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Our Muddled Masses

Fri, 01 Jan 2010 00:00:00 -0500

It would appear that America needs a miracle to escape the “new normal” of low growth. We know of no means to induce miracles, but there is a next best thing. Perhaps it is not accidental that the Holy Land was called the land of milk and honey rather than gold and oil. You need skilled farmers to manage the capital of bees and herds properly, to assure living from their returns only while not using up the capital.

Behind the seeming miracles of economic history, we uncover a common thread: the sudden arrival of skilled immigrants. “Short of admitting a few million skilled, entrepreneurial immigrants,” David P. Goldman and I wrote in an earlier essay (“The Needle’s Eye,” December 2009), America must increase savings, investment, and exports to climb out of its economic slump. Innovation can multiply the effect of savings and investment, however. To get innovation, one first needs innovators. That is one reason that the immigration issue should be at the top of the national agenda: The right immigration policy will contribute mightily to America’s prospects for recovery. There is also this: American immigration policy threatens to become an economic as well as a humanitarian catastrophe.

Without innovation, America faces prolonged stagnation. The outlook seems bleak. Between 1988 and 1998, manufacturing productive growth rose from less than 2 percent to more than 5 percent per annum. By 2008, it had fallen back to the 2 percent range as the great wave of innovation abated. This outcome is not inevitable, however. America has been obtaining a disproportionate flow of skilled innovators by attracting these “vital few” to its shores. Without their contribution, America may neither sustain the economic growth required to absorb the penurious many nor raise their standards of living. The impact of the vital few does trickle down.

The problem lies in policy. American sentiment toward immigrants has swung from boomtown hospitality to churlish xenophobia in the course of the present recession. The burden of illegals is blamed for at least part of the budget crisis in states such as Arizona and California. As state budget problems worsen, people with the least clout will be pushed aside: When a state is facing cold budget cuts, foreigners get less sympathy. California is considering a ballot initiative to refuse state benefits to the children of illegal immigrants, and local governments in some jurisdictions are using extralegal means to drive immigrants out. The latter happened in Arizona, where a sheriff known for hard-line immigration enforcement vowed to press ahead with an illegal immigrant sweep, defying a revised Department of Homeland Security policy that took away his federal authority to make such arrests.

It is hard to blame opponents of immigration. Earlier this year, the Pew Hispanic Center reported that California’s estimated 2.7 million illegal residents”7 percent of the state’s population”add $4 billion to $6 billion in costs. Cutting off state payments for the American-born children of immigrants supposedly would save about $640 million a year. By similar estimates, Arizona’s illegal immigrant population is costing the state’s taxpayers about $1.3 billion per year. Whether these estimates are exact or only in the ballpark, it is clear that poor migrants drain state finances under the present institutional and regulatory landscape, and the drain is substantial.

The consequences of such flows of migrants are not “economic miracles,” even if historians label them as such: They are predictable, and they depend, almost without exception, on the rapid absorption of talented immigrants. The implications for today should be clear: The world is training more talented and ambitious young people than at any time in human history. Where the best of them choose to live and work will have a dominant effect on comparative well-being for both the poor and the rich, and tolerance”a significant advantage of the United States”is key to such choice.

America still is better positioned to create such miracles than are most other places. The obstacle to bringing in and retaining the vital few lies in a combination of present wrong-headed immigration policy and domestic institutions that have not been adjusted to the increased mobility of people”and the flow of migrants in particular”since the fall of the Berlin Wall twenty years ago. But would-be migrants’ opportunities at home are growing, and America’s ability to continue to attract talent is hindered by a misguided immigration policy. This is illustrated, in part, by the fact that, at present, applications by American businesses for specialized work visas for immigrants have a backlog of over five million.

This situation is the consequence, in part, of the present seemingly unbridgeable gap within the United States between, on one side, humanitarian concern and, on the other, budgetary soundness and the rigidity of institutional arrangements that came into being in the less mobile world before the fall of the Berlin Wall. President George W. Bush failed to find a compromise position between the opposing camps, and the Obama administration has avoided treading in the minefield for the moment. A sound basis exists, however, for a solution that will preserve America’s role as an immigrant nation while strengthening, rather than overtaxing, its people. Immigration opponents must be dissuaded from barring the door against their own best interests. Immigration advocates may have to acknowledge that to make room for the many, America must tilt immigration toward the vital few whose contribution to economic growth is disproportionately high.

