Wall Street Bailout Won't Do Much to Help Ailing Economy
by Mark Weisbrot via reed 2008-10-11 10:27:05

It is now clear the approval by Congress of President Bush's $700 bailout package on Friday October 3rd has done nothing to ease the current financial crisis. Credit markets have worsened for several days after the bill passed the Congress. The stock market also plummeted to nearly ten-year lows.

So much for dire warnings from the Bush Administration that Congress was risking a Great Depression if it did not quickly fork over the dough. The bailout's supporters said Congress had to do something to unfreeze the credit markets. It didn't work.

There is a basic misunderstanding of the current financial crisis and economic recession that is widespread. Most people think that the current economic downturn - which will be officially designated a recession some time in the near future - is the result of the financial crisis. But this is not true. The current recession is mainly the result of a collapsing housing bubble. This bubble of more than $8 trillion dollars accumulated between 1996-2006, and it is only about 60 percent deflated so far. This means that even if all the problems in the financial system were miraculously solved tomorrow, the United States would still be facing a serious recession.

Of course the financial crisis can make this worse, as financial institutions cut back on lending and short-term interest rates for commercial borrowing rise. And we are indeed facing a serious financial crisis. But the bailout package is a wasteful and inefficient way of dealing with the problem of banks holding bad debt, mostly related to mortgages gone sour in the housing bust. It enables the U.S. Treasury Department to buy up "troubled assets" - mostly mortgage-related securities - from financial institutions, at prices that will likely be much higher than they are worth.

Economists across the political spectrum saw this as a wasteful and inefficient way to fill holes in banks' balance sheets. Ordinary citizens and taxpayers saw the bailout as an enormous rip-off, and flooded Congress with phone calls, defeating the bailout on its first vote.

Indeed, the most important ways that our government is currently holding the financial crisis in check do not involve overpaying banks for bad assets. The Federal Reserve and U.S. Treasury have intervened repeatedly to pour liquidity into the banking system. They have agreed to federally insure $3.4 trillion of money market mutual funds held by millions of Americans. This week the Fed created a new facility to buy commercial paper, the short-term debt issued by banks and corporations, where lending has been shrinking. The Federal takeover of Fannie Mae and Freddie Mac, and the nation's largest insurer, were also necessary to preserve the stability of the financial system.

All this is just the beginning of cleaning up the mess that has resulted from a de-regulated and un-regulated financial system gone wild. The government will have to take over more insolvent financial institutions and provide capital to others. It will have to take steps to help homeowners, to minimize foreclosures and evictions. And it will need to provide the largest fiscal stimulus package since the Great Depression, to prevent this recession from dragging on for years. The worst part about the bailout is that some politicians will say we can't afford the necessary stimulus because we just added $700 billion to the national debt.

Americans will have to fight for measures that protect the public interest, not the interests of those who made this mess. Treasury Secretary Henry Paulson made $163 million as CEO of Goldman Sachs in 2006. Now he and his former colleagues at Goldman are running the Wall Street bailout.

During the Asian financial crisis ten years ago, there was an expression for this kind of system: "crony capitalism."

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Statement on the Need for Coordinated Stimulus

By Dean Baker and Mark Weisbrot

The current economic crisis is the result of an extraordinary period of extreme economic mismanagement. The world's central banks, most importantly the Federal Reserve Board in the United States, made the decision to ignore, if not actively cultivate, the growth of asset bubbles. This was the case with stock market bubbles in the 90s and housing bubbles in the current decade.

They compounded this mistake by ignoring the explosive growth of credit and new complex derivative instruments. They allowed financial institutions to become hugely over-leveraged, ensuring that the collapse of the bubble would lead to major financial disruptions.

Finally, they failed to recognize the seriousness of the problem, understating the size of the problem at every step. This has slowed efforts to muster an adequate response to the situation. President Bush and other political leaders markedly worsened the situation when they raised the specter of the Great Depression and otherwise sought to raise fears in order to gain public support for the bank bailout package.

