Will Paulson’s bailout plan create a monster?

Will Paulson’s bailout plan create a monster?

Like Nixon’s wage-price controls, the Treasury Secretary’s plan is no panacea
By ROBERT SAMUELSON
CALL it Paulson’s Panic. That’s both unfair and accurate. It’s unfair because Treasury Secretary Henry Paulson didn’t create the underlying conditions that led to today’s financial turmoil, and the failure for not quelling it is shared by Federal Reserve chairman Ben Bernanke. But it’s also accurate, because as world financial markets verged on panic, Mr Paulson himself panicked. He saw no remedy except a massive bailout: having the government buy up to US$700 billion worth of risky bonds.
 
Mr Paulson: Historians will judge whether his outsized US$700 billion proposal was necessary, but the notion that its congressional enactment would magically end the crisis may be wishful thinking 
Historians will judge whether his outsized proposal was necessary, but the notion that its congressional enactment would magically end the crisis may be wishful thinking. Americans often delude themselves that all problems can be ’solved’ if only government will act ‘boldly’. This may be another example.

Contrary to much commentary, Mr Paulson’s plan would not be the largest government intervention in the private economy since World War II. That distinction still belongs to Richard Nixon’s imposition of wage-price controls in August 1971. True, Mr Paulson would socialise unprecedented amounts of private debt; but Nixon asserted control over the entire economy. What’s fascinating are the possible parallels between the two episodes, starting with a shared irony: Both came from administrations committed to ‘free markets’.

When Nixon declared the wage-price freeze - a complete surprise because he had consistently opposed controls - the decision proved ‘wildly popular’, writes Rice University historian Allen Matusow in his book Nixon’s Economy. By one survey, 75 per cent of Americans supported it.

‘There was widespread public rejoicing that at last the government was protecting the people,’ Herbert Stein, a Nixon economist, later observed.

 
The difference between now and two years ago is that financial managers then thought they understood the system; now they know they don’t. Ignorance breeds risk-aversion and fear.
 
 
 
 
 
 
Consumer price inflation, which had been rising at a 4 per cent annual rate, dropped towards one per cent. People believed that by acting decisively government could outlaw inflationary psychology. It couldn’t.

Inflationary pressures built up under the artificial lid of the controls. Moreover, the faulty economic doctrines that produced inflation - easy-money policies aimed at maintaining ‘full employment’ of 4 per cent joblessness - remained. When controls ended in 1974, inflation exploded to 12 per cent. It averaged almost 9 per cent from 1975 to 1981. Only the brutal 1981-82 recession, imposed by Paul Volcker’s Fed and raising unemployment to 10.8 per cent, ended the wage-price spiral.

Mr Paulson argues that relieving banks of dubious mortgage-backed securities will ‘unclog’ the financial system and encourage essential business and consumer lending. Maybe. It’s true that these securities, because they cannot easily be valued, have created immense uncertainty.

Banks and other financial institutions reduced routine lending to each other; everyone worried that the other bank might be in trouble. Having the Treasury buy these mortgage securities, on which losses have already been booked, might minimise these fears.

The trouble is that fears extend beyond mortgage securities. It wasn’t just home mortgages that were bundled up into bonds and sold to institutional investors (pension funds, insurance companies, college endowments). Car loans, credit card debt and commercial real estate loans have been similarly packaged, US$900 billion worth in 2007. Naturally, doubts about the value of these securities have also increased. ‘Securitisation’ may survive, but this lending is already down (80 per cent in 2008), reports Thomson Reuters. Credit is tightening across the board; issuance of high-quality corporate bonds is down 22 per cent, while riskier ‘high yield’ bonds are down 65 per cent.

What we are discovering is that all the complex securities, combined with ever-greater international investment flows, have created a global financial system ’so arcane that few people can understand its workings’, writes David Smick in his book The World Is Curved: Hidden Dangers to the Global Economy. The difference between now and two years ago is that financial managers then thought they understood the system; now they know they don’t. Ignorance breeds risk-aversion and fear.

Like wage-price controls, Mr Paulson’s plan is no panacea. Banks, hedge funds, private equity funds and others are trying to reduce risk by ‘deleveraging’ - selling stocks and bonds to raise cash, increase capital and cut their own debt. The rush to cash is a hallmark of financial crises.

But what makes sense for one may be ruinous for all. Heavy selling depresses prices; lower prices then increase losses, deplete capital, prompt more selling and heighten fear. At best, Mr Paulson’s plan might pre-empt this spiral by allowing investors to unload their least attractive securities.

But it wouldn’t automatically stimulate new lending, revitalise ’securitisation’ or prevent more ‘deleveraging’. Time is needed. The rescue is being constructed so hastily that it may include all manner of flawed provisions: too much power for the Treasury Secretary; authority for bankruptcy judges to modify mortgages.

Congress faces a wrenching dilemma, imposed on it by financial markets and Mr Paulson. If it dawdles, it may invite the panic that Mr Paulson has brazenly predicted. But if it acts quickly, it may create a monster whose full implications - possibly adverse - emerge only with time. — The Washington Post Writers Group
Source : Business Times - 25 Sept 2008

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