The conventional opinions on the Fannie and Freddie bailout are not terribly broad. From the Left, we hear recycled market-failure arguments, whereas from the Right we hear that the bailout is a necessary evil to be endured until the economy and the housing market rebounds in a few years, at which time–mirabile dictu!–real free market reforms can be implemented by a future congress supposedly more enlightened than the present one.
This is, of course, a con to deflect blame and pacify an otherwise enraged public at least until November 5, 2008. But then what? Here are a couple of scenarios that I see as likely.
The best-case scenario is for Fannie and Freddie to be allowed to chug along in some form for a couple more years, at the expense of higher inflation and an even weaker dollar (if that is even possible). Bernanke’s term is up on 2010, and the next president will then appoint a Volcker-like figure who will remove not only this liquidity from the economy, but also much of the already significant liquidity of the Greenspan-Bernanke Feds. (If Obama is elected, he may even appoint Volcker himself.) This Fed chairman will be reviled–the ultimate skunk at the garden party–but he will serve the purpose of clearing the deck for the political class that trashed it through the 1990s and 2000s. Once those dollars are removed, then the Fed can repeat the mistakes of the last 20 years. It will be Open Market Operations as usual.
That is my best case scenario (among likely scenarios). The worst-case is that the bailout will not allow Fannie and Freddie to simply chug along, and the US and global economies continue to atrophy. The result will be a future Bretton Woods-like meeting that announces the end of the implicit international dollar standard on the basis that it proved insufficiently liquid and while also being incompatible with the speed of modern capital flows, thus requiring the creation of a new currency that will be global, issued by a world central bank, and legal tender. This is the scenario currently called for by Robert Mundell.
None of these scenarios are especially encouraging. Fannie and Freddie need to fail (to say nothing of many badly-run banks), and the short-run political and economic upheavals welcomed as necessary precursors to true free-market reforms and the emergence of a long-hindered liberal international order. That they are not being allowed to fail means that these reforms are even less likely. What is happening now reflects the situation in Japan around 1990, when its over-inflated banking system busted and the response was to print as much yen as necessary, resulting in a prolonged and painful recovery. We are following the same path, thus proving that those ignorant of economic history are doomed to repeat it.