Cato Institute Warns against Cash Bailouts to Banks

The Cato Institute has just published essays in which the libertarian think-tank warns against central bank bailouts via cash injections whenever there is a temporary financial crisis.

The essays come in the wake of the problematic housing bust and the epidemic of mortgage loan defaults that are costing financial institutions, lenders, banks, and investors who put money into sub-prime loan backed securities billions of dollars altogether.

The bursting of the housing bubble is also making investors on Wall Street and abroad jittery, as the tumbling average price of new homes and defaults are making it more difficult to find equity to borrow against. When consumers cannot readily find sources of borrowing, they grow more conservative in their spending, which in turn hurts business profits and therefore business' value. Falling business value means falling stock prices.

While savvy financial advisors tell their clients that falling stock prices simply mean that stocks are on sale, the typical investor and the institutional investors who have huge stakes leveraged in large companies do not like to see sustained falling stock prices and are likely to engage in profit taking, pushing the value of the market down even further.

With lenders now growing more cautious about lending money, and having less of it to lend, investors also fear a decline in mergers and acquisitions activity, which has been on a record tear in 2007 and inspiring billions of dollars to be invested.

With borrowers defaulting, even though banks and lending firms take possession of homes, they are not very keen on doing this-they want the cash they though they would be getting. When consumers go to their banks to pull out their cash, wanting to spend more of their own money since they can't rely as much on credit under the circumstances, they put the banks in financial strangleholds-for the banks, too, have invested their money, or lent out more than they hold in reserve.

Banks by law only need to hold 10% of all their deposits in ready cash. This policy is called fractional reserve banking. The banks lend out the other 90% at interest and invest some of it in the stock market to make more profits for the bank. However, critics have long pointed out that fractional reserve banking only works in a stable economy where most people are not going to come making withdrawals all at once.

If the pizza man delivers a pizza to you and you have $300,000 worth of equity in your home, but no cash, he is not going to give you your pizza. He wants cash, not equity. The same problem now faces many United States banks.

So, the Federal Reserve is called on to step in and lend out all the money the banks need. The Fed can do this because whenever the Fed lends out money, it simply creates all the money it needs, backed by "the full faith and credit of the United States government". There are harsh critics of this set-up, but that is how the central banking system works.

One of the great fears of economists is that when the Fed injects the new money into the economy to prop up the banks, it will set off high inflation. Inflation is caused by new cash entering an economy. Inflation has been quite low in the U.S. for many years.

"It seems to make sense in the middle of a financial crisis for someone to bail out a failing firm or firms. The inconsistency is that, however sensible a bailout seems in the heat of crisis, bailouts rarely make sense as a standard element of policy. The reason is simple: Firms, expecting aid if they end up in trouble, hold too little capital and take too many risks. As every economist understands, a policy of bailing out failing firms will increase the number of financial crises and the number of bailouts," writes William Poole, president of the Federal Reserve Bank of St. Louis, in one of the essays.

Source:
The Cato Institute (PR Newswire), "Scholars Caution Against Federal Reserve Interventions"