Federal Reserve rescues the ailing firm, Bear Stearns, defying the essence of free market principle
A.H. Jaffor Ullah
On the early hours of March 14, 2008 the NY Stock Exchange (NYSE) was in a free fall along with other secondary markets, NASDAQ and AMEX, because the news got out that the financial giant Bear Stearns faced a liquidity crunch. The consequence would be dire if the firm does not get a massive infusion of capital to avert a possible bankruptcy. Therefore, a crisis was looming large in the financial market. The rapid downward movement of the market averages tells it all that things are turning outright ugly in Wall Street. Before the market could deteriorate, the Federal Reserve Bank of
The news of the financial meltdown in Bear Stearns took a bite in the stock price of the company. It lost about 50% of its value in just one day. Central bankers invoked a rarely used Depression-era provision to provide loans, and said they were ready to make available extra resources to combat an erosion of confidence in
Now, a student of economics in America, who was told by his or her professor for the umpteenth times that in free market economy each and every company should stand on its two feet without government's support, would scratch his or head thinking why the hell the government intervened to rescue the financial behemoth this time? Good question, indeed!
In a free market system each and every company should conduct business to make a profit. The more the profit, the more is the share price. If the company makes bad business decision, it may have to pay a price. The stock price will plummet and in dire circumstances the company may even bite the dust.
Bear Stearns probably got heavily involved in sub prime lending in the heydays of the housing boom of early 2000s offering loans to customer who either did not have a good track record of repaying loan or who did not qualify to borrow money to buy a house. In the go-go days of housing boom when housing prices were shooting up 10-15% annually, many a lending institute became greedy to issue sub prime lending. They thought as long as the price of asset goes up, they will have no problem selling the house to get their money back. But now, housing prices are plummeting; therefore, the lending institutes will have hard time selling the house at market value to realize the money they loaned to the defaulting borrowers.
Did the Feds' action to stop the hemorrhage at Wall Street is justified? Not really, if one believes in the free market theory. When a small business fold, the company or the owner go bankrupt, then it is the norm. If a small or medium sized public company becomes insolvent, the company may go bankrupt or reorganize under chapter 11 bankruptcy laws to save the company's assets from creditors. However, when a super sized company faces the possibility of a financial meltdown, only then Uncle Sam comes to rescue the firm.
And we have example of the Federal Reserve Bank coming to rescue the ailing firm. In 1978 when Jimmy Carter was the president, the car manufacturing company Chrysler was on the brink of becoming a bankrupt company; the company badly needed a massive capital infusion. The Federal Reserve Bank gave the loan guarantee at the time. Chrysler under CEO Lee Iacocca received the loan guarantee to avoid the impending bankruptcy and the rest is history. The Federal Reserve Bank then justified the move by saying that if Chrysler was let go, it would have impacted many of other industries. Besides, the nation was in a recession then.
Thirty years later another recession was looming large in
The financial giant Bear Stearns is not only an investment banker but it is a brokerage firm where tens and thousands of ordinary Americans have their retirement account, investment accounts, etc. The government perhaps thought that if Bear Stearns is allowed to go bankrupt, then the fall out of the bankruptcy in the stock market will be too great. This is precisely why the Feds moved right away to save the company from its demise.
This morning the stock market took a tumble when the wire services ran the story of Bear Stearns economic woe. To support the NY Federal Reserve Banks move JP Morgan Chase and Company also offered financial assistance to stabilize the ailing company. Bear Stearns' stock value also went down precipitously. All in all, there was a bloodbath in Wall Street this morning. However, because of the Federal Reserve Bank's action the hemorrhage was stopped by a proverbial band aid approach. The market at the close dropped about 1.6%. If however no action was taken by the Federal Reserve Bank of
There are many conservative talk show hosts and financial gurus who have the perfect gift of gab in CNN, MSNBC, and elsewhere who propounds the merit of free market economy. One of them is Dr. Larry Kudlow who served as an adviser to White House during President Reagan era (1980-1988). Kudlow is a host of "Kudlow and Company" in MSNBC network. He is a supply-sider economist who strongly believes that if rich people are given a tax break, they will invest in the economy, which would generate more jobs and help grow the economy. This sounds good outwardly but Kudlow hardly talks about the pitfalls of free market and supply-side economy. Also absent in his monologue is how much help the Federal Reserve Bank should give to an ailing company.
A true free market economist will propound that government should stay out of helping any company. If a firm makes bad choices while running the business, the company should face the consequence. This is true if the company is a small or medium one. In 1978 we saw how the Federal Reserve saved the infirm car manufacturer, Chrysler. In 2008, we witnessed how the same Federal Reserve came in to rescue the financial behemoth Bear Stearns.
No matter how much Mr. Kudlow and the rest of the talking heads in the media foam through their mouth extolling the great virtue of free market economy, it surely looks as if the government is willing to rescue the giants by providing the liquidity or giving loan guarantee. If the smaller firms are in this predicament, they have to fend for themselves or just bite the dust. So much for the American brand of free market economy.
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A.H. Jaffor Ullah, a researcher and columnist, writes from
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