No other political issue today seems to attract as much passion founded on uninformed opinion as does the topic of migration, and no political issue is of such consequence to America’s economic future. In the absence of leadership on immigration policy, the matter will be resolved brutally and hurtfully, as the trends in California and Arizona suggest. With Washington immobile on this issue, states and cities are taking matters into their own hands under conditions of crisis; the consequences of this are dire, not only for illegal immigrants, but also for the United States. Such paths of least resistance lead to a vicious circle in which economic stagnation nurtures xenophobia, and hostility toward immigration stifles innovation by inducing the vital few to seek more tolerant shores.

The global exchange of human capital influences economic outcomes as much as the exchange of financial capital. Because it is easier to regulate the exchange of human capital, though, the world has been slower to adapt to this reality. Until the 1990s the large industrial democracies enjoyed a monopoly on both kinds of capital. Money and top talent, the latter often nurtured in the global south, had only the industrial north as a prospective destination. And capital and talent within the dozen Western democracies could move mainly among those nations, mostly in response to fiscal and regulatory changes. But while capital markets became more fluid among the Western countries, the movement of people among them remained restricted, and the Unites States stood out as having the most democratized capital markets. This allowed for the best matching of capital and talents, no matter where the latter came from.

As a result, the cream of the Asian crop, the greatest addition to the world’s talent pool in history, found superior training as well as superior opportunity for entrepreneurship and employment in the United States. The contribution of highly skilled immigrants to America’s tech boom and the productivity surge of the 1990s is well documented. A quarter of high-tech firms in the United States had at least one Asian founder. Foreign-born students still receive more than three-fifths of all engineering PhDs granted in the United States. There is nothing new in such trends.

The miracle of seventeenth-century Europe was neither Spain nor Portugal”both of which fit the “finding oil and gold” mold”but Amsterdam, in Holland, a city and country whose riches were created despite an endowment of natural disasters, the land being below sea level. Later, in the twentieth century, there was West Germany, rising miraculously from the ashes of World War II. There are more recent miracles such as Hong Kong, Singapore, Israel, and Dubai. These miracles have some common features, the migration to their shores of critical masses of the vital few”human capital not given opportunities in their countries of origin”being one of them.

The Dutch formed the first European republic, a nation tolerant toward all religions (while the rest of Europe still discriminated severely against many) and with sound rights to property. These factors opened opportunities for relatively unhindered trade and financial innovation. But it would be misleading to say that “the Dutch” performed this economic miracle. There was globalization during the seventeenth century, even if nobody bothered to use the term. The Dutch did not make this miracle: Seventeenth-century fishermen did not become bankers and financiers within ten years. Immigrants”Jews thrown out of Spain and Huguenots thrown out of France prominent among them”brought about the miracle.

The histories of Israel, Hong Kong, Singapore, Taiwan, and West Germany have much in common with that of Amsterdam. In each of these places, the state provided a relatively decent umbrella of law and order compared with what was offered by neighbors. This gave people a greater stake in what the business society was doing: attracting immigrants and entrepreneurs from around the world. In turn, the influence of these critical masses of talent radiated around the world and made people richer in distant places, too. Other places such as Malaysia and even Australia and Europe, as hard as their governments have tried with massive investment funds to create venture capital, have not been as successful. You need the vital few in a tolerant environment to properly deploy that capital. If a place does not attract them, governments create statistical venture capital but not real capital. It’s the ability to attract and retain talent that sheds light on the above miracles.

Sir Stamford Raffles designed Singapore as a port at the beginning of the nineteenth century and backed it with an administrative, legal, and educational system that was open to its multiracial population of Chinese, Malays, and Europeans. Taiwan (after the seventeenth century), Singapore, and Hong Kong offered immigrants opportunities denied them in the Chinese hinterland, which was dominated at first by warlords and a status-conscious bureaucracy and later by a communist bureaucracy. Hong Kong benefited from waves of emigration from China, in particular from the inflow of Shanghai merchants and financiers when Mao Zedong “liberated” China in 1949. The arrival of these immigrants, an approximation of a flat tax, and a relative lack of local politics certainly helped Hong Kong. Now the present Chinese diaspora of about 55 million brings its network and know-how back to the more open China of today.

