The Feds Pick the Recession's Losers, Impoverish Us For Doing So

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The recent recession in the U.S. ended four years ago. Amazingly enough the government, some corporations, and advocates for various groups of people are still arguing over who deserves the losses incurred in the recession. More amazingly, some losses have not been determined yet and we are not sure who will get stuck with the bill. Markets, contracts, and the law should determine such things, but today the decisions are made by politicians with little regard for markets, contracts, or the law.

A recession is defined as a period of time during which general economic activity slows down significantly or contracts. Usually, the period of time must be at least six months to be deemed an official recession. The causes of recessions are somewhat complicated, but a basic explanation is that a recession happens when people overinvest in some sector(s) of the economy to the point where oversupply leads to losses on those investments. At that point, the investors normally try to rescue what investment funds they can and reinvest in some other economic sector that promises healthy returns. However, because money was lost, people who lost it spend less while other investors are more cautious about starting new businesses for a time. Together, these effects cause an economic slowdown-a recession.

In a free market economy it is easy for a sector to suffer from overinvestment. Imagine that your hometown has sufficient demand to support two new hotels. The current imbalance between the supply of and demand for hotel rooms has made hotel ownership very profitable. This attracts the attention of investors. Although only two new hotels are needed, five separate investors decide to build one of those two new hotels. With five new hotels instead of two, the oversupply leads to fierce competition for guests, lower prices, and losses for most of the hotels in town. Earnings drop, the investors' spending declines, and a recession begins (locally, anyway).

The most recent U.S. recession had roots in the finance industry, auto manufacturing, and real estate. Auto manufacturing had overinvestment due to a past when more investment was warranted and union contracts that made adjusting to the new reality difficult. Finance and real estate drew overinvestment with high profits in the ten to fifteen years prior to the recession. When enough people realized the extent of overinvestment in these three sectors, credit standards in those industries tightened, the value of their stocks and bonds declined (as people demanded more compensation for the now-perceived high risk involved), real estate prices dropped, and investors began to lose money.

In a pure, free market economy the story would end shortly thereafter. Who lost the money would be clear and determined very quickly. The economy would rapidly reorganize itself, shifting remaining resources toward more promising industries, and the economic recovery would begin.

Unfortunately, the U.S. is becoming a government-dominated economy and the question of who lost trillions of dollars in the past recession is still unsettled. Political, economic, and legal disagreements over these losses continue today and have been very influential in slowing the current recovery. Who lost how much is still muddled, so investors cannot easily reallocate their remaining funds to more attractive sectors. That is slowing the recovery.

In total, there are five potential losers from a recession. They are: borrowers, lenders, taxpayers, citizens, and savers. All look set to get stuck with some of the losses, but some would have been unharmed if not for the government reallocating some losses to them. Below, I will take each in turn to examine how losses can accrue to each group.

Borrowers can lose in a recession when their investments go bad, they cannot make their payments, their property (house, factory, etc.) is repossessed by the lender, and they lose potentially all that they had invested in the venture. In the housing bust, a borrowing might have lost his house to foreclosure and his down payment along with any equity built up since purchase. A business owner can also have property (plant and equipment) repossessed and lose all equity in a business. Borrowers can also lose even if they continue making all their payments simply through a devaluation of their investment. For home owners, that happens when you keep paying your mortgage but your house is worth less than you paid for it. Many people in the U.S., Spain, and Ireland are in that situation at the moment.

Lenders lose when they do not get repaid. This can be when unsecured loans go bad such as credit card accounts that are uncollectable. It can also happen with secured loans, like home mortgages, when the asset that served as collateral has insufficient value to cover the unpaid portion of the debt. Many U.S., Irish, and Spanish real estate lenders have lost or stand to lose money because home values dropped enough that even foreclosing on the homes does not allow the banks to recoup the full outstanding balance owed.

Without government intervention, the story would end here. Contracts between borrowers and lenders would control how the losses were shared between those two parties and the economy could go about the business of recovering. However, government intervention brings three more possibilities into play.

Taxpayers lose when the government takes their taxes and uses them to bail out either the lenders or borrowers who suffered the original losses. The taxes could be collected at the same time as the bailout, or later and used to pay off debt incurred during the bailout. Government has the power to shift some or all of the loss onto the taxpayers. There is no rational reason for doing this. After all, the taxpayer never voluntarily entered into an agreement to guarantee either of those parties (lender or borrower) from losses. However, if the lenders or borrowers have more political power than the taxpayers, such bailouts can happen nonetheless.

