The Bubble Doom

In the first chapter of his most celebrated work, Czech novelist Milan Kundera illustrates Nietzsche’s idea of “eternal return:” “There is an infinite difference between a Robespierre that occurs once in history, and a Robespierre who eternally returns, chopping off French heads.” When it comes to the tumultuous financial markets of the past year, countless editorialists, economists, and even some public officials have likened the current crisis to the Great Depression of the 1930s and the Savings and Loans debacle of the late 1980s. And who better than Federal Reserve Chairman Ben S. Bernanke, that erudite, Ivy League scholar of the Great Depression, to steer the world’s largest economy away from the abyss of the past?

Yet, the weight of history has become too heavy. As the events of the last week unfolded, ad hoc solutions from Bernanke’s Fed and the Treasury, led by the vigorous former Goldman Sachs CEO Henry M. “Hank” Paulson, proved unable to bring lasting calm to the market: Neither lower interest rates, nor greatly expanded liquidity helped thaw frozen credit markets. Even after brokered shotgun weddings like those of Merrill Lynch and Bank of America or Bear Stearns and JP Morgan Chase, what Professor Kenneth Rogoff once called the “flagship” American sector, the financial services industry, seems to have no bottom.

As of Thursday evening, however, the Fed and the Treasury proposed a more fundamental solution to the meltdown, and it curiously seems to embrace the idea of eternal return. The bailout package sent to Congress envisages the purchase of toxic mortgage-related assets from banks by a government agency directly dependent on the Treasury. It has a direct precedent in the Resolution Trust Corporation (RTC), an institution created during the Savings and Loans crisis to avoid dumping real estate assets after bank failures, and thus to avoid a further decline in real estate prices through the usage of federal funds. The current proposal is explicit about its monumental cost: $700 billion, a sum larger than the 2009 budget of Medicare and Medicaid, which also dwarfs the de facto nationalization of Fannie Mae and Freddie Mac just weeks ago.

If there were a real choice for Bernanke and Paulson, no one has been brave enough to voice it. Yet, in a matter of hours, several prominent thinkers rushed to deem the bailout the abandonment of classical economic theories about free market capitalism, as well as the expiration date of Reaganite de-regulation. The former is a plausible argument, but the latter rather inconsequential given the RTC precedents of the current bailout. More importantly, the plan designed by Bernanke and Paulson socializes the risk of the most toxic real estate assets, which have been polluting Wall Street balance sheets since the advent of the credit crunch over a year ago. In that way, the $700 billion bailout works just like any social security or welfare scheme, by passing costs on to the shoulders of every American taxpayer. This bailout adds roughly $2,000 to the U.S. national debt per capita, rather than letting markets correct household prices and take down more flagship American investment banks. So today is just like 1989.

The strategy makes sense beyond historical precedent. The US is a republic where most citizens have most of their money invested in home equity, also known as the bricks that house them, and every one of them can vote. Hence, amidst the heat of an election year, Congress suddenly seems blessed with bipartisanship and eager to approve the RTC-inspired bailout.

In the long run, however, the rational conclusion is simple. Just like in the past, the U.S. government remains unwilling to withstand a downturn in house prices. As every investor knows, past performance is no guarantee of future performance; yet past performance does remain a powerful market sign. Regardless of the tragic fate of Lehman Brothers, this seems like a perfect time for foreign investors to get some exposure to U.S. real estate. For if something were to go wrong, history suggests some sort of bailout will protect them, and none other than the American taxpayer will foot the bill. Despite all the talk about avoiding further moral hazard, the hefty bailout package will create nothing but more incentives for risky investors to seek sweet returns. This a tragic consequence of the package; but as long as Americans homeowners refuse to accept losses on home equity in the short run, they must face the burden of this bailout as taxpayers in the long run.

History is not in vain. Not only does it offer memories, but also precedents. And those precedents may continue to make housing crises recur. Perhaps next time a scholar of the 2008 housing meltdown will be Chairman of the Fed.

Pierpaolo Barbieri ’09, a former Crimson associate editorial Chair, is a history concentrator in Eliot House.