Government Can Influence Banks with $250 Billion Stock-Buy, Say Economists

By Matthew Hadro | October 29, 2008 | 7:54 PM EDT

Rep. Ron Paul (R-Tex.) opposes the $700 billion financial bailout and $250 billion purchase of bank stock by the U.S. Treasury. (AP Photo).

( - The federal government is now able to more easily manipulate banks through the purchase of $250 billion in bank stocks, as part of the $700 billion financial bailout, warned free market economists and investors.
“The greater the emergency, the more you need the free market,” Thomas E. Woods Jr., a senior fellow with the libertarian Mises Institute, told, in reference to the $700 billion bailout and bank-stock buy. “If anyone even cares about the Constitution any more, this shows that obviously we don’t have one.”
The deal allowing the U.S. Treasury to purchase stock in banks nationwide, with no requirement or timeline on selling the stocks back to the banks or private investors, should be “condemned,” said Woods.
The Emergency Economic Stabilization Act of 2008, passed by Congress and signed into law by President Bush on Oct. 15, includes a $250 billion government purchase in “senior-preferred shares” in U.S. banks. The purchase is designed to infuse capital into the banks so they can keep credit flowing and apparently help stabilize the market.
Half the money, $125 billion, is being spent to buy non-voting shares in nine major U.S. banks, and the other $125 billion will buy shares in smaller banks around the country.
Both President Bush and the U.S. Treasury have described the purchase as “temporary.” However, the law does not state that the government is mandated to sell the stock back to the banks. Only the Treasury secretary’s authority to purchase shares will expire -- but not the authority to keep or relinquish the assets purchased.
As Treasury spokesperson Jennifer Zuccarelli told in early October about the bank stocks: “We can hold them for as long as we want.”
Rachel Mills, a spokesperson for Rep. Ron Paul (R-Tex.), said that the conservative congressman thinks the bailout and stock purchase are unnecessary, and that such intervention in the economy might cause inflation or even hyper-inflation in the future.
“You can’t just dump this kind of money on the economy that’s basically just been created out of thin air and not expect some kind of consequence,” Mills told
Dr. Allan Meltzer, a visiting scholar at the American Enterprise Institute and former economic adviser to Presidents Kennedy and Reagan, said the government intervention was “not desirable -- but certainly a failure to intervene would have been even less desirable.”
He also criticized the anti-capitalist critics on this issue, saying, “Despite the stupid statements that people make about the end of American capitalism, that isn’t going to happen.”
Meltzer added, though, that what happens in between the government purchase and selling of the stocks will matter. “It’s the damage that they do in between that will be the problem,” he told “But the more damage they do, the quicker the banks, will want to buy back the stock.”

Economist William Niskanen, former acting chairman of President Reagan's Council of Economic Advisers (Cato Institute).

William Niskanen, chairman emeritus of the libertarian Cato Institute and former acting chairman of President Reagan’s Council of Economic Advisers, essentially agreed with Meltzer, stating that the U.S. Treasury probably will sell the stock back to the banks.
The stock held by the Treasury will pay dividends to the federal government at a 5 percent rate for five years, with a subsequent jump to 9 percent. Multiple sources cited this provision as evidence that the government will eventually sell the shares back to the banks.
“That gives the banks a lot of incentive to buy back that stock before that rate of return skyrockets,” Niskanen said, in reference the jump in percentage.
Bert Ely of Ely & Company, Inc., a financial and monetary policy consulting firm, is not convinced the government will ever sell the stocks. The banks will definitely have an incentive to re-purchase the stocks after five years, given the projected dividend rates, said Ely. But “what we don’t know is to what extent we will see modification of these program terms,” Ely told
Another concern, some of the economists noted, is the potential political influence the government can now exert on the banks.
According to Woods, the banks will now be “forced to lend to politically favored constituencies.” He cited the Reconstruction Finance Corporation’s emergency loans to banks in 1932 as an example. At the time, Herbert Hoover’s Republican friends benefited from the transaction, said Woods.
Meltzer said the federal government will influence the banks. “The likes of Senator Schumer, and Senator Dodd, and Congressman Frank are certainly going to want to decide how credit gets allocated by the banks, and that’s a bad thing,” Meltzer told
When asked about the overall effect of the legislation, however, the views of the economists queried varied.
Many smaller banks will be resistant to sell their stock, said Niskanen, because it would relinquish their control over executive compensation.
The real problem, he added, though,  is future legislation by the government. “On the purchase of preferred stock by itself,” said Niskanen, “I think it is not something to be very concerned about, unless it is a precedent for much broader action.”
Both Mills and Woods said the legislation will damage the free market in the United States. Ely said the future is unclear. “We’re going to just have to see how it plays out,” he said. “And there’s just a lot of details that just are not known at this time.”