[Richard Painter, guest-blogging, March 26, 2009 at 12:52am] Trackbacks
Bailouts and Government Ethics

have never mixed, and never will.

Let's start with the great bailout of 1789. The Treasury Department was born and its Secretary, Alexander Hamilton, proposed that the new federal government use the Bank of the United States to pay off the Continental Revolutionary War debt at 100% of face value and also bail out the states by paying off their debt at 100%. The notes were trading at 20% to 30% and speculators -- many of them Hamilton's friends -- were buying them up furiously. Members of Congress had to approve Hamilton's plan, which they eventually did, but many bought up notes first.

Senator William Maclay (D --PA) and some other Democrats complained that this entire business was unethical. Maclay recounted in his Journal that Members of Congress and other speculators sent stage coaches all over the West and South with cash to find and buy as many of the notes as possible from farmers and war veterans and bring the notes back to New York to sell as soon as Hamilton's plan was a done deal. The scheme worked, but Congress responded by imposing a statutory ban on the Secretary of the Treasury or the Treasurer from being "involved" in the purchase or sale of federal or state government bonds while in office. The 1789 statute is still on the books today and incoming Treasury Secretaries are warned to make government bond purchases and sales before taking office. Hamilton's First Bank of the United States was also plagued by the allegations of corruption. Jeffersonian Democrats in Congress eventually succeeded in denying renewal of its charter in 1811. Congress, however, did nothing to address the trading in government bonds by its own Members.

When I gave a lecture in 2006 on the 1789 bailout plan, I thought government bailouts of this magnitude and the corruption that came with them were an interesting part of legal history. See Ethics and Corruption in Business and Government: Lessons from the South Sea Bubble and the Bank of the United States (University of Chicago Law School 2006 Maurice and Muriel Fulton Lecture in Legal History) (published by the Law School and available on SSRN)

2008 and 2009 brought another series of massive federal bailouts. These bailouts are no more compatible with government ethics than was the bailout of 1789. The fact that we have more rules on the books about financial conflicts of interest and insider trading will make some difference, but probably not much.

There is clearly dissatisfaction with the "Goldman Sachs goes to Washington" phenomenon that has spanned at least two administrations. True, the top Treasury officials who came from Goldman were forced to sell their Goldman stock (the sales in 2005 and 2006 were at high prices compared with what the stock would fetch today and the Office of Government Ethics provided the "certificate of divestiture" needed to defer capital gains tax on the sales). Nobody thus had any more Goldman stock upon reaching the Treasury Department, and in any event I doubt anyone at Treasury consciously intended to help Goldman in any bailout decisions.

It doesn't matter. Others on Wall Street and elsewhere complained that bailouts were arbitrary. Lehman Brothers, an old Goldman rival, was allowed to fail. AIG, which owed Goldman about $20 billion as counterparty in derivative transactions, was bailed out. When officials left Treasury, some went to banks that also were asking Treasury for bailout money. Actual impropriety I very much doubt; but there were and there will continue to be appearance problems. These problems however were unavoidable if the bailout deal was going to get done.

How do we fix this going forward? First, we can tinker with ethics rules and agency procedures to make things better at the margins. I discuss some of these ideas in my book. There could be quotas on the number of very senior Treasury officials from a single investment bank. Treasury officials could be prohibited from discussing any official matter with a previous employer for a period of two or three years. As I suggested in an earlier post, Treasury officials could be barred from speaking at or even attending political fundraisers where they are likely to be pressured for bailout funds and pumped for inside information about who is going to be bailed out next. Departing Treasury officials for one year could be prohibited from taking a job at a bank that received funds in a bailout which they participated in personally and substantially (similar restrictions are now imposed on some government procurement officials). All of this might make some difference.

