The Confidence Game

There are some alternatives that would offer more pain for the banks, but less pain for the taxpayers

ANIRVAN BANERJEE
Director, Economic Cycle Research Institute, New York

SINCE THE US credit crisis began well over a year ago, the authorities have taken increasingly bold, even unprecedented, steps to tackle the problem. So why do we now face the prospect of the greatest US Government intervention in the markets since the Great Depression?

The reason is that, while most people are mesmerised by the shenanigans of the 800-pound gorrilla represented by the financial markets, they’re ignoring the elephant in the room driving that gorrilla crazy — namely, the deepening recession.

It is because of recessionary job losses that home foreclosures have been rising faster than markets had anticipated, increasing the inventory of unsold homes and slashing the value of the mortgage-related derivatives held by Wall Street houses. Because of the enormous leverage, the inexorable slide in home values has triggered an earthquake in which major institutions have collapsed.

This is a key reason why increasingly desperate and frequent interventions by the Federal Reserve and the Treasury Department have not worked, leading us to the current watershed. And what we hear now is that we face certain disaster if bad assets are not moved off the banks' books to restore confidence. According to Fed Chairman Ben Bernanke, if the credit markets are not functioning, “jobs will be lost, the unemployment rate will rise, more houses will be foreclosed upon, GDP will contract,” and “the economy will just not be able to recover”.

I have news for Mr Bernanke. All that will happen anyway, because the US is already in recession: it has been losing jobs for eight months now, and the unemployment rate has been rising for a year and a half. The bottomline is that the economy has seen cyclical declines in industrial production, employment, income and sales, a combination that defines a recession.

The notion that “the economy will just not be able to recover” without a bailout is absurd, because in a market economy, it is the wringing out of excesses (perhaps at considerable cost to certain banks) that sets the stage for a business cycle recovery. Of course, we will never know, because if Congress passes the bailout package and the economy shows little sign of a turnaround, we will be told that things would have been so much worse without the bailout.

What has many Americans upset is the government proposal to buy the mortgage-related paper from the banks at far above market prices (if the banks were willing to accept what the market is prepared to offer, they would not be waiting for a government bailout). The purchase of these assets is estimated to cost $700 billion — and many say the total price tag may be as high as a trillion dollars.

That is a staggering sum of money, even for the $14 trillion US economy. Some have said that the money would be enough to end world poverty. Perhaps that is an exaggeration, but to understand why Americans are so upset about this bailout, just consider this: If a trillion dollars were to be equally distributed to every Indian family, each Indian household would get two lakh rupees.

The political reality is that with six weeks to go before elections and the economy and markets in dire straits, it will be difficult, if not impossible, for politicians to refuse to provide the bailout for fear of being held responsible for the economy’s woes. While something sweeping does need to be done, there are clearly other alternatives that involve much less moral hazard, along with more pain for the banks, but less pain for taxpayers.

Yet such alternatives are unlikely to see the light of day as long as Treasury Secretary Hank Paulson and Bernanke are essentially coercing Congress into providing them with a carte blanche under the threat of being held responsible for something that has already begun — just not widely recognised yet — namely, a recession. The bailout package will be passed, but the recession will persist anyway.