The post“World War II West German miracle fits this pattern, too, although in popular memory its success is associated more with the Marshall Plan, which is often used as an example of a particularly successful government policy. Behind this miracle, though, was a large transfer of talent: From 1945 to 1961, Western Germany accepted 12 million immigrants, for the most part well trained”a transfer of human capital relative to which the Marshall Plan assistance becomes rather insignificant. About 9 million of these immigrants were Germans from Poland and Czechoslovakia; 2.5 million more escaped from East Germany between 1949 and 1962. Many were destitute but had their skills.

Since 1990 Israel has done spectacularly”wars, terror, and relatively high taxes notwithstanding. Many observers have suggested ways to emulate what was done there; but, for the most part, no country can, simply because there is no other country that would accept a 20 percent addition to its population within three years, which is what Israel did. In fact, the accumulation in Israel of debts and deficits at the time of the Russian immigrants’ arrival between 1989 and the early 2000s led to a radical financial deregulation, lowered taxes, and privatization, because the government realized that there was no other way to absorb a million people. Before 1990 Israel had no venture capitalists, and there were no Israeli equity offerings on United States stock exchanges. In 1990“91 the total amount of venture capital raised in Israel was a meager $58 million. By 1996 more venture capital”$421 million”was flowing to Israel than to any other country except the United States.

Today Israel’s venture capital industry still raises more funds than any other venue except the United States. In 2006 alone, 402 Israeli hi-tech companies raised over $1.62 billion”the highest amount in the past five years. That same year, Israel had 80 active venture capital funds and over $10 billion under management, invested in over 1,000 Israeli start-ups. By 2007, with 71 companies listed on NASDAQ, Israel had become second only to the United States, having leapfrogged now third-place Canada.

Israel was the beneficiary of immigration “shock.” Of the million Russians who moved to Israel during the 1980s and 1990s, more than 55 percent had postsecondary education, and more than half held academic and managerial positions in their former country. Fifteen percent were engineers and architects, 7 percent were physicians, 18 percent were technicians and other professionals, and 8 percent were managers. By 1998 Israel had 140 scientists and engineers per 10,000 members of its labor force. This made Israel the world leader in the scientist and engineer workforce, followed by the United States with 80 and Germany with 55 scientists and engineers per 10,000 members of its labor force. The influence of Israel’s scientists and business leaders radiates now around the world, to Russia and Eastern Europe in particular.

At the height of the last tech boom in 1999, Chinese and Indian engineers were at the helm of 24 percent of the technology companies started in Silicon Valley. Recent updates of that study show that 60 percent of PhDs in engineering in the United States are awarded to foreign nationals. Of that percentage, about 85 percent of those of Indian and Chinese origin are still in the States five years after graduation. Other statistics are perhaps even more revealing. In high-tech and engineering companies in the United States between 1995 and 2005:

• In 25.3 percent of the companies, at least one key founder was foreign-born.

• Of all immigrant-founded companies, 26 percent had Indian founders; 7 percent had founders of British and Chinese origin; 6 percent had founders from Taiwan; Japanese and German founders each led 5 percent; 4 percent had founders from Israel; 3 percent had founders from Canada; and 2.5 percent had founders from Iran.

• In Massachusetts the single largest founding group was Israelis, at 17 percent.

• Indian entrepreneurs dominated in New Jersey, leading 47 percent of all immigrant-founded start-ups.

• Immigrants also represented 24.2 percent of international patent applications filed from the United States in 2006. Chinese filed the largest number of patents, followed by Indians, Canadians, and British.

This is by no means a random sample of the migrating population: Immigrants from China and India constitute less than 1 percent of the American population. The above numbers show, statistically, why the issue is not simply one of counting immigrants with diplomas. Not all degrees reflect the same knowledge”or the same entrepreneurial spirit that wishes to seek out risk capital in the United States.

As the above cases show, the view that migration has a negative effect on the local population is false. Much depends on what type of migration we are talking about and under what conditions the migrants come. Attracting top human capital is a key because the place to which top human capital moves”or is expected to move and stay”will also be the place that will have no trouble attracting tangible capital as well. Both human and tangible capital increase the performance of teams and, in particular, the compensation of the relatively unskilled. And when all become richer, there is more to give to the poorer, whether within the United States or, through remittances, to those in the countries of origin of the vital few.

If this is the case, what is to be done?

