On the Bailout

Submitted by Anonymous on 9/29/08

New York City -- With the terms of the historic $700 billion bailout of the U.S. financial system now evidently fixed, it is appropriate to offer some reflections on what we know, what we may surmise and what we don't know.

What we know is as follows:

  • As noted by Wolfgang Munchau, Daniel Gros and Stefano Micossi in the Financial Times, banks in some countries are now too big for their governments to bail them out and, in the United States, the overall financial sector is too big for the government to bail it out.  This is an important sea change in finance.  For this reason, the bailout offers a reasonable chance of stabilizing the system, but not is not a guarantee.
  • Other countries from our allies in Europe to our enemies elsewhere are already crowing in glee at the U.S. comeuppance as the penalty for our previous hubris.
  • The failure of the U.S. financial sector -- and it is a systemic failure -- will humble U.S. exceptionalist claims for some time to come.
  • The United States is in need of radical redesign of its financial regulatory and bank supervisory regime.  Congressional hearings and a blue ribbon commission to study this and come up with recommendations -- rather than a clubby insider process run by Wall Street -- should be at the heart of overhaul of the system.

We may surmise that:

  • The bailout will work and that the recovery will occur more rapidly than, say, that in Japan in the 1990s.  Our chief advantage here -- and let us hope we retain this advantage, is the flexibility of our more capitalist system.  The mark to market rules for troubled holdings that arguably accelerated the onset of the crisis but may also acclerate working through it.
  • Treasury will use the cryptic authority granted it by Congress to minimize foreclosures.  As the eventual holders of much of the non-performing paper, the government should have the ability to alter loan terms to keep families in their homes.  However, it is up to Treasury and Congress to determine whether this happens or not.

What we don't know is as follows:

  • Whether and how quickly the bailout will restore calm to financial markets.  While the promise of debt relief is designed to restore trust in the markets, how quickly that trust returns remains to be seen.  It is not entirely inconceivable that we may see further runs on vulnerable institutions.
  • What Treasury will pay for securities and what securities they will buy.  The goal of the plan is to make banks solvent.  This means Treasury will have to pay more than market value for securities.  As they will have to allocate the $700 billion across numerous financial institutions and classes of securities, the devil is in the details.  The possibilities for abuse and simple incompetence are immense.  (This is why many economists favored direct government investments in the firms with equity rather than overpaying for bad assets.)
  • Whether the plan will work long term.  A key flaw identified immediately in the Paulson plan but never resolved is that the plan leaves the system largely unchanged and has no explicit method to replace the bad debt with good.  What is to prevent banks from making more bad loans?  How can we be sure that other loans don't go bad if the economy tanks  And why should we expect non-performing loans to ever begin to perform if loan terms are not altered?  In accepting the Paulson plan, Congress rejected proposals by Alan Blinder, Nouriel Roubini and Hillary Clinton to create a Homeowner's Loan Corporation that would have issued affordable mortgages in place of predatory or unaffordable ones.  This, in my view, would have not only turned bad loans into good ones but helped people stay in their homes.
  • How the crisis will impact the real economy.  Last quarter, the economy grow by a respectable 2.7%.  Most analysts now expect a recession.  How long and deep the recession goes is unknown.  However, with interest rates already as low as they can go, judicious fiscal stimulus in the form of investments in clean infrastructure, as I have argued, and other worthwhile spending, are the only real option for limiting the depth and duration of the recession.
  • How the crisis will affect the willingness of foreigners to buy our debt and the dollar's role as a reserve currency. While this crisis has been difficult, it is nothing compared to what it would have been like if the United States did not have the luxury of borrowing in our own currency and continually selling the new debt we accumulate daily due to our deficits to overseas investors, a luxury we enjoy thanks to the dollar's position as a reserve currency  Some would like to see the Euro replace the dollar as a reserve currency just as the dollar replaced the Pound after the Suez crisis. 

These are all critical questions and how the government manages the use of the $700 billion authorized will be critical to determining whether this crisis ends up being a footnote in history or a painful chapter.