When news broke last week that insurance giant AIG--into which the federal government has poured close to $200 billion since last September--planned to pay out $165 million in bonuses to executives in its financial products group, the backlash was swift. And understandable. These are the blockheads who pioneered the use of credit default swaps that purportedly allowed banks and other investors to hedge against losses in the secondary mortgage market. In so doing, they created new financial instruments and hence a new marketplace that, for a while anyway, flourished wildly. It didn't last.
The real estate bubble popped and took the banking sector and AIG down with it. AIG didn't have the money to pay the counterparties to its swaps. The feds stepped in and began pumping cash into the insurer so it could pay its counterparties--the likes of European giants Deutsche Bank and Société Générale and Wall Street's Goldman Sachs and Merrill Lynch. To do otherwise, sayeth the Treasury, would invite a "systemic collapse" of the swap market, and thereby the destruction of the firms who participated in it. Who knows what sort of financial apocalypse would ensue?
That's why the American taxpayer is keeping AIG on life support. The economic risks of letting it fail, we are told, are greater than the economic risks of allowing it to live as a zombie. But when Fed chairman Ben Bernanke, Treasury Secretary Hank Paulson, and--you may have heard of this next guy--then-New York Fed president Timothy Geithner came up with this plan, they did not think of the political risks involved. Big mistake.
What Bernanke, Paulson, and Geithner did not recognize is that, as soon as a company is bailed out, social justice replaces market justice. In the private marketplace, bonuses and other forms of executive compensation are deemed necessary to maintain a competitive edge. Otherwise "talent" leaves for another company. The value or justice of such compensation isn't determined by ethics, morality, philosophy, or civics. It's determined by the market. And the market is amoral. Indeed, had AIG's fate been left to the marketplace, those executives owed bonuses, like everyone else to whom the firm owed money, would be standing in a long, long line at the bankruptcy court, with very little hope of recovery.
Ever since last August, the U.S. government has removed dozens of entities--Fannie Mae and Freddie Mac, AIG, Citigroup and Bank of America, GM and Chrysler--from the private market and placed them in the political market. It has done this because the alternative, doing nothing, is apparently too horrible to contemplate. Fine. No one wants the global economy to collapse. But the government also ought to understand that, as soon as these institutions enter the political market, the way in which they are managed becomes subject to political (i.e., moral, philosophical, and ideological) considerations. It becomes a matter of public debate.
Clearly the Democrats who run the government do not understand this. If they did, they would neither have requested nor permitted the chairman of the Senate Banking Committee, Christopher Dodd, to insulate AIG from a provision in the stimulus bill that capped bonuses for companies receiving federal dollars. If they did, Treasury Secretary Geithner would have prepared a political strategy to deal with the fallout at the moment he first heard about the bonuses. Didn't happen. As recently as Sunday, March 15, White House economics adviser Lawrence Summers was telling the media that, while he didn't like the payouts, they were "contractually obligated," and there was nothing the government could do about them.
Within 24 hours of that pronouncement, of course, President Obama was saying that the administration would do everything in its power to recoup the money. Congress marched AIG chairman Edward Liddy--who came out of retirement to wind down the company and takes a dollar-a-year salary--in front of the cameras so it could publicly beat its chest and howl at the injustice it abetted. House Democrats passed legislation to tax the bonuses at Eisenhower-era 90 percent marginal rates. The anger fed on itself. The reaction launched a thousand potentially destructive policies. The moment called for presidential leadership. But Obama was unavailable because he had to run to California for two town halls and an appearance on Jay Leno's Tonight show.
Obama and Congress can fulminate, preen, and retaliate all they want. It won't solve the problem. The problem is that major financial institutions are now on the public dole, and will be accountable to the public as long as they are. Already there's news that (1) Fannie and Freddie are about to hand out their own bonuses, (2) Citigroup is planning on building a $10 million executive suite, and (3) 13 bailed-out institutions owe more than $200 million to the IRS. How will the Democrats respond to these new injustices, and the further injustices that are sure to emerge?
It took the United States several long and painful decades to learn that public assistance to individuals encourages destructive behavior. Welfare promotes dependency and gives rise to social pathologies such as illegitimacy, crime, and substance abuse. It also warps politics, dividing the public into those who want to give more and demand less and those who want to give less and demand more. Eventually we learned our lesson and reformed welfare so that the program encouraged work and self-reliance. Welfare rolls plummeted. None of the dreadful repercussions the pro-welfare lobby fantasized about came to pass.
It seems that the same lessons apply to the financial welfare program begun last year. Direct cash assistance--the bailout--fosters a culture of dependence and entitlement. It does nothing to discourage irresponsible corporate behavior. The financial welfare cases shuffle along, moving from blunder to blunder, sparking an empty furor and punitive measures that miss the mark. Whereas the job of politics was once to promote growth in the market economy, it's now preoccupied with limiting the damage created in the political economy. And everyone suffers.
This is a horrible situation. It threatens Obama's presidency and the future of the American economy. The time has come for a financial welfare reform that gets these institutions off the public dole and promotes responsible accounting and corporate governance. Forget about retribution. Where is the plan for recognizing financial losses, for reorganizing or closing failed firms, for an orderly withdrawal of federal support from zombie institutions? The first party or political leader to apply the lessons of welfare reform to the financial crisis will benefit the country--and profit at the polls.
Matthew Continetti is associate editor of THE WEEKLY STANDARD .