Many of the policies that now hinder the flow of the vital few to the United States came into being in the more immobile world”a place of communist countries behind Iron Curtains and ruthless dictatorships in much of the rest of the world except the Western countries, Japan, and Australia”that came into being after Word War II and lasted until November 9, 1989, when the Berlin Wall fell. These policies no longer fit today’s more mobile world. Until they are changed, however”and the sooner, the better”the least the United States can do is try, explicitly, to attract the vital few to its shores and, at the same time, speed up the domestic production of talent. (This is achievable by reducing the number of years youngsters spend in school.)

Congress should first increase visas for skilled immigrants”those who would invest in their own entrepreneurial ventures in the United States in particular. Congress also should facilitate a temporary worker program, but without instantaneously bestowing on those workers the many monetary government benefits for which America’s already taxpaying citizens are eligible. For immigrants in the United States who do not have proper documentation but who have built up equity in this country, opportunities should be provided to obtain legalization if they can demonstrate good moral character. Such an “earned” legalization should be achievable and verifiable in an accountable manner.

The United States should pay special attention to its 100 million“population neighbor to the south. Once again, Mexico is heading backward: diminishing the legal channels available to its young, entrepreneurial, and willing-to-work-hard population and driving them either into desperate attempts to migrate illegally to the United States or into the entrepreneurial, although criminal, drug trade. Although the United States has tried almost every political option to induce Mexico’s leaders to democratize its capital markets and give better options to its youth, it has met with no success. There seems, however, to be another, peaceful option remaining that has not yet been pursued: allowing more young, hardworking, entrepreneurial Mexicans to move legally to the United States. Perhaps by so weakening Mexico’s tax base, some of that country’s leaders will come more quickly to their senses. Policies pursued at present, such as closing America’s borders to Mexico’s vital few, will induce the latter to move to South America and Spain, leaving the masses of relatively unskilled and destitute Mexicans behind”people who then may try desperately to get into the United States, walls or no walls. How does such a policy serve the United States’ interest over the long term? In short, it does not.

America’s economic policy at present amounts to reshuffling debt between public and private entities. It offers no remedy for the dismal “new normal” of minimal economic growth that America now confronts. Urgent economic self-interest as well as ethical demands require a fundamental change in immigration policy.

Reuven Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management and is author of The Force of Finance and A World of Chance.

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The Rule of Law and the Wealth of Nations

Sat, 01 Aug 2009 00:00:00 -0400

Fundamentals seem to cluster in foursomes. Classical alchemy had four elements, and classical medicine had four humors. Though it’s neither alchemy nor medicine, economics, too, turns out to have four elements that are helpful to think of when discussing remedies for restoring a country to health. In essence, it comes down to this: Restoration of economic health requires that risk capital and talent move from yesterday’s industries to tomorrow’s industries, and that someone must match them accountably.

There are four key terms that emerge from that statement: talent , capital , matchmakers , and accountability . Under normal conditions, venture-capital firms, banks, investment banks, leveraged-buyout firms, and asset-management firms make matches, offer risk capital, and bet on entrepreneurs or managers. The suppliers of capital also decide whether to terminate their investments or continue them when it takes longer than expected to bring such visions to life or when these visions turn out to be erroneous.

Capital markets thus both finance experimentation and, by holding the players accountable, prevent mistakes from persisting. The innovation on which prosperity depends stems from the experimentation of countless players”most of whom will fail. Out of the mass of failure and the occasional success, society somehow manages to thrive.

So what allows dynamic order to arise out of the seeming chaotic bets that drive economic growth? Although innovators change people’s patterns of behavior”using cell phones instead of watches, for example, or Googling rather than searching through papers”the rules that govern commercial life in general have grown stable over the years in the prospering countries. Who gets into existing markets and creates new ones (licensing and regulation) and who gets out (bankruptcy laws) came to be well understood and anticipated. Relative risks such as the rights of different investors became clear and protected by law. And, for investors to bet on risky ventures, there was access to low-risk assets for portfolio balance, insurance against falling behind.

There are thus preconditions for commercial matchmaking, and they all relate to the responsibilities of government. Guarding the entrance to the market is the first: Not just anyone can start a bank, for example. And just as there must be criteria for startups, so someone must be guarding the exits , through the criteria for bankruptcy, for example. Likewise, creditors and equity holders must be able to assert their claims on profits and assets, if necessary in courts of law. And, finally, there must be provision for risk-free assets ”typically from the government (Treasury debt, for example, and guarantees on deposits that promise no default), which has been a sine qua non of American finance since the first Treasury secretary, Alexander Hamilton, funded public debt”built on a solid, nondefaulting currency.

