America's bail-out plan

I want your money

Sep 25th 2008
From The Economist print edition

No government bail-out of the banking system was ever going to be pretty. This one deserves support



SAVING the world is a thankless task. The only thing beyond dispute in the $700 billion plan of Hank Paulson, the treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, to stem the financial crisis is that everyone can find something in it to dislike. The left accuses it of ripping off taxpayers to save Wall Street, the right damns it as socialism; economists disparage its technicalities, political scientists its sweeping powers. The administration gave ground to Congress, George Bush delivered a televised appeal and Barack Obama and John McCain suspended the presidential campaign. Even so, as The Economist went to press, the differences remained. There was a chance that Congress would say no.
Spending a sum of money that could buy you a war in Iraq should not come easily; and the notion of any bail-out is deeply troubling to any self-respecting capitalist. Against that stand two overriding arguments. First this is a plan that could work (see article). And, second, the potential costs of producing nothing, or too little too slowly, include a financial collapse and a deep recession spilling across the world: those far outweigh any plausible estimate of the bail-out’s cost.

Mr Market goes to Congress

America’s financial system has two ailments: it owns a huge amount of toxic securities linked to falling house prices. And it is burdened by losses that leave it short of capital (although the world has capital, not enough has been available to the banks). For over a year, since August 2007, central bankers, principally Mr Bernanke, have been trying to make this toxic debt liquid. But by September 17th, following the bankruptcy of Lehman Brothers and the nationalisation of American International Group earlier that week, the problem started to become one of the system’s solvency too. The market lost faith in a strategy that saved finance one institution at a time. The economy is not healing itself. If credit markets stay blocked, consumers and firms will enter a vicious spiral.
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Mr Paulson’s plan relies on buying vast amounts of toxic securities. The theory is that in any auction a huge buyer like the federal government would end up paying more than today’s prices, temporarily depressed by the scarcity of buyers, and still buy the loans cheaply enough to reflect the high chance of a default. That would help recapitalise some banks—which could also set less capital aside against a cleaner balance sheet. And by creating credible, transparent prices, it would at last encourage investors to come in and repair the financial system: this week Warren Buffett and Japan’s Mitsubishi-UFJ agreed to buy stakes in Goldman Sachs and Morgan Stanley. Some banks would still not have enough capital, but under Mr Paulson’s original plan, the state could put equity in them, or, if they become insolvent, take them over and run them down.
The economics behind this is sound. Government support to the banking system can break the cycle of panic and pessimism that threatens to suck the economy into deep recession. Intervention may help taxpayers, because they are also employees and consumers. Although $700 billion is a lot—about 6% of GDP—some of it will be earned back and it is small compared with the 16% of GDP that banking crises typically swallow and trivial compared with the Depression, when unemployment surged above 20% (compared with 6% now). Messrs Bernanke and Paulson also have done well by acting quickly: it took seven years for Japan’s regulators to set up a mechanism to take over large broke banks in the 1990s.
Could the plan be better structured? Some economists want the state to focus on putting equity into the banks—arguing that it is the best way to address their lack of solvency. In theory you would need to spend less, because a dollar of new equity would support $10 in assets. Yet the banks might not take part until they were on the ropes and, if house prices later fell dramatically more, the value of the banks’ shares would collapse. The threat of the government taking stakes would scare off some private investors. And in the charged atmosphere after this bail-out meddling politicians, as part-owners, would have a tempting lever over the banks.
Mr Paulson’s plan also has its shortcomings. He will find it hard to stop sellers from rigging auctions, if only because no two lots of dodgy securities are exactly the same. Taxpayers may thus pay over the odds and banks may be rewarded for their stupidity. Yet these costs seem small against the benefit of putting a floor under the markets. And fine calculations about moral hazard are less pressing when investors are fleeing risk.
If the economics of Mr Paulson’s plan are broadly correct, the politics are fiendish. You are lavishing money on the people who got you into this mess. Sensible intervention cannot even buy long-term relief: the plan cannot stop house prices falling and the bloated financial sector shrinking. Although the economic risk is that the plan fails, the political risk is that the plan succeeds. Voters will scarcely notice a depression that never happened. But even as they lose their houses and their jobs, they will see Wall Street once again making millions.

Buckle a little, but do it briefly

In retrospect, Mr Paulson made his job harder by misreading the politics. His original plan contained no help for homeowners. And he assumed sweeping powers to spend the cash quickly. He was right to want flexibility to buy a range of assets. But flexibility does not exclude accountability. As complaints mounted, Mr Paulson and Mr Bernanke buckled—agreeing, for instance, to more oversight. Now that Messrs McCain and Obama have returned to Congress to forge a deal, more buckling may be necessary. Ideally, concessions should not outlast the crisis: temporary help for people able to stay in their houses, a brief ban on dividends in financial firms, even another fiscal package. They should not be permanent or so onerous that the programme fails for want of participants—which is why proposed limits on pay are a mistake (see article).
Mr Paulson’s plan is not perfect. But it is good enough and it is the plan on offer. The prospect of its failure sent credit markets once again veering towards the abyss. Congress should pass it—and soon.

Giving a huge sum of money to the failed financial industry and depend on it to provide credits to the general economy will not work. A far more effective way to deal with this credit crisis is for the government to provide loans directly to businesses. This way, taxpayers are directly supporting the economy and the money is going into worthy investments like GM and other businesses that actually produce something. It also reward the good businesses for their responsible behaviors. Buying the bad loans from financial companies is like throwing money into a burning fire hoping to put it out.
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Machiavelli Jr. wrote:
September 25, 2008 22:40
I have a modest proposal: let Wall Street eat cake (no bailout).
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Edward Chen wrote:
September 25, 2008 22:36
There shall be more transparent and object information and assessment of the results of both bail-out and not-bail-out. Unfortunately, there is almost none in the public press right now, including this article of The Economist.

And to be honest, The Economist’s arguments can hardly support the proposition: “the potential costs of producing nothing, or too little too slowly, include a financial collapse and a deep recession spilling across the world: those far outweigh any plausible estimate of the bail-out’s cost”. What is the “plausible estimate” of the bail-out “cost”? There is only partial and one-dimension perspective in the analysis of this article.

When you want to use tax-payer’s money, whether the money is used to fund the bail-out or pay for the interest of the debt used to pay for the bail-out, the wording of “cost”, “plausible estimate”, and “work” can not be assessed in some narrow and single dimension.

To just ask some simple questions out of many: Why shall the taxpayers who have nothing to do with the financial storm pay for the troubles caused by those involved?

What Congress “shall” do is to express the real public’s intention. I mean “real”, which stands for every penny of the federal fund and everyone of the taxpayer.

The only way to persuade that all taxpayers shall pay is to provide really “plausible” reasons that what non-bail-out could cause for every taxpayer of the America and to demonstrate that consequence of non-bail-out is worse than that of bail-out, which also comes from “plausible” analysis. Then let them decide.
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Alien8 wrote:
September 25, 2008 22:32
The Economist suggests that proposed limits on executive pay might limit participation in the plan and should therefore be dropped. I suggest that most executives would prefer to have their pay capped temporarily than to find themselves jobless in the wake of a bankruptcy. Executives demanding golden parachutes in this political environment are likely to find themselves in need of the more traditional kind, if only briefly.

I am astonished that the Economist would foist such an asinine and self-contradictory argument upon its readers.
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drdlc wrote:
September 25, 2008 22:30
As a recent graduate entering the job market, I am somewhat sympathetic to notsoyoung's worry of this coming back to haunt out generation. Inevitably it will be our generation and future generations that will have to bear the brunt of this financial meltdown.

Something that few people have actually mentioned, either in The Economist, or in other media outlets is how we got into this whole mess. During the Clinton administration Congress repealed many of the laws and regulations that governed how banks could lend money and whom to. I am not saying that it is entirely politicians fault. Greed did take over and banks thought that they could make a lot of money.

As for a government "bailout plan"...I do not want the government to give $700 billion dollars to these companies. It should lend them the money. I have no clue why no one has mentioned this possibility. Companies can ask the government for a loan to provide them with the necessary capital they need to stay afloat, but they will pay these loan back with interest. Until the companies pay back these loans they will be unable to pay dividends to their shareholders. Also, loans to these companies would allow time for the government to seriously concentrate on the needed reforms and regulations that need to be implemented and debate IF further action should be taken by the government in the market.
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Ziegenmelker wrote:
September 25, 2008 22:11
You are calling the US$700 at question "taxpayer's money". The opposite is the case. It is money that the taxpayer does not have. The money will be borrowed on behalf of the taxpayer, just like the money that "bought you a war in Iraq". It will be borrowed from the Chinese government, from the oil-rich nations of the Middle East, from the Japanese government, and from institutions and private individuals around the world that are looking at US treasury bills as the ultimate safe investment.

But as a borrower, the US government is becoming suspect. It is not enough that this borrower needs to borrow more every year just to serve his interest payments. He now says that he is seriously ill (we hear his arteries are clogged), and needs more money for an emergency operation. He promises to get better soon, after the operation. But didn't this borrower claim to be in good health, recently? What happens to the loans when the operation fails? Even if the operation is successful, are there other illnesses that he has been hiding from his lenders, which will require expensive operations? Is there any hope that this borrower will get back to work? Will he ever actually start paying back the loans?

After the dot-com bubble and the housing bubble, it is US treasury bills that became the bubble of last resort, before the US government goes bankrupt, and the US economy and society collapses.
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OldSpencer wrote:
September 25, 2008 21:54
"I thought the Economist was an enterprise that supported capitalism"

Maybe you're a bit naive ? =] No offense intended.
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notsoyoung wrote:
September 25, 2008 21:50
As brilliant as this paper has and will continue to be I have to take issue with this quote:

"And fine calculations about moral hazard are less pressing when investors are fleeing risk"

As a 23 year old I am (probably selfishly) less concerned with the current status of the 401k funds of my parent's generation and more concerned about the long-term consequences of this disaster. I have heard no suggestions on addressing the moral hazard issue here. There seems to be no reason why banks cannot simply reengage in this reckless behavior, reap tremendous profits and then simply turn to us, the taxpayer, for bailouts again.

I understand that in the sort term something needs to happen, but please, for the sake of my generation who is sure to foot the majority of this bill, let's at least look up from our blind panic to look around the the next corner.

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EliasX wrote:
September 25, 2008 21:40
There should be some restrictions on the amount of (bad) loans the federal government accepts from individual banks. After all, why do they have reserves and write-offs? Let them take some of the heat, too.
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ozeconomics wrote:
September 25, 2008 21:26
Well, in response to FREELUNCH3210, can I make the point that there are two possible providers of the goods and sevices that we consume, the government and the market. Pizzas, for example, we leave to the market mostly because a pizza made by government wouldn't taste better than the box it came.

With police services though, we want government to do it... because justice isn't based on user pays principles.

But government makes the money market, and this financial crisis is in the money market and its derivatives. Debt-equity swaps, another derivative, went a long way to solving the various international debt crises, and should be applied now. This heavily penalises bad decision-making on Wall Street, restores the system to a point, and in the longer term at least, gives some potential for the taxpayers to get some of their investment back.

Wall Street doesn't want to give up equity of course, but that is too bad for them.