Think the Bailout Is Radical? Just Wait.

Federal Reserve Chairman Ben Bernanke addresses the the National Association for Business Economics' 50th annual meeting.
Federal Reserve Chairman Ben Bernanke addresses the the National Association for Business Economics' 50th annual meeting. (Chip Somodevilla - Chip Somodevilla/Getty Images)
By Greg Ip
Sunday, October 19, 2008

In the past month, the unprecedented has become routine. The Treasury Department and the Federal Reserve, headed by Republicans, have intervened in the U.S. economy to an extent that would have shocked liberals a year ago. The Treasury is now a major shareholder of U.S. banks, the Fed is a principal lender to private business, and the American taxpayer stands behind huge swaths of the financial system, from home mortgages to business bank accounts. "Socialism has now washed over free-market capitalism," Sam Donaldson of ABC News recently sighed.

Momentous? Sure. Socialism? Hardly. Breathtaking though these past weeks have been, they're nothing compared to what both the United States and other Western countries have experimented with in the past. But even though they have often departed from free markets in response to crisis, they eventually find their way back. Let's not get hysterical about changing the very nature of our system over the long haul. But in the meantime, don't rule out even more radical action.

Government ownership. You have to go back to the Great Depression and World War II to find examples of widespread U.S. government investment in private enterprise. But in other Western capitalist countries, nationalization was routine during the postwar period. Starting in 1946, Britain's Labor government nationalized transport, energy and communications companies, and by 1971, a Conservative government had taken over the failing automobile manufacturer Rolls Royce. At the peak, 10 percent of British economic output came from nationalized companies.

France, not surprisingly, went even further. When Francois Mitterrand's Socialists took power in 1981, they embarked upon a massive wave of nationalizations. The new government added 39 banks to those already owned by the state, putting 95 percent of the French banking system in government hands. "I am forced into retirement," declared a glum Baron Guy de Rothschild, head of the famed banking family's French branch. "I wish I could go on strike."

Unlike Mitterrand's moves, Treasury Secretary Henry M. Paulson Jr.'s partial nationalization of U.S. banks is driven by a need to keep the financial system intact, not a desire to take control of the means of production. In the 1990s, Japan and Sweden took over weakened banks and sold most of their stakes once the economy recovered.

If the current crisis deepens, Treasury's $250 billion passive investment -- which is less than a quarter of total bank capital in the United States -- could grow. And having said yes to banks, the government might find it hard to say no to buying stakes in other industries that also show up, cap in hand, or to other types of debt.

Fed loans. In total dollars, the expansion of Federal Reserve lending is actually larger than the price tag of the Treasury Department's actions. That might grow even further.

By law and tradition, the Fed is the lender of last resort, a role it fulfills by making short-term, secured loans to banks. But many of the firms whose failure threatens the entire economy nowadays aren't banks. A clause in the Federal Reserve Act lets the Fed lend to other types of firms -- under "unusual and exigent circumstances." Since March, Fed Chairman Ben S. Bernanke has routinely invoked this clause to let his institution help out investment banks, mortgage giants Fannie Mae and Freddie Mac, the insurer American International Group (AIG) and large companies that issue unsecured IOUs known as "commercial paper," such as General Electric.

It has been a huge change. Before the crisis began, the Fed had $868 billion of assets, 91 percent of them in innocuous Treasury bills and bonds. Now it has $1.6 trillion in assets, with less than 30 percent of them in Treasuries; the remaining assets are mostly in the form of loans to banks, securities firms, AIG, foreign central banks, commercial-paper programs and so on.

Could Bernanke go even further? He has promised to use "all of the powers at our disposal" to stop the credit crunch. As of June 30, loans to U.S. households, non-financial companies and state and local governments stood at $27 trillion. In theory, the Fed could supply all of this. But that doesn't mean that it should. At some point, Fed loans would keep alive borrowers that simply ought to fail. And the more credit the Fed extends now, the longer it will take to withdraw once the crisis passes -- a process that risks spurring inflation.

But the Fed could go quite a ways yet: Its $1.8 trillion in assets is equal to just 12 percent of America's gross domestic product. To battle deflation earlier this decade, the Bank of Japan stuffed Japanese banks with cash, hoping they'd lend it back out. At its peak, the Bank of Japan's balance sheet amounted to 30 percent of GDP. All this government effort didn't help much: Japan's banks were still so undercapitalized that they were reluctant to lend. But the Bank of Japan's exertions didn't trigger inflation, either.

Buy other assets. Ask the average congressman why he voted for the $700 billion bailout package, and he'll probably point to the sickening plunge in the Dow Jones Industrial Average. So would it be better for the U.S. government simply to buy stocks?

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