Bail-out to where?
The 110 page U.S. Emergency Economic Stabilization Act of 2008 is certainly better than Paulson’s original 3 pageÂ proposal, but it falls so far short of what is needed that I wonder whether it will do more harm than good. Â
Despite its growth in size, it is still little more than a bail-out-come-swapÂ financing deal for the Â financial sector.Â The question is where and what will it lead to and there’s little sign of that.
They added a number of controls and conditions to Paulson’s original apalling plan, as well as other measures included for both Republicans and Democrats to get a consensus. Â Measures to help homeowners keep their homes, such as reducing interest rates and amounts owed will certainly help, but one would think that these are measures that any lender would employ.Â
On the postive side, it also includes provisions for the Treasury to get options and warrants for preferred shares in the bailed-out companies so the government can benefit from an upside to their share price.Â This is something that Joseph Stiglitz pushed for based on the Swedish experience.Â The media and the bill’s summary say this is a requirement, but it looks like an option (“may” rather than “shall”) in the actual text of the bill.
On the other hand, deep down in the billÂ appears to beÂ a provision that would allow financial firms to treat their losses on these securities as ordinary income for tax purposes, rather than at the lower capital gains rates.Â This would provide many billions in tax benefits to the companies affected.Â
Still, IÂ don’t see how it addresses the fundamental problems in the U.S. economy and it may in fact make them worse. Â Average housing prices in the U.S., as in many other countries including Canada, are still overvalued and they will need to come down more.Â Â The current housing boom has lasted twice as long as housing booms usually do and involved three times the average level of appreciation, according to the IMF April 2008 economic outlook.Â Given that housing busts tend to last twice as long and are twice as deep as stock market busts according to a IMF report from 2003, we still have a lot more downside.
The housing boom was extended by about five years or more by all the financial “innovation” and alchemy that sold all the leaden mortgage debt as a supposedly golden portfolios of financial instruments held by unsuspecting investors. Â This bail-out would then force the debts held by these investment bank Â speculators onto the public’s bill.
The rationale for this Emergency Act is that the U.S. economy is
1) suffering from a credit crunch or “credit lock-up”, and that
2) intervention is necessary to restore confidence in the U.S. economy. Â
I don’t know what evidence there is for a credit crunch or “lock-up” in the business sector. Â Certainly investment in residential construction is down, as it should be. Â However, there continues to be growth in non-residential investment in the U.S. (although investment in M&E did drop in the 2nd quarter).Â Corporate debt of the non-financial sector has increased at a fairly rapid clip in recent years in the U.S., but it is a smaller ratio of their assets than it was in 2002.Â Â
I don’t see how this will get money and credit flowing to the areas where it is needed: into productive investments in the economy and to the overburdened household sector.
This may sound Austrian school of me, but as far as restoring confidence in the economy and the financial sector, I’d have a lot more confidence in the U.S. financial system if these investment banks were allowed to go down or if they were taken over, rather than kept on life support as arm’s length financial zombie agents.Â Â Isn’t that what happened in Japan though in a more drawn out way?Â Â Â Then there’s the on-going problem of moral hazard that would come from such a massive bail-out for speculators.
Joseph Schumpeter’s theoriesÂ about the role of creative destruction inÂ capitalismÂ became popular a few years ago with the dot-com financier crowd, but now that destruction of parts of the financial system is happening, I don’t see a lot of creativity being shown–or that we want more in terms of financial innovation. “Innovation” has mutated parts of the financial sector into a cancerous growth on the real economy: do we really want to keep them going?Â
So what is needed?
I think that selected takeovers andÂ interventions rather than wholesaleÂ bailouts would be necessary to prevent financial meltdown from destorying the whole economy.Â Deposit insurance should protect the direct investments of most ordinary households from complete losses and the economy from bank runs.Â Pensions will be hit, but then they would under thisÂ bail-out anyways and these investmentsÂ can be hold for the longer term.Â
More importantly, what is needed are the essential elements of the new deal: regulatory and legislative reform, especially for the financial sector; reliefÂ and support forÂ the public to prevent a spiralling decline in demand; and re-investment in the economy.Â There’s a desperate need for the latter in terms of municipal infrastructure and to improve the energy efficiency and productivity of the economy.Â As the Apollo Allliance has shown, these investments could create millions of jobs while being good for the environment.Â
It’s important that this doesn’t throw Democrats off their plans to ensure broad health care coverage and to invest in child care and early education.Â If anything, it should help accerelateÂ themÂ to provideÂ greater social securityÂ and relief for the public.Â
These measures would do a lot more to increase confidence in, and improve the productivity of, the U.S. economy than a wholesale bail-out package for the financial industry.