Fed's Bear Bailout Hobbles Free Markets

No free market goes up forever without interruption. But it's my belief that the government's escalating intervention, including the Fed's latest moves on Sunday, isn't helping matters, but rather making them far worse.

The seeds of financial crisis have been sown by the various government backstops and bailout programs that encourage banks, brokerages and other financial institutions to take on unsustainably high levels of risk. Instead of having to accept the consequences of bad judgment, as businesses should, the message is being sent that the American taxpayer stands by to save financial institutions that, in a truly free market, would otherwise be brushed aside into insolvency. That's precisely what we've seen in recent days.

The Federal Reserve Bank of New York's bailout of Bear Stearns (BSC) has unwillingly exposed innocent taxpayers to precisely the risk the smart ones have sought to avoid. The collectivist underpinning of such maneuvers is that, although many of us didn't invest in Bear Stearns — or leveraged hedge funds or speculative real estate for that matter — somehow "we're all in it together." As such we share the cost and responsibility for keeping many of these fundamentally unsound institutions and markets afloat.

It's an ideology that allows unstable mortgage lenders such as Countrywide Financial (CFC) to tap the Federal Home Loan Banking system for billions of dollars under terms that the private market (read: free market) would never accept. Or that perversely incentivizes small S&Ls, the type now romanticized by populist politicians, to take on inordinate risk knowing that the FDIC will bail out depositors even if the bank itself fails. In fact, there have been two bank failures already this year, compared to three in all of 2007 and none in 2006 and 2005.

The moral hazard created by the New York Fed's liquidity lifeline to Bear Stearns can't be understated. Although it was a large, multibillion-dollar institution with 15,000 employees world-wide, Bear Stearns was actually one of the smaller investment banks on Wall Street. If the Fed is willing to intervene to stem the bleeding at the fifth-biggest investment bank, much bigger institutions like Citigroup (C), Merrill Lynch (MER), and even J.P. Morgan (JPM) can expect the same taxpayer-subsidized treatment.

In a truly capitalist economy, banks would have to compete for reputation in financial stability, not simply offer high rates or make reckless investments knowing that it's ultimately the taxpayer who's responsible for their fiscal mismanagement. Yet depositors and investors put much more effort into investigating the purchase of a flat-screen TV than into the solvency of their financial institutions because they know the government always stands at the ready to make them whole.

Thus thousands of poorly managed financial institutions receive the benefit of a taxpayer-funded backstop no other industry receives, which only prolongs the market-based corrective processes needed to separate the sound institutions from the poorly performing ones.

The rationale most would offer is that such assurances are necessary to make sure "our money is safe." But is it? Because beyond the daily instability — the Dow up 400 points on news of one type of government intervention, down 300 points the next day on news of another — the net result is massive inflation, a continual debasing of the very currency we work so hard to earn.

As I pointed out a few years ago, there's no intrinsic difference between a $1 bill and a $50 bill. Both are simply pieces of paper, run off a printer and backed by the faith of those who hold them. By weakening the currency, either by artificially lowering interest rates or expanding entitlement spending and bailout programs, the government is, in essence, writing a rubber check to be unwillingly paid off by the future labor of its citizens. The value of the dollar, not surprisingly, drops accordingly.

The philosophical grounding of such a policy is pragmatism, in which leaders pursue a policy devoid of an ethical (read: capitalist) foundation or long-range plan. For this administration, it's all about results today and damn the price the country will pay down the line.

Moreover, the entire financial industry is being re-regulated on a daily basis, with the SEC, CFTC and various congressional committees ruling on everything from the CME Group's (CME) consolidation and clearing operations to Rep. Barney Frank's (D., Mass.) proposal to guarantee mortgages that are rapidly declining in value.

Heralded as attempting to stabilize markets, these efforts have the opposite effect. Indeed, how is it possible to build a business that's continuously being micromanaged by overzealous politicians in an election year?

On top of all of this is the overriding political trend toward larger government involvement in everything, from health to education to regulating how much employees must be paid or where a truck driver can smoke.

The New York Fed's Machiavellian bailout of Bear Stearns further solidifies this dangerous trend. Suddenly an outright nationalization of banks, commonplace in socialist countries like Venezuela, isn't as unlikely as it once would seem. America, long the world's shining example of free-market capitalism, is quickly becoming another banana republic with sweetheart deals, a volatile economy and a worthless currency. The markets seem to agree.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.