The meeting this weekend of the G-7 provides an extraordinary opportunity to begin the reversal of this dismal record. First, it is necessary to have a coordinated financial and monetary policy to stem the immediate financial crisis. This will require bank bailouts that focus on the direct injection of capital into the banking system, following the example of the United Kingdom earlier this week.

The financial system will also benefit from further cuts in overnight lending rates, especially by the European Central Bank (ECB). The ECB's focus on concerns over inflation at this economic junction is almost as foolish and potentially more harmful than the decision to ignore the growth of the housing bubble.

The other key component of an economic recovery package should be a coordinated fiscal stimulus. In the United States, this stimulus should be on the order of $300 billion to $400 billion (2.0-2.7 percent of GDP). This stimulus is essential for counteracting the sharp falloff in consumption that is following the loss of $5 trillion in housing wealth and President Bush's scare tactics for promoting his bank bailout.

The stimulus should be designed to quickly boost demand. In the United States, this can best be done by aiding state and local governments, extending unemployment benefits, tax rebates to low income individuals, accelerating infrastructure spending and support for energy conserving retrofits of homes and businesses. It is also essential that the dollar fall against other major currencies in order to bring the trade deficit back to a manageable level.

It is possible that even larger boosts to spending may be necessary to restore normal economic activity. The federal government must be prepared to spend whatever amount is needed to keep the economy creating jobs. This was the main lesson that we learned from the Great Depression. Concerns over deficits prevented the government from taking sufficient measures to boost the economy out of its slump until World War II left the government no choice. It would be an enormous tragedy for the country and the world if the United States were to repeat the same mistakes almost 80 years later.


Author retains copyright.

http://www.commondreams.org/view/2008/10/11-3

Recession? Depression? How Deep, How Far and What Can Be Done?
by Joshua Holland via rialator 2008-10-11 11:14:23

As the financial crisis gains steam, moving from overextended American households to global banking giants, fear of a major crash is spreading. Talk of "Another Great Depression" has entered the mainstream discourse, 1 out of 6 homeowners are "under water" -- owing more to the banks than their houses are worth -- and $2 trillion of retirement wealth has evaporated over the course of a few short months. The markets have not been "calmed" by the government's heavy interventions; the Dow Jones Industrial Average touched a five-year low this week, and is now 40 percent below its peak of one year ago.

The question on most people's minds is just how far and deep the fallout from the crisis will go. Are we looking at the kind of recessions we've seen -- and survived -- in the early 1980s, early 1990s and at the beginning of this century, or are we staring into an abyss that will be far more painful, one that will profoundly transform our lifestyles?

There's no definitive answer. We're in uncharted waters, and anyone who says they know what will transpire in the next few years is selling snake oil. But some deep thinkers who have a solid command of the structures of the global economy can help us understand the best- and worst-case scenarios, the way the crisis is changing some of the economic establishment's most cherished and long-standing assumptions and what role government -- the American government and those overseas -- might play in minimizing the damage created by Wall Street's excesses.

I contacted a number of leading experts this week -- all highly respected in their field -- to get their reads on the possible impacts of the financial sector's meltdown, the likelihood of the recent bailout having the desired effect and where we might go from here.

There was quite a bit of consensus on several points. First, all agreed that we're in the early stages of a deep recession. Second, most believed that it was in no way inevitable that the crisis would develop into a full-blown 1930s-style depression, and some were skeptical that such an event is even possible in today's economy. Third, all agreed that the length and depth of the crisis would hinge on the actions taken by governments in the coming months. Finally, there was something approaching a consensus that the economic and political establishment has been deeply shaken by the events of recent months, and that the banking mess might lead to a very different approach to governing the "free market."

The Worst-Case Scenario

In a nutshell, the lack of transparency in the system -- the fact that nobody knows precisely who's holding what liabilities on their books -- has the potential to lead to a global loss of confidence among investors and institutions, and what would effectively be the modern-day equivalent of a bank run on the myriad institutions that hold (or guarantee) "toxic" debt-backed securities.

