your post seems to wrap around itself, saying regulation is good because the government might bail companies out sooner or later, and thus should bail them out.

DJS October 1, 2008 at 10:08 pm

It is bad enough to create moral hazard as Sowell explains, but it helps to have a match to ignite. Pray tell, Mr. Greenspan, there wouldn't be any connection between the current mortgage crisis and the Fed's super-loose monetary policy in the wake of 9/11, would there?

Charlie October 1, 2008 at 10:44 pm


Here is Greenspan taking the argument to it's logical conclusion in 2004 (

Sorry it is so long. I've cut it down a lot.

"The GSEs' special advantage arises because, despite the explicit statement on the prospectus to GSE debentures that they are not backed by the full faith and credit of the U.S. government, most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt. An implicit guarantee is thus created not by the Congress but by the willingness of investors to accept a lower rate of interest on GSE debt than they would otherwise require in the absence of federal sponsorship."

"The Federal Reserve is concerned about the growth and the scale of the GSEs' mortgage portfolios, which concentrate interest rate and prepayment risks at these two institutions. Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage. Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt."

"As always, concerns about systemic risk are appropriately focused on large, highly leveraged financial institutions such as the GSEs that play substantial roles in the functioning of financial markets. I should emphasize that Fannie and Freddie, to date, appear to have managed these risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.
As a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. However, the existence, or even the perception, of government backing undermines the effectiveness of market discipline. A market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties' strength. However, many counterparties in GSE transactions, when assessing their risk, clearly rely instead on the GSEs' perceived special relationship to the government. Thus, with housing-related GSEs, regulators cannot rely significantly on market discipline. Indeed, they must assess whether these institutions hold appropriate amounts of capital relative to the risks that they assume and the costs that they might impose on others, including taxpayers, in the event of a financial-market meltdown. The issues are similar to those that arise in the context of commercial banking and deposit insurance–indeed, they are the reason that commercial banks are regulated and subject to stringent regulatory capital standards."

"In sum, the Congress needs to create a GSE regulator with authority on a par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear process sanctioned by the Congress for placing a GSE in receivership. However, if the Congress takes only these actions, it runs the risk of solidifying investors' perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt. The GSEs will have increased incentives to continue to grow faster than the overall home mortgage market. Because they already purchase most conforming mortgages, they, like all effective profit-maximizing organizations, will be seeking new avenues to expand the scope of their operations, assisted by a subsidy that their existing or potential competitors do not enjoy.
Thus, GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold. Fannie and Freddie should be encouraged to continue to expand mortgage securitization, keeping mortgage markets deep and liquid while limiting the size of their portfolios. This action will allow the mortgage markets to support homeownership and homebuilding in a manner consistent with preserving the safe and sound financial markets of the United States."


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