Many explanations have been written about what caused the 2008 financial crisis. George Mason University economics professor Russ Roberts’ paper “Gambling with Other People’s Money: How Perverted Incentives Caused the Financial Crisis” is among the best.
Capitalism, Milton Friedman once said, is a profit-and-loss system. “The profits encourage risk-taking. The losses encourage prudence,” Roberts wrote. The recent meltdown occurred because Wall Street figured out a way to collect all the profits while sticking you, the taxpayer, with all the losses.
Specifically, Wall Street looked at the implicit government guarantee given to Fannie Mae and Freddie Mac debt, along with the special status the Basel II international accounting regulations given to AAA securities, and they figured they could make a ton of money by borrowing big money to make bets on rising home prices.
If those prices kept rising (heads, Wall Street wins), Wall Street CEOs would make billions in bonuses and stock options. And if housing prices fall, the federal government would step in to bail out Fannie, Freddie, Bear Stearns, and AIG (tails, you lose). Meanwhile, the Wall Street CEOs walk away with only the millions they made in salary over that time.
In other words, the crisis was caused not by a lack of regulation, but by existing regulations that misaligned incentives toward excessive risk-taking. The financial regulations President Barack Obama signed in 2010 did nothing to realign these incentives. Even worse, his political allies on Wall Street and in the labor movement are now conspiring to cheat you again.
The new game goes something like this: Government unions help elect pliant Democrats who then reward unions with generous defined-benefit health and retirement plans. Unlike higher wages, which have to be paid today, defined-benefit plans allow politicians to promise higher payoffs later while only setting aside a fraction of that money now. This all works out great as long as the assets the politicians choose to invest in perform well. This is where Wall Street enters the game.
Managing government worker pension investments is a trillion-dollar business — a business where politicians have complete control over the investment decisions. When Obama’s auto-bailout czar, Steve Rattner, paid $10 million to the state of New York to settle pension-kickback charges, Politico’s Ben Smith noted: “Top politicians whose salaries are stuck in the low six-figures are suddenly in control of pots of money running into the twelve-figures. And top Democratic donors who cast themselves as high-minded, disinterested dabblers in the public good are revealed to have quite a bit of interest after all.”
And it is not just politicians who get corrupted. Last year, Byron Wien, an economic adviser for the Blackstone Group private equity firm, told a trade publication that “retirement benefits for state workers” are “too generous.”
Problem is, government pension funds were major Blackstone investors. So Blackstone was then forced to issue a statement disavowing any link between government employee retirement benefits and state and local deficits.
The partnership between Wall Street and government unions wouldn’t be so troubling except for one simple problem: When things go south, the taxpayer will end up holding the bag. “Defined-benefit plans are explicitly designed to shift investment risk from employees to employers,” the Manhattan Institute’s Josh Barro said.
And since we are talking about government employees, when Barro says “employers” he means you, the taxpayer. So as long as the market produces bull-market returns, all is well (heads, Wall Street and unions win). But if there is a bear market, taxpayers will have to pay more to make up the difference (tails, you lose).
Conn Carroll is associate editorial page editor of The Washington Examiner.