Private factors thus provide the four elements of talent, capital, matchmaking, and accountability, and government sets these four basic rules for entry into and exit from certain activities, rights of investors, and the provision of a risk-free asset, the latter anchoring prices and negotiations. With these preconditions in place, many independent sources finance many independent players betting on a wide range of ideas, some ending up creating products and services people want, and others ending in failure.

Confusing the responsibilities of the private markets and the government leads to misguided policies. Some analysts draw the dangerously wrong conclusion that the crisis of 2008 simply was a failure of capitalism. Judge Richard Posner, for example, recently argued that “the key to understanding is that a capitalist economy, while immensely dynamic and productive, is not inherently stable.” Whether a capitalist economy is stable or not might be a worthwhile topic for abstract speculation. But the events of 2008 shed no light on it, since what they actually tell is the story of what happens when governments neglect their responsibilities.

In a well-functioning market, the chances of all the players making the same mistake in the same direction is negligible. But systemic errors”errors in which a plurality of the players all err in the same direction”can and do occur when governments forget what makes a commercial society tick. This can occur suddenly, as in a communist revolution. Or it can occur imperceptibly over years, as during the past decade in the United States. Such governmental neglect of responsibilities prepared the ground for the present day, the worst American financial crisis since the Great Depression.

A review of what happened can help us see a path out of the present maze of confusion. The first responsibility of governments is to guard the entrance to the marketplace. During the past decade the Treasury and Federal Reserve let the equivalent of an alien entity take over the banking system.

Commercial banks were supposed to run leverage of about 12 to 1 on their credit books”that is, they were to put up $1 of shareholders’ capital for every $12 of risk assets on their books. Yet regulators let the financial industry run arbitrarily high amounts of leverage on the false premise that derivatives protected credit books against prospective losses. Rather than guarding the entrance of the marketplace, the government let barbarians in, with devastating consequences.

The regulators told the banks that, if the rating agencies assigned high ratings to certain assets (meaning that they were nearly default proof), banks could drastically reduce the amount of capital held against them. The banks then structured assets with the greatest chance of defaulting”such as subprime mortgages, junk bonds, and so forth”into packages to which the ratings agencies obligingly assigned AAA ratings. In addition, the regulators allowed the banks to hold these assets in off-balance-sheet structures, using a fraction of the capital they normally required. A boom in bank profits ensued. Shareholders demanded that bank managers maximize leverage so as to replicate more of these highly profitable endeavors, and boards, management, and regulators all succumbed. Seemingly arcane bits of bank regulation running in the background of the economy, far from the scrutiny of financial journalists or even the majority of securities analysts, transformed the financial system.

To make matters worse, a rapidly aging Asia and Europe, following an export-driven growth model, sought a secure destination for their savings. They poured capital into the United States’ capital markets, abetting the expansion of leverage to 6 percent of America’s gross domestic product. Wall Street created seemingly low-risk assets to exploit the new capital rules, and foreigners bought a substantial share of these presumably low-risk assets. The AAA-rated securities backed by subprime home mortgages, commercial mortgages, or lowest-grade junk bonds could not have been in the trillions and spread around the world if not for such imbalances. Indeed, as Federal Reserve Chairman Ben Bernanke observed in 2003, capital inflows kept U.S. interest rates lower than they otherwise would have been, feeding the availability of cheap credit and supporting the housing bubble. Sustaining a solid currency could have mitigated this impact of the capital inflows, but the Federal Reserve has abandoned that responsibility for long stretches of time (the dollar losing more than 95 percent of its value since the Federal Reserve’s creation in 1913).

It helps in this context to distinguish between two types of business. One type fulfills contractual agreements with the cash flows it generates. The second type digs for oil or searches for new technologies and has no cash flows until it makes a discovery. The latter kind of company normally sells equity to investors willing to accept uncertainty about future outcomes in return for the possibility of excess returns. It also can sell debt paying a very high coupon, so-called junk bonds , which are really a special kind of equity, a financing instrument fitting certain types of uncertain projects.

