Government Needs to Take Baby Steps on Bailout

The proposed $700 billion bank bailout is stalled in Washington, though as of early Friday negotiations (and finger-pointing) were still ongoing. Perhaps that's for the best. At this point, I'm on the fence about whether we'll be better off with the bailout or without it.

It could help. It should help. I want to think that we saw the bottom in stocks last week.

I'd be more encouraged if the recent bailouts of Fannie Mae (FNM), Freddie Mac (FRE) and American International Group (AIG) had been more successful. But they weren't. They ended up making matters worse, requiring now an even bigger bailout.

So what happens if this one fails? Do we do another one, even bigger yet? Already in the interim the government had to cobble together a rescue of Washington Mutual (WM), which late Thursday sold to J.P. Morgan Chase (JPM) for $1.9 billion.

That's the way it is with government, and why government is fundamentally different than private enterprise. When private enterprise fails, people don’t repeat the mistake. When government fails, people do repeat the mistake -- only bigger.

Yes, the situation we are talking about here is a strange blend of the private and the governmental. In one sense we wouldn't be talking about a bailout at all if the private sector hadn't screwed up. But I never said the private sector was perfect. I just said it doesn't often make the same mistake twice. That's government's job.

And when the private sector knows that a bailout is possible, then the disincentive to make and repeat mistakes is lessened. So more mistakes are made, only bigger ones. In fact I could make a pretty good case that the current crisis is precisely the result of a deadly blend of private-sector greed and public-sector foolishness, reinforcing each other in the worst possible way.

But that doesn't mean that eventually we won't figure it out and get it right. What are the chances that we're going to do that with the massive $700 billion bailout now being debated on Capitol Hill?

As a matter of first principles, the underlying idea of the proposed bailout is a smart one. There are impaired assets on the balance sheets of banks and brokers. There's no ready private market for those assets, except at ruinous prices. But that doesn't mean the assets are really worthless -- it just means no one wants them, because everyone already has too many of them.

So it's a perfect time for government to step in and help. Well, strictly speaking there's no such thing as "perfect" when it comes to government interference in the economy, but if ever there was a good time to do it right, this could be it. Here's why.

If the federal government were an investor, it would be the most efficient one in the world. It has the lowest cost of funding to buy investments, because it can raise money by selling Treasury bonds at low interest rates, while banks and brokers have to pay high rates to get their hands on borrowed money. And because of its vast size, and the diversity of its income streams and asset holdings, the government is in the best position to take on risk.

That means that the government ought to be the highest bidder in the market for risky investments because those investments are worth more, and present less overall risk, to the government as compared to any other possible investor.