That prospect has already led to a near-freeze in the flow of loans that individuals and businesses require, and if the credit system doesn't shake loose it will make the economic contraction that's already begun longer and more severe and lead to further financial losses.

That might create a vicious cycle in the "real" economy, as jobs are lost, people lose their homes, local governments' revenues -- in the United States, based largely on property taxes -- are cut and their work forces slashed.

As Max Wolff, an economist at the New School, wrote me via e-mail, "we're dependent on our banks. Thus, their pain is ours. Millions will be fired. Retirements will be decimated. Opportunity will vanish, (and) consumption will fall. Everyone is already deeply influenced. This will become more obvious and more painfully evident with each passing day. When it rains on the top of the hill, those who live on the bottom of the hill drown." He added, "there's now a major flight from all risk assets" which will "cause massive pain and dislocation in the developing world." Wolff predicted that "large sections of the consumption economy" will vanish, which will "slam into the leading exporters' markets and undermine much of the recent surge in commodity prices."

"We have now baked a severe and largely global recession into the cake," Wolff said. "The losses are already way too large to swallow. ... The numbers about failures from car dealerships, stores and many small businesses are alarming and will get worse." He added: "The epicenter of the crisis is already shifting out of America and finance."

That point was echoed by Walden Bello, a giant in the global justice movement and founder of the Third World Network, a group of NGOs focusing on development and poverty relief. Bello offered that "given the globalization of national economies over the last two decades, the downturn is going to be a synchronic one, and there is going to be no decoupling of one region from another." The crisis in the United States will continue to expand worldwide, at just the moment when international cooperation is most necessary. "For instance," Bello said, "China's main market is the United States, and China purchases many of its industrial inputs and raw materials from Japan, Korea and Southeast Asia. So Japan and Southeast Asia cannot rely on Chinese demand to make up for a fall in U.S. demand. China, East Asia and the U.S. are tied together like prisoners on a chain gang."

Robert Pollin, co-director of the Political Economy Research Institute at the University of Massachusetts, thinks there's "a good chance this crisis will become a general crisis, pushing unemployment up to the 10 percent level, as we experienced in 1982-83. This would mean a severe slowdown for everyone," regardless of whether they're in the financial markets or struggling to keep up with a mortgage. "A severe employment crisis would hit lower-income people the worst -- that is, people who have little savings and rent, rather than own, their homes," he wrote me via e-mail. Pollin also believes, "the odds are closer to the worst- rather than the best-case scenario, mainly because I think we are already too far gone for this to be a mild downturn, no matter how successful" the government's bailout of Wall Street might be.

Is a Major Crash Inevtitable?

"I won't go so far as to draw parallels with the Great Depression," James Galbraith, a senior scholar with Bard's Levy Economics Institute, told me by phone. "I don't think that's appropriate."

In the best-case scenario, Galbraith said, "the government has the power and should use it, first of all to secure the liquidity of the banking system and the payment system, and then to resolve the underlying housing problem. These things should be done, can be done and if they are, the whole experience would be relatively mild. I mean, it'll be severe by the standards of the past 20 years, but it can be contained and resolved in the next two to three years." He predicted that "if the system is kept liquid," the crisis may be short in duration. "What will happen is that the financial sector will shrink, it will disintermediate, but it will not collapse."

When I interviewed Dean Baker, co-director of the Center for Economic and Policy Research, two years ago, he was one of a very few voices warning of the dangers the housing bubble posed to the larger economy (at the time, he had been discussing it for a couple of years). This week, Baker said that the best-case scenario for the underlying housing market would be for prices to "quickly fall by 10 to 15 percent, returning to their long-term trend levels." That would allow the real estate market to begin to clear "a vast overhang of vacant properties" and unfreeze the credit markets.