A more radical step would be to eliminate the revolving door and staff the senior ranks of government entirely with career bureaucrats. If we are going to have an industrial policy like France where the government chooses winners and losers in the private sector, why not have a civil service like that of France? The American system of political appointments is not well suited for a government that gets into everything, pays for everything and ends up owning a piece of everything. There are simply too many conflicts of interest.

Finally, perhaps because we value the type of government we have and the experience that private sector jobs bring to government, we might consider a radical idea: no more bailouts. We will have to avoid allowing companies to get "too big to fail", through antitrust laws or otherwise, or alternatively figure out a way to protect the rest of the economic system when a big company does fail. Whatever is done, we cannot escape the fact that bailouts and ethics don't mix. We found this out in 1789 and we should know this now.

Thoughtful (mail):
How does the old saying go?...

Fool me once, shame on you; fool me for 220 years, shame on me...
3.26.2009 3:39am
A well-written and interesting analysis, the conclusions of which I find persuasive.

I think the historical analysis is a little facile, however. For Congress to decline to repudiate the war debt of its predecessor is not seriously equivalent to bailing out a private firm that has screwed up in the marketplace. It was -- as Hamilton persuasively and IMHO correctly argued -- more substantially a question of establishing the financial sobriety of the new nation, of giving investors, particularly foreign investors, confidence that the United States would pay its debts and not take the excuse of a new government to welsh on them to some random degree.

Furthermore, it's not clear how much "bailing out" of the states was being done. The largest states (e.g. Va) had gone quite a way to retiring their debt and would have had no particular problem paying it. The debt was assumed, as Hamilton admitted, in large part to bind the states more closely to the new Federal government, and, by creating a debt that would take decades to retire, to establish a Federal credit market that could be used to stabilize the currency, if not (anticipating the monetarists) the economy itself.

The speculation and "unreasonable" profits by Hamilton's friends and others was real enough but a bit of a sideshow, the AIG executive retention bonuses of its day. It certainly did not influence Hamilton's ideas or plans, and I would be surprised if it influenced except at the margin any Congressional votes. Congressmen had plenty of reasons in the structural changes it would make to the Federal-State relationship to like or dislike it.

Fascinating stuff about the connections between Goldman Sachs -- well beloved by Democrats, particularly Clinton machine Democrats -- and the triage decisions the Federal government made. I was always a little mystified by why they let one firm die and saved another, inasmuch as their explanations rang hollow at the time. Now much is clear.

Gee, more than ever I feel a little nauseated when I read or hear one of these sanctimonious kleptocrats rear up on his hind legs and TelePrompTer us about morals and good sense. Feh. Jefferson was probably right about the tree of liberty and its nutritional needs.
3.26.2009 3:48am
Bill Harshaw (mail) (www):
A bureaucracy like France? Never happen. France has a strong central government, we have a weak one. We protect out liberties by our fragmentation. The people are too paranoid about misuse of centralized power.
3.26.2009 8:21am
I have often wondered why the FED and Treasury are filled with people from the private sector, mostly folks from large East Coast banks. Other cabinet and important department positions are filled mostly from career politicians or academia. I am certain there is a large number of very smart capable people, other than the same ole white shoes, who could come in from afar (west of the Mississippi) and perform very well. And they would not have the immediate appearance of being manlipulated by the establishment. Any good law profs out there ready to fix the economy?
3.26.2009 8:46am
rosetta's stones:
Your conclusion is correct, the answer is "no more bailouts". To the Paulsens of this world, ethics are meaningless. And as for Bernanke, I can't help but think that the most critical (to the Beltway crowd) pre-confirmation question that he fielded was made privately, with no public record: "Mr. Bernanke, when the time comes, will you break faith with 30 years of public policy, and print money to buy US paper, so as to finance an increase in deficit spending?"
3.26.2009 9:01am
corneille1640 (mail):
I agree with SPLUNGE's historical analysis.
3.26.2009 10:28am
MarkField (mail):
To Splunge's excellent post, I'd add two other points. First, the original bank expired in 1812, not 1808. Second, I think it's stretching things to say that the First Bank was "plagued by the allegations of corruption". There's not that much evidence of corruption in the First Bank (there is with respect to the Second).