It is theoretically possible that a government bailout could save taxpayers money if the damage to the borrowers or lenders that would otherwise be incurred from a recession would by itself cost the taxpayers even more money than the bailout. Such an argument was made to justify the U.S. bank bailouts, the auto industry bailout, and a number of the recent European Union actions. These arguments seem rather weak and shortsighted, however. Even if the bailout is cost effective in the short term, the corrosive effects of the moral hazard it introduces likely make the costs of the bailout much higher in the long term.

Citizens lose when the government assumes the losses from a recession (through a debt-financed bailout) and then chooses to print money to pay off the debt. The resulting inflation imposes a hidden tax on all citizens, making them bear the burden of the bailout. A government which follows inflationary policies to make its debt more manageable, even if it does not pay the debt down, is still transferring the loss to its citizens through inflation. Note that lenders also lose from inflation, because they get paid back in money that is worth less than it was when they lent it.

Savers lose when a government saddled by debt, either from recession-induced bailouts or recession-associated government spending, decides to force low interest rates in order to lower the expense of all that debt. Low interest rates reward borrowers (private and government) by keeping the cost of their profligate behavior below the true market rate. Meanwhile savers lose income compared to what normal interest rates would provide on their savings. That lost income is essentially transferred to the borrowers through the lower interest expense.

What happened in the last US recession? Losses were suffered by borrowers and lenders in the financial, real estate, and auto manufacturing sector. Home owners and commercial real estate investors who could not make their payments, the banks that lent them the money, investors who had bought the mortgage backed securities, bank stockholders and bondholders, and auto company lenders, bondholders, stockholders, and auto union workers all were in line to share the losses.

These people all fall into the first two groups mentioned above: borrowers and lenders. They had contracts and bankruptcy law to guide them on how the losses would be divided up.

Then the government stepped in and decided to move the losses around among the five groups listed above.
First, lenders and their stockholders and bondholders were helped via the bank bailout. Those losses were transferred to taxpayers and are still being transferred to citizens and savers through the government printing money (several trillion dollars worth) and through the Federal Reserve's policy of artificially low interest rates.

Second, auto union workers (UAW members) were allowed to avoid their loss. Rather than Chrysler and GM going through a normal bankruptcy, the federal government stepped in with a bailout that transferred money into a UAW trust fund to pay for retiree health care costs. This money, under normal bankruptcy law, would have gone to company bondholders (investors who had loaned GM and Chrysler money who were ahead of the union in the line for money under bankruptcy law). Instead, the federal government used borrowed money to provide financing to GM and Chrysler in exchange for the UAW Trust being fully funded. So in this case, a loss was transferred from union workers to bondholders along with some combination of citizens and savers. Bondholders protested loudly, but the government got its way and ignored the law.

Third, the federal government interfered in the residential mortgage market, forcing and bribing banks to modify terms of individual mortgages, buying up mortgage backed securities that no private investor wanted, and providing assistance to banks and other lenders to encourage mortgage lending. These actions transferred losses from both borrowers and lenders in the residential mortgage market to taxpayers, citizens, and savers in some share that is still being determined. Exactly who ends up paying how much won't be known until we see the path of interest rates, inflation, and the government deficit in the future.

Finally, the government also used the recession to create some winners and losers by redistributing income. Large increases in federal spending for income support programs (food assistance programs, unemployment payments, and direct welfare payments) moved money to people that received the government transfer payments. This was all financed with government debt, leading to the Federal Reserve both keeping interest rates low and essentially printing money by direct purchases of government debt. These actions cause savers and all citizens to pay for the redistribution.

All this government intervention was unnecessary, unproductive, and ultimately harmful. Perhaps the most important function of government is to set the rules of commerce through laws and regulations. Markets cannot function efficiently and wealth cannot be created easily without all parties trusting that the rules will be applied uniformly and consistently.

Ex post facto laws are expressly prohibited by the U.S Constitution (Article 1, Section 9), meaning no applying new laws to actions that have already occurred. Yet the federal government is clearly changing the rules as it goes. By reallocating losses from the recession, rewarding people who behaved recklessly and punishing people who were nothing more than innocent bystanders, the federal government is creating a situation in which contracts and other market transactions cannot be trusted to be enforced as enacted.

When people and businesses cannot rely on the enforcement of contracts, fewer contracts will be entered into and much effort and expense will be wasted on additional lawyers and measures designed to protect each party's interests. All of this means a nation that will be poorer in the long run. The federal government has neglected this considerable cost to its actions. Over time those losses will be far greater than the amount of wealth lost in the recession.

Jeffrey Dorfman is a professor of economics at the University of Georgia, and the author of the e-book, Ending the Era of the Free Lunch

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