In the bigger picture, Baker argued that the recession, while painful, might be mitigated by "large injections of government stimulus ($300 billion to $400 billion) combined with a substantial fall in the value of the dollar." A broader stimulus package -- cash injected into the economy to help keep goods and services moving -- "can sustain demand in 2009, while the fall in the dollar can begin to boost net exports in the second half of 2009 and 2010." Baker added, "even in this case, unemployment is almost certain to rise above 7 percent by early 2009, but hopefully will not get too much higher."

Although Pollin is not optimistic about the prospects of a quick recovery, he told me that in his view the best-case scenario "at this point would be a mild recession that lasts roughly a year. This would be similar to the recession that occurred after that last financial crisis, the 2001 stock market crash. In that case, unemployment rose to only about 6 percent, where we are now. Financial markets would stabilize over the next six months."

A Positive Outcome Will Require Good Governance

All of the experts I surveyed agreed that the modified "Paulson Plan" passed by Congress won't work, but many also thought a large injection of cash into the banking system was a necessary first step. The crucial factor in our economic prospects for the coming years is what will follow next.

Robin Hahnel, an economist at American University, told me that "while it's not necessary for the U.S. financial crisis to become a world financial crisis, and for the U.S. recession to become a depression of the magnitude and duration of the Great Depression of the 1930s, if the short-term, medium-term and longer-term responses continue to be as incompetent as the short-term response in the U.S. has been so far, this worst-case scenario could happen." Hahnel noted that "for the most part, governments in Europe have gone about their bailouts in a competent way -- building up equity in stricken financial institutions by buying shares, making loans to banks in exchange for banks making the loans they have refused to make so far, and making credible government guarantees to depositors."

Pollin agreed. "I do think the bailout will contribute to stabilizing global financial markets, relative to a situation where the U.S. government did absolutely nothing," he said, noting that it was inaction that resulted in the demise of Lehman Brothers -- the decision "to allow the free market to work as its supposed to" -- and that "led to the total panic that has since gripped markets."

But, he added, "that doesn't mean that this was the right bailout strategy. It wasn't. Indeed, it was close to being the worst possible strategy ... because it did nothing to assist homeowners who face foreclosures; it contributed to the sense of panic by emphasizing this huge sum -- $700 billion -- coming out of the Treasury, when in fact, the Fed could have managed the crisis without any tax dollars being committed." He added that the plan "didn't offer any measures to regulate the markets and thereby create a sense of stability moving forward."

Pollin laid out steps that he believed must follow the government's interventions thus far if we hope to stave off a far deeper crisis, including: a new system of financial regulations; increasing the cash reserves required of institutions that deal in the speculative economy; restructuring people's mortgages; and a significant economic stimulus package designed to "create jobs and get people a new stream of income."

Baker emphasized that "paying too much for banks' bad assets is a very inefficient way to address their main problem -- they're under-capitalized" (meaning they don't have enough cash on hand to cover their potential liabilities and also make new loans). In calling for a major stimulus package for the "nuts and bolts" economy, Baker noted that it's "far more efficient to directly inject capital."

Galbraith told me that the "Paulson Plan" was an "act of desperation from an overwhelmed Treasury Department" and that to the extent it might "do anything at all" it would do so "both inefficiently and slowly." He was adamant that it had to be considered as only a first step, and that other measures must follow in short order.

Galbraith said it's "absolutely essential" that the government do more to protect homeowners. "If nothing is done, the fact that there is excess inventory of 4 million homes in foreclosure and many more to come" will be a drag on the housing and credit markets "for a long time."

But that's just the first of what he called "three necessary steps" for stabilizing the "real economy." The second is dealing with the inevitable fiscal crisis that will face states and localities, which "will be cutting expenditures as their property taxes implode." Galbraith urged the federal government to bail out struggling local governments with revenue-sharing plans and infrastructure investment, "on the condition that they maintain their level of spending," meet "their public sector needs" and avoid "mass layoffs of their work force." Finally, Galbraith said, the elderly and near-elderly who have seen their retirement accounts take a heavy hit are going to need help -- through increased Social Security payments if need be.