The financial technology of the past decade created trillions of dollars’ worth of structured bonds”in effect, attempting to do a magic trick by turning the inherently uncertain cash flows of junk bonds into the predictable cash flows of high-grade debt. Subprime mortgages, for example, are a kind of junk bond. Households with insufficient incomes, and often without prospects of securing good ones in the future, were not just granted entry into the market but were also helped (actively, though indirectly, by the mortgage agencies Fannie Mae and Freddie Mac) to speculate in housing on an unprecedented scale.

Home-mortgage debt relative to disposable personal income stood stable around 80 percent between 1957 and 2000 but jumped to 140 percent by 2007. The availability of adjustable-rate mortgages at very low interest rates prevailing in the early part of the decade allowed households to carry these much higher debt levels for a while. However, once the Federal Reserve raised the federal-funds rate from 0.5 percent in 2002 to 5.25 percent in 2007, households no longer could pay the higher debt burden. Meanwhile, financial institutions resold about 65 percent of the face value of the mortgages in the form of AAA-rated securities. This means that they sold the other 35 percent to investors who would absorb losses before any losses accrued to the AAA-rated securities.

Yet, since the Federal Reserve considers a AAA-rated security nearly defaultproof, it let banks use the spurious AAAs for more than 60-to-1 leverage, rather than the standard 12-to-1 leverage for loans. Today, many of the AAA-rated mortgage-backed securities backed by subprime collateral issued in 2007 are trading at around 25 cents on the dollar. Lower-rated securities backed by the same collateral, including securities originally rated AA, are trading at close to zero, and loss rates on many mortgage pools backing these securities are likely to reach 80 percent.

By accepting the rating agencies’ opinions as the criteria for the amount of leverage that banks could apply, the Federal Reserve turned the ratings agencies into a quasi-official monopoly. And by securitizing trillions of dollars of structured bonds on the strength of these ratings, the financial system put the ratings agencies into a pivotal position in the economy. The ratings agencies never grasped their new roles. On the contrary, they saw their monopoly position as a license to print money by issuing rubber-stamp opinions about structured product that they neither understood nor cared to understand. Meanwhile, in the case of the federally sponsored mortgage corporations Fannie Mae and Freddie Mac, the government made it cheaper for a while for anyone to speculate in the housing market.

That is how so much debt accumulated on U.S. balance sheets. The government abandoned its responsibilities. And the making of such mistakes has little to do with capitalism, with ingrained cycles, or some peculiar features of human nature. It has to do with amnesia about what constitutes the pillars of a commercial society.

This conclusion becomes even clearer when we examine how the government and the Federal Reserve managed to destroy other pillars as well. The next function to fail was the government’s responsibility to act as gatekeeper at the exit to the marketplace. Accountability and responsibility require bankrupt companies to be closed and fraud and incompetence are to be punished. That does not quite work, however, for financial institutions under our present banking system.

Individuals and firms thought money-market funds to be reliable substitutes for bank deposits: always available and invested heavily in structured securities as well as corporate commercial paper. Once it became clear that supposedly AAA-rated securities were in fact prone to default, money-market funds faced a run by fearful depositors, and the market for corporate commercial paper crashed as well.

The collapse of the structured securities market in July 2007 led to the collapse of Bear Stearns in March 2008, the failure of the government-sponsored mortgage guarantors Fannie Mae and Freddie Mac, and eventually the Lehman Brothers bankruptcy in September 2008, followed by the bailout of the nation’s largest commercial banks and the reincarnation of the remaining investment banks and of GMAC as bank-like institutions, with access to funds from the Federal Reserve. Capital markets, as we knew them, shut down. And asset prices predictably then crashed. Too many mistakes, too much mispriced debt.

When this happened, there was no alternative but for the government and the Federal Reserve to step in and become a financial intermediary. The intervention was needed because the mistakes suddenly exposed the fragility of the financial institutions’ funding mechanism. To restore it, the government had to insure the counterparty risks.

Whatever the reasons, at first the government did not, and it allowed Lehman Brothers to fail. Then the government suddenly did: Correcting this blunder of letting the edifice of counterparty claims collapse led then to the dramatic expansion of the Federal Reserve balance sheet and the Treasury’s bailing out the banks.

