Government has distorted our economic choices. Through pumping irrational amounts of liquidity, the economy has stabilized for the moment. However, we live in a post apocalyptic financial world wherein this interference has created perverse incentives. Some examples:
- Free Car Rentals from GM
Why rent a car from Avis or Hertz? GM, now owned by the US government and financed through its generous checkbook, permits a buyer to drive a newly purchased car for 60 days, travel up to 4,000 miles and return the car for a full refund for any reason (GM 60-Day Satisfaction Guarantee). Doesn’t this put non-government owned auto manufacturers at a significant disadvantage?
- Can’t Qualify for a Private Mortgage? Try the FHA
To stem the decline in house prices, the FHA has stepped in to make loans that no sensible private party would make. Buyers can put as little as 3.5% down. (In “What does the FHA think it is doing?” – One buyer borrowed from her retirement account to fund the 3.5% down payment). Didn’t we get into the financial crisis through sub- prime lending? As a footnote, a former FHA official projects the agency is more than $54b underwater on its portfolio and is expected to need a major taxpayer bailout.
- Why Lend Money When You Can Earn Risk Free Returns Courtesy of the Fed?
The Federal Reserve has adopted a zero interest rate policy and promises to keep it in place for an extended period of time. Complementing its zero interest rate policy, the Fed now pays interest on excess reserves kept on deposit with them. In a recessionary economy it is risky to lend money to private borrowers. Why lend in the real economy, when you can borrow at zero percent, redeposit the money to earn interest on these Fed reserves, and pocket the differential? This risk free maneuver is a disincentive for banks to lend to borrowers. Isn’t the Obama administration trying to stimulate the real economy through lending? See Fed’s Zero Rate Policy Sparking Complaints and Banks are Not Lending? So What
- Why Return to Prudent Investing or Compensation Policies When You Have a Government Guarantee?
The “Too Big to Fail” institutions have a federal guarantee if they get into trouble. If you are socializing losses through government guarantees and leaving profits in private hands, the real world result is excessive risk taking and reckless speculation. Merely look at the rising “value at risk” (the amount of money a firm could lose in one day of trading) at firms like Goldman Sachs and you see a microcosm of capitalism run amok. Why not leverage up and speculate in the commodity markets when the government is the ultimate underwriter of risk? Excessive leverage was one of the triggers for the financial crisis. These activities have returned and have possibly exceeded pre- crisis levels.
Excessive risk taking has led to record bonuses on Wall Street. Prudence would suggest reinvesting profits in the firm instead of record payouts. Why be prudent if the government is your guarantor?
- On the Verge of Bankruptcy? Why Not Raise CD rates?
If you are a financial institution in trouble, why not offer CD rates far in excess of your competition? In a world where the FDIC effectively guarantees these CDs, there are no limits on offering CD rates to attract deposits. Just before Washington Mutual became effectively insolvent, it offered CDs way above market. Only the taxpayers have to worry about any future losses.
Conclusion
When the government intervenes in the real economy, the laws of economics and prudent business practice are suspended. This is all done in the name of “saving the economy.” I have highlighted some of the perverse incentives. I am sure there are more and more will develop with continued government meddling. Is it worth it? If I am a taxpayer underwriting financial follies, I might want to express my disapproval to my elected representatives.
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