If those steps aren't effective, Galbraith suggests that more dramatic measures be taken, including a temporary suspension of the payroll tax, which would give every working person (making under $97K per year) an effective 7.65 percent raise to make ends meet, while giving businesses a tax break on their payrolls.

Those measures would greatly expand a budget deficit that has already become bloated during the Bush era. But, as Pollin pointed out, "The fiscal deficit in 1983 was 6 percent of GDP -- that was under Reagan -- and that pulled the economy out of crisis then. Right now, the fiscal deficit is in the range of 3 percent of GDP. Increasing the deficit to, say 5 to 6 percent of GDP now would inject more than $300 to $400 billion in new spending into the economy -- to go for state and local spending on schools and health care, investments in energy efficiency and renewable energy, raising unemployment insurance benefits and food stamps."

Reason to Be Hopeful, as a Failed System's Flaws Are Exposed to the Light of Day

It was during an earlier economic crisis that Richard Nixon famously said, "we're all Keynesians now." According to those I contacted, that's more true today than at any time in recent history; there's broad agreement in Washington that more government action will be required.

When I asked Galbraith about the prospect of running up large deficits, he responded that today "no serious person" in the economic establishment is a deficit hawk, adding that "it's striking how quickly consensus is moving" in Washington toward the idea that a major bailout of the "nuts and bolts" economy is needed. (Deficit spending to kick-start the economy during a downturn, as opposed to financing tax cuts for the wealthiest or paying for wars of choice, is a tried-and-true policy tool.)

Despite the general consensus among the experts I surveyed that we are almost certainly headed into very rough waters, there was cause for optimism as well, in that most agreed that aggressive and coordinated actions by government could contain the damage. More importantly, the bright spot in this crisis may be (stress on the word may) the blow it deals to the center-right, anti-regulatory paradigm that has guided economic policymakers both at home and in many of the world's capitals over the past three decades.

Of that paradigm, Bello said, "goodbye to all that," adding, "We should not underestimate the sea change that is occurring. Neoliberalism and free-market fundamentalism have been severely discredited, as has globalization." He predicted that "capitalism itself will come under severe questioning, and many will think that regulating or re-regulating it is not enough. I think you will find the same fundamental questioning happening throughout the world." He added, "Radical economics and Keynesian economics will regain respectability, and neoclassical or neoliberal (trickle-down) economics will be delegitimized."

Pollin wrote that he has hope that "the commitment to financial deregulation by mainstream economists and politicians -- Democrats as well as Republicans -- is now dead." He added: "It is time to recognize that unregulated financial markets always have, and always will, cause financial crises. There are no historical exceptions to this observation at all. This point has to be grasped."

According to Baker, the degree to which that point sinks in is an open question. "In principle," he said, "the Wall Street mentality that has dominated the political thinking of both parties should be on the defensive. These guys had it all their own way, and it led to a colossal disaster." But, he added, "in this country, failure doesn't count against you. It will be necessary for progressives to demand an end to Wall Street-driven policy. If there is successful organizing on this front, then it is possible that the next administration will take a very different course. But the Wall Street boys have to be pushed away -- they will not surrender power voluntarily."

Hahnel offered a word of caution, noting that "80 years ago people thought (unregulated) free market finance was dead. If the funeral had a name, it was Glass Steagall (the New Deal-era legislation that made banks choose between issuing mortgages and securities). In 1999 Phil Graham, Robert Rubin and Bill Clinton killed Glass Steagall, signaling the return and triumph of free market finance. Hopefully this crisis will kill free market finance once and for all. 'Never again' is the appropriate response."

He added what was perhaps the most salient point: "I hope this lesson will be the beginning of a larger lesson: The economics of competition and greed does not serve us well."


© 2008 Independent Media Institute

http://www.alternet.org/story/102379/