October 23, 2008 | WebMemo on Economy
Last week, the Treasury Department announced a new approach to addressing the crisis gripping financial markets: the direct purchase of equity stakes in U.S. banks in order to increase the capital levels of those institutions.
While it is a potentially effective step toward rebuilding confidence in the banking system and restarting the credit markets, the action is also a dangerous one. Policymakers must ensure that the result is not a legacy of political control of the financial system, threatening the efficiency of markets and the principle of private ownership.
Under normal circumstances, the very concept of direct government purchase of bank stock of any type would be unthinkable and unacceptable. That is no doubt one reason the Treasury initially contemplated only the purchase of troubled, non-equity assets for its Troubled Assets Relief Program (TARP). But the persisting and severe disruption in financial markets led policymakers to take stronger action.
Moreover, to a large extent, the hand of U.S. policymakers was forced by overseas governments that provided similar capital programs to their banks. If the U.S. government had not established this program, foreign banks would have been seen as safer, and ours would have been at a disadvantage. Subsequently, large depositors and investors would have moved their money to the foreign banks.
However, the U.S. should not allow international pressure to determine its financial regulatory policy. The U.S. government's responsibility is to develop and implement policies that are in our national interest, not to make those interests second to international opinion. While it is reasonable for governments to consult during an international financial crisis, no government should be expected to take actions that put its own citizens' interests at a disadvantage.
The program sparked a generally positive reaction in financial markets and appears so far to be effective. But as a matter of principle, the government should not be allowed to control or unduly influence the management decisions of private banks through partial ownership in them. A banking system free from such government control is an essential part of a free market economy.
In order to minimize this danger, policymakers should stake out clear boundaries for the bank capital system that must not be crossed:
Preserving Independent Institutions
Because the recent turmoil in the financial system threatens the operation of the credit markets and could seriously damage the economy, solutions that would be anathema at other times may be justified. The financial situation remains serious, and further steps may be necessary. As a result, policy makers should give the Treasury Department and the financial regulators the flexibility necessary to act.
However, those actions must be carefully controlled and limited in both time and scope so as to preserve over the course of this situation the free market principles and independent institutions that are necessary for America's economic health.
David C. John is Senior Research Fellow in Retirement Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
 The bank capital purchase program was one of many programs that were announced by Treasury last week. FDIC's temporary deposit insurance coverage of all amounts held in non-interest-bearing transaction accounts and its temporary guarantee of bank debt are both appropriate responses to the current financial turmoil. Similarly, the Federal Reserve's temporary commercial paper funding facility is an important step toward restarting the credit markets.