The AIG Bailout and the Tea Party, Part 2

The bailout of American International Group (AIG) during the financial crisis illustrates the conflicts between philosophy and reality that the Tea Party will have to address if it wants to actually change anything.

During the financial crisis the Federal Government injected $182 billion into American International Group (AIG), a very old insurance company that had sold tens of billions of dollars of unregulated insurance on mortgage backed securities. The government worried that if AIG was allowed to fail it would take down several leading investment banks and this in turn could take down our whole economy, turning the recession into a depression.

It was undoubtedly the right thing for the government to do, but this was also perhaps the most galling of all of the government’s bailout efforts. AIG and the large investment banks had generated billions in profits during the mortgage bubble by creating, buying, selling and insuring mortgage backed bonds. Now taxpayers had to protect AIG and the banks from the collapse in value of mortgage backed bonds even as taxpayers were seeing their own home values fall.

For Tea Party members and for many voters, AIG highlighted everything that was wrong with the various government bailouts. It was a massive extension of the government’s responsibility for the economy and it was inherently unfair – giant companies got government assistance they didn’t deserve while thousands of smaller businesses were allowed to fail.

There is a part of the Tea Party movement that feels the answer to avoiding a repeat of the bailout is to end the federal government’s role as the guarantor of our financial system. But while this has a nice ring to it philosophically, it’s not realistic. When Adam Smith wrote about the glory of the free market, he used sheep markets as an example. The key to the functioning of the market was that each buyer could decide for themselves the value of a sheep – the buyer could feel its coat and muscle tone, check its eyes and mouth.

This level of personal knowledge and inspection isn’t possible in a national economy. Instead, the federal government assumes the role of guarantor of claims, providing assurances that banks aren’t using your deposits for their own purposes and that companies on the New York stock exchange accurately report their financial results. It’s not too much of a stretch to say that a national economy isn’t possible without a strong national government – federal financial regulation is a critical element of our capitalist system.

And the financial crisis didn’t happen because we had too much government financial regulation. It happened because the government rolled back regulation. With pushing from Wall Street and both Republicans and Democrats, the federal government backed away from two key regulatory principals – you can only buy insurance on something you own, and if you sell insurance you have to maintain financial reserves to cover possible losses. The mortgage bond insurance that AIG sold was bought by companies that didn’t actually own the bonds, but instead were speculating that the bond’s value would fall. And AIG didn’t maintain reserves to cover potential losses.

One of the ways the government protects our economy from financial swings that could become recessions and depressions is by keeping individuals and companies from doing things that are speculative and frankly, stupid. By limiting the stupidity up front, the government insures that it won’t be forced to step in and clean up a mess that could bring down the whole economy. When we rolled back regulation and started allowing very large financial institutions to do stupid things, it was inevitable that eventually the government would have to step in to clean up the mess.

Thus the quandary for the Tea Party movement. It is rightly angry at the bailout and the extension of government responsibility that it represented. But the best way to insure the government isn’t again put into a position where it is forced to bail out giant financial institutions is to again increase regulation of the financial sector. This is the paradox – it will take a stronger government to insure we have a smaller government.

AIG Bailout and the Tea Party, Part 1

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