Bailouts are debatable, but nothing new

Associated Press / September 22, 2008
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CHICAGO - The stock market plummets, investors pull out money, and loans dry up, triggering global financial turmoil. Enter the government, buying up bad mortgages and other problem assets.

This scenario from the 1930s sounds eerily current, in part because the Bush administration is taking pages from the playbooks Herbert Hoover and Franklin D. Roosevelt used to keep Americans from losing their homes three-quarters of a century ago.

From the Great Depression to the savings and loan crisis that cost taxpayers $125 billion in the 1990s, the current administration has many government interventions from which to learn. If history holds any single lesson, however, it's that the outcomes are unpredictable and the problems will take years to work out.

"Some of these measures have been effective in propping up the economy at times when our private sector needed a little help," said Scott Anderson, senior economist at Wells Fargo Economics. "And that's the role of the government. But in the long term there are negatives."

Some rescues have worked but have turned out to be "pouring money down a rat hole," said economist Sam Peltzman, citing the 1971 bailout of Lockheed Aircraft, which kept Lockheed afloat through $250 million in government loan guarantees. Critics say the government set a poor precedent of rewarding corporations that ran their businesses inefficiently.

"The individual cases can work out well," said Peltzman. "But in the long run you're just laying the groundwork for more because you're giving people an incentive to take too much risk."

While the government stepped in to resolve banking panics several times in the nation's first 150 years, 20th century precedents are heeded more closely - none more so than the country's worst financial meltdown.

A student of the Depression, Federal Reserve chairman Ben Bernanke well knows that the government's slowness to step in following the Crash of 1929 is often blamed for contributing to what turned out to be a full decade of misery. By the time the government took comprehensive action, unemployment was 25 percent, much of the steel business had disappeared, and thousands of homeowners a week were losing their houses to banks.

The Hoover administration created the Reconstruction Finance Corp. in 1932 to spur economic activity by first lending money to financial, industrial and agricultural institutions, then injecting capital into thousands of banks by investing in their preferred stock.

The RFC fared well financially and did not ultimately prove a costly burden for taxpayers, said Richard Sylla, financial historian and economist at New York University. By the time it closed in 1957, it had made loans of about $50 billion.

The same held true for Home Owners' Loan Corp., started under FDR in 1933. It helped stop a flood of foreclosures by buying $3 billion worth of defaulted mortgages and refinancing more than a million loans at lower rates and longer terms.

The government also created the Federal Deposit Insurance Corp. the same year, guaranteeing the safety of checking and savings deposits in member banks.

The notion of the government putting taxpayers on the hook for a huge financial burden was not popular at first.

"The 1930s reforms were detested at the time," Sylla said. "But later on people said they really were pretty good."

The 1970s and '80s brought a series of government rescues of corporations - including Lockheed and Continental Illinois National Bank and Trust - but none was more heralded than the 1979 bailout of Chrysler Corp. The nation's 10th-biggest company had fallen into near-collapse amid high oil prices that tanked demand for its big cars, and the Carter administration arranged for $1.2 billion in subsidized loans. That spurred a Chrysler comeback and ultimately netted a profit for the government.

But Barry Ritholtz, CEO of the research firm FusionIQ, argues it actually helped cause the decline of the auto industry. Automakers kept on doing business as usual after the rescue, rather than learn a needed lesson.

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