In truth, the government had no choice: Depositors had to be convinced that they were secure. Otherwise, the government would have failed in its responsibility of providing the default-free assets that are the foundation of commercial banking. We would have had a massive run on the system, and the vanishing liquidity would have been much worse than what we experienced. By guaranteeing bank deposits as well as a great deal of bank debt, and by purchasing more than a trillion dollars’ worth of securities, the government prevented a collapse of the financial system. That was not a matter of ideology or politics but of necessity.

Once government has the deciding vote in the financial system, however, one of two things can happen. Government can try to get out of the financial business and restore decision-making to the private sector. Or it can use its new power for political ends.
Public officials have more power when the access to capital markets decreases. People can access capital either through capital markets or the government. Except for resorting to crime and reliance on family and friends, there are no other sources.

Yet, relying on government and the Federal Reserve to access capital is not the same as relying on banks and other financial institutions. Bankers make decisions about who gets the loans, and on what terms, based on the ability of entrepreneurs and managements to carry on successfully. But a government’s decision to finance ventures”as in the case of the auto industry”is based on political clout.

Of course, political clout sometimes passes under the name of national interest , a phrase that bankruptcy judge Arthur Gonzalez used in his opinion concerning the objection of investors challenging the administration’s use of TARP money for Chrysler: He wrote that the U.S. government “made the determination” that it is in the “national interest to save the automobile industry, in the same way that the U.S. Treasury concluded that it was in the national interest to protect financial institutions.”

Using national interest as a criterion for financing has allowed politicians at all times and in every country to usurp the responsibilities of the private sector. It is happening again in the United States, and without much resistance, since the public’s attention has been focused on the failure of private financial institutions to correct their mistakes. This failure destroyed public trust in these institutions, especially since their mistakes were visible, whereas the mistakes of the government”without which the private sector could not have carried on with its own”were less visible.

Under these circumstances, it is not surprising that the public seems to put its trust in politicians, even though there is no historic precedent in which politicians successfully solved commercial problems. Even France’s François Mitterand gave up on the experiment of nationalized banks three years after starting it.

It is one thing for the government to maintain the functioning of the financial system by guaranteeing deposits and providing liquidity for well-collateralized loans and quite another thing for the government to pick commercial winners. Judge Gonzales’ inference was wrong: Protecting core financial institutions was in the national interest, but that does not imply that either the auto industry or any other industries qualify. The banking system is unique because the Federal Reserve can provide liquidity to the economy only through it. Deposit insurance and commercial banks’ access to the central bank’s lending windows give the banking system quasi-official status, even more so now that the Federal Reserve has increased its balance sheet by trillions of dollars, and the Treasury has provided trillions of dollars of equity in financing and loan guarantees as well.

The credit of the central government stands or falls with the credit of the banking system. That is why no Western government can allow the liquidation of commercial banks in deep recession, even one induced by an egregious accumulation of mistakes, even if the banks would be insolvent under regulatory capital requirements. That is why the big commercial banks had to be bailed out, while ordinary businesses had to suffer”ordinary businesses that lacked the autoworkers’ political clout, that is.

The spending and managing powers of the government have limits. If the government abuses its financial power to buy political support and does not restore the eroded responsibilities, it will eventually fail in its function of providing default-free assets. Without such assets, a commercial society cannot exist, no matter what the constitution of the country says. The words would lose their meaning, and the traditional institutions would be much weakened, becoming a mere façade.

To have such assets, the Federal Reserve must sustain the value of the dollar while it restores capital markets to health. Otherwise capital will flee the United States, the Treasury will not be able to finance its deficit, and risk capital will dry up for private business. And without risk capital, equity cannot be rebuilt, unless we stumble on new natural resources. That happened to neither the ill-fated Callaghan government in the United Kingdom nor the Carter administration in the United States during the 1970s.

For the time being, the United States is lucky that the world does not presently have a good alternative to the dollar. This gives the country a window of opportunity to make the necessary changes. Part of the world is committed to the politically motivated export model, and another part (Europe) is in the midst of the unique experiment of betting on a paper money that is not backed by any government, making the coordination between treasuries and a central bank during crisis hard to achieve. These experiments cannot be corrected fast.

The window of opportunity for the United States will not last long, however. That China, Russia, and Brazil are starting to experiment on a small scale with such alternatives to dollars as IMF-backed bonds should serve as a warning to the administration. Washington may have the power to intimidate the speculators who owned the senior debt of American auto companies, but it does not have the clout to do the same thing to the bondholders of the world.

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