It's not clear to me why you seem to tie the First Bank to the monetization of the debt. They were seen at the time as separate issues. There was little controversy over the Revolutionary War debt, though a big dispute regarding payment to original holders or bona fide purchasers. The far more significant debate involved assumption of state debts, which was compromised by the location of the capital in D.C.
3.26.2009 10:46am
Bob White (mail):
I'm not as up on my Founding-era history as I should be, but IIRC Virginia was one of the few states that had repaid much of its war debt and thus the Virginia aristocracy, with the typical farmer's hatred of debt and a state that didn't serve to benefit that much, were among those most vociferously opposed to federal assumption of the state debts. Note, of course, that this doesn't impact the wisdom of the assumption of state debts or the non-repudiation of the pre-Constitutional-era debt, on which points I agree with Splunge that these were desirable.

As to the desirability of the French example, I don't think it particularly solves the ethical problem so much as necessitates a longer time-horizon-instead of switching from private practice to government to private practice after a couple years, it is instead a relatively seamless transition from government to private practice. It happens in France, it happens in the U.S. most prominently in the defense industry, and it happens in Japan, where it's known as amakudari, lit. "descent from heaven."
3.26.2009 12:05pm
Bob from Ohio (mail):

I doubt anyone at Treasury consciously intended to help Goldman in any bailout decisions.

Just a coincidence, I'm sure, that Goldman is a massive beneficiary.
3.26.2009 1:00pm
c.gray (mail):

A bureaucracy like France? Never happen. France has a strong central government, we have a weak one. We protect out liberties by our fragmentation.

Do we?

Couldn't that just mean the USA will wind up like 18th century France instead of modern France, oppressed by _both_ the central AND local authorities?
3.26.2009 1:32pm
Perseus (mail):
Assumption was not a bailout either. A settlement of accounts was supposed to occur in which all money spent on behalf of the war by each state was to be totaled and then apportioned. Those states that had paid a disproportionately large share of the cost of the war were supposed to be reimbursed by the other states. Assumption would merely facilitate this process.

Also, you fail to mention that "land jobbers" also bought the depreciated debt on the open market to buy government land because the government accepted the debt at face value. Hamilton's plan would put an end to this little bonanza for them. And speaking of land jobbers, they, including Madison, would benefit by locating the capitol near the Potomac, which was the price they exacted for supporting assumption.
3.26.2009 3:14pm
A civil service like France would be a plus, with or without an industrial policy. Americans are much worse at staffing its government bureacracies than the French, had pure patronage until a quite late date, and have still not done a lot of good thinking about how to run a civil service system well.
3.27.2009 7:32pm
keithwaters (mail):
Jefferson thought of himself as a Republican, not a Democrat or a D-R.
3.27.2009 9:13pm
Rich Rostrom (mail):
How on earth do you propose to insulate government officials from the private economy completely?

For one thing, they have spouses, children, and siblings, any of which could be the indirect beneficiary of a favor done officially.

They also may have investments on the side. I can think of a hundred ways to launder payoffs. For instance, if I wanted to be sure that the Attorney General of my state was friendly, I could arrange for the AG's spouse to make a large profit in some securities market. In fact, I rather think that might have happened at least once.

Is the suggestion that public officials should be financial eunuchs - denied all opportunity for private financial activity lest that activity give them private incentives for or against official actions?

Incidentally, I would not look to France as a model in this respect. The French ruling elite - the enarques - are all tied up between public and private sectors, and make good use of the connections. There is corruption on an epic scale. Google on "whore of the republic" for some of the recent scandals.
3.27.2009 11:41pm
ChrisTS (mail):
Jefferson thought of himself as a Republican, not a Democrat or a D-R.

Love the anachronism.
3.28.2009 9:49pm

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