Will the Government Destroy American Capitalism?

You're living through a financial meltdown unlike any other in American history. The destructive forces now being unleashed are so potent and powerful that they threaten not only to trigger a severe recession, but also to attack the core underpinnings of capitalism itself. If left unchecked, the long-term consequences will be disastrous.

I'm speaking, of course, of the U.S. government and its heavy-handed interventions. The law of unintended consequences is still stronger than any bailout package or regulation, and the more strongly the government intervenes, the bigger the problems it causes.

Capitalism's underpinnings
Two things are absolutely key to any market economy's success: contract integrity and consequences for failing to deliver. Through its attempts to "help," the government has essentially nullified both. While its actions may seem politically expedient in this contentious election year, the long-run results will be devastating.

For example, shortly after taking over failing bank IndyMac, the government halted foreclosures on that bank's defaulted loans. While that may sound like a kind thing to do for distressed homeowners who found themselves in over their heads, the message it sent was anything but kind to the rest of the market.

To other lenders, the message was, "Don't make a mortgage loan with the expectation that you can foreclose if the borrowers miss their payments." To prospective borrowers, the message was, "Go ahead and continue to take out mortgages you don't understand, on houses you can't afford. We'll protect you from the consequences if you screw up."

In an environment like that, where the contracts aren't respected and failure isn't punished, is there any wonder why banks are treating nearly every mortgage applicant like a likely deadbeat? Any Fool should have seen that coming.

Freddie, Fannie, and AIG.gov
As misguided as the decision may have been to halt IndyMac's foreclosures, at least the government had some legitimate basis for its takeover of that failing bank. Not so with its other major interventions, like the feds' guarantee of billions of Bear Stearns' liabilities to sweeten the pot for JPMorgan Chase's (NYSE: JPM) takeover of that failing broker.

Emboldened by that bit of economic engineering, and an apparently financially illiterate Congress exercising questionable oversight, the feds have continued to maul the markets. Thanks in part to yet another bailout, the U.S. Treasury completely controls Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). Almost ironically -- and ominously, when it comes to the potential for fixing things in the future -- the seeds for their destructions were largely sown by their so-called saviors.

Now our government is the proud owner of failing insurance giant AIG (NYSE: AIG). Like Bear, Freddie, and Fannie, AIG overleveraged itself to make gigantic bets on mortgages and derivatives based on the housing market. Like the other aforementioned beneficiaries of the government's largesse, AIG and its principals benefited from those bets when they were winning. Of course, now that they've gone bad, you and I, the American taxpayers, are stuck with the costs of cleaning up their mess.

Bad mortgages? Toxic derivatives? Excessive debt? All wholly owned subsidiaries of, or backed by, the U.S. government. No wonder gold just had its largest one-day price jump in history, the dollar has once again started sinking, and oil has bounced back from the dead. The feds seem to be doing everything in (and beyond) their power to destroy the very foundation of the country's success, all to bail out billionaires.

The right model for failure
Troubled companies with legitimate assets can often find a home without endangering the public's finances -- even if they're large financial businesses. Bank of America (NYSE: BAC), for instance, bought out troubled lender Countrywide, and it's in the process of acquiring prime broker Merrill Lynch (NYSE: MER) after the latter stumbled. No bailout needed.

Even Lehman Brothers is settling its failure the market-friendly way, under bankruptcy protection, and for the benefit of senior debt holders, under an impartial judge. Sure, vulture capitalists like Barclays (NYSE: BCS) stand to benefit by picking apart Lehman's carrion, but at least we taxpayers aren't saddled with the risks.

If capitalism is going to survive this crisis, it needs more Merrill Lynch-, Countrywide-, and Lehman Brothers-style failures, and fewer government-subsidized ones. Let the market participants bear the full risk and cost of failure. It's the only way to ensure that the lessons learned from this debacle will help dampen, rather than exacerbate, the next round of problems.

Otherwise, the long-term consequences to American capitalism itself could be absolutely apocalyptic.