Better Than a Bailout

Four steps policy makers could take to help financial markets

What should the federal government have done in lieu of the $700 billion bailout signed into law by President George W. Bush? Here are four common-sense steps that don't involve the partial nationalization of the finance industry:

1) Raise the capital ratio for government sponsored enterprises and other investment banks to at least the level imposed on commercial banks—a cash balance of generally 8 percent of the market value of each firm’s tradable assets weighed for the risk of each asset. In a free banking system, there is no need for artificial, one-size-fits-all Securities and Exchange Commission rules. In such a system the amount of capital on hand should be left up to the banks themselves rather than government regulators. Sadly, we are not in a free banking system. We have a central bank, a lender of last resort, and not only does it implicitly guarantee certain banks’ losses but it won’t let them go under when they make mistakes, which creates some poor lending practices.

In this context, raising the reserve level would force institutions to have enough capital to face sudden increases in their default rates during tight credit markets. The bailout law does nothing to address this question.

2) Extend the capital gains and dividend tax cut past 2010, when it is due to expire under current law. This would raise the rate of return of financial assets at little cost to the Treasury and give a strong incentive to taxpayers to stay in or go back into the market.

3) Lift all Roth IRA contribution and eligibility limits for the rest of 2008. Because Roth IRA contributions are not tax deductible, this measure has no immediate cost to the Treasury, but it would likely pump billions of dollars into a tight market.

Such simple measures would have allowed the market to continue reorganizing its financial sector at absolutely no cost to taxpayers. That being said, if the president and Congress were dead set on directly injecting liquidity into the banking system, they still could have done so in a way that would have exposed taxpayers to far less uncertainty:

4) If Congress is absolutely committed to spending the bailout’s $700 billion, then it should send checks worth $3,600 to the 191 million U.S. taxpayers instead. Such checks would then have to be deposited into some type of retirement account or be subject to the Internal Revenue Service’s premature IRA distribution rules. The most risk-averse people would invest this windfall into relatively safe money market funds, thereby preventing the credit crunch predicted by the pundits. Some would buy instruments such as mutual funds, which would sustain the market. Savvier investors, or at least those with a high risk threshold, would profit from the low prices on Wall Street to purchase stock in distressed banks.

Such a measure would have proven popular with an electorate that does not trust the very politicians and technocrats who for years ignored the warning signs of a looming housing crisis. And it would have done so without socializing a big chunk of Wall Street, a risky and unprecedented intervention into markets whose full effects won’t be clear for many years to come.

Philippe Lacoude is the president of the consulting firm Algokian. Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.