The $700 billion ‘bailout’ proposed by the dynamic duo of Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke last week is emerging as one of the most contentious issues in years. Everyone senses a lot is at stake here. Nobody, including Nobel laureate economists, is very certain of whether it will work.
Many in both political parties reacted strongly against Paulson’s three-page plan, but both houses of Congress remain divided on what exactly needs to be included in fair and effective legislation.
I don’t claim greater wisdom on the issue than others, but when readers and friends ask about it, here’s what I have been saying.
Q Is a bailout necessary?
A Nobody knows for sure. It hinges on how well markets function during financial crises without government intervention, and opinion varies about that.
Free-market fundamentalists argue the government should butt out and let the chips fall where they may. Carnegie-Mellon’s Allan Meltzer is perhaps the most prominent, but there are others, both in academia and on Wall Street. They are a minority, however.
Most economists see a bailout plan as terrible policy, but still better than doing nothing. I’m in this group. I’m not a fundamentalist, but I believe markets function well for society in most day-to-day circumstances and I know government action is not guaranteed to cure all problems.
But it also is clear that markets don’t always function well and that financial crises, where panic and desperation begin to snowball, are one case where they don’t. There are many historical examples of financial panics where free markets tumbled into an enormous loss of wealth and damaging recessions that hurt all levels of society.
Paulson and Bernanke argue strongly that we are in such a crisis right now. I agree and prefer to err of the side of caution, believing the odds and magnitude of great harm from not acting outweigh the odds and probable harm of acting.
Q Where will the $700 billion come from?
A This is a Treasury program and the money will come from higher taxes or by adding to the national debt. In other words, it comes out of our pockets now, or out of our children’s pockets later. Paulson proposes spending up to $700 billion to buy up dicey securities. These supposedly will be sold off later, after markets stabilize, recovering some money, so the net outlay need not total $700 billion. But no one really knows what this recovery would amount to.
Q Is the plan a good one?
A Few people seem to think so.
Q What would a good plan include?
A Several things:
Transparency, so that everyone knows how much money is being spent, how decisions are being made, how risky or safe the securities are and what companies the debt is being bought from. The sort of anonymity that characterizes most borrowing from the Fed is a bad idea here.
Ongoing oversight and reporting to the public. The Constitution gives Congress the responsibility of deciding how to spend public money. Congress should not give this power to one individual, particularly since Paulson is out the door in January, after a new administration takes office. A special bipartisan oversight board composed of knowledgeable, respected people like Paul Volcker, Warren Buffett, Sam Nunn, Bob Dole and Michael Bloomberg is one good idea that’s been mentioned.
Audit and legal review. Paulson wanted complete exemption from any challenges in federal court. This is a bad idea. The General Accountability Office should have power to audit any aspect of the program, including financial records and statements presented by selling firms. And normal constitutional guarantees of federal court review should stand.
A fractional stake for the Treasury in the eventual recovery and future profits of companies that unload bad securities. The public is taking on great expense and enormous downside risk and should share in any eventual upside. The public now has a stake in insurance giant AIG and should get some stake in other firms that unload bad paper.
Paulson and Bernanke would criticize these requirements, arguing that too-stringent requirements will deter firms from participating. In that case, those companies and their shareholders should take their chances elsewhere.
Q Will the plan work?
A No one knows. Paulson accentuates the positive, but he is the guy who told Congress that if he had a “bazooka”— broad statutory authority to bail out mortgage giants Fannie and Freddie — he probably would never need to use it. Even if the plan provides temporary support to the stock market, the history of past crises demonstrates that things could fall apart six months or even a year down the road.
Bernanke once said that fallout from subprime mortgages would be well contained and that the bailout of investment bank Bear Stearns in March would quell financial market turbulence. He now warns that without this new plan, the chances of a bad recession are greater. What he doesn’t say is that the chances of a stiff recession are already at 99 percent. But I think he is correct that things are likely to be even worse without some package than with one.
No one should expect a magic recovery if some plan is implemented. Many banks still will fail, credit will remain tight, unemployment will rise, the dollar will fall and inflation will rise. But the situation could get